Democrats and Republicans are busy "lobbying" the SEC these days. Republicans want the SEC to nix Nasdaq's proposal for new listing rules regarding board diversity and disclosure. Democrats want the SEC to beef up its insider trading rules in connection with Rule 10b5-1 plans. Will either find a receptive audience?
Letter from Republican Senators. In a letter to Acting SEC Chair Allison Lee, Senator Pat Toomey and the other Republican members of the Senate Committee on Banking, Housing, and Urban Affairs asked the SEC to reject the Nasdaq board diversity proposal. You might recall that, at the end of 2020, Nasdaq filed with the SEC a proposal for new listing rules regarding board diversity and disclosure. The new listing rules would adopt a "comply or explain" mandate for board diversity for most listed companies and require companies listed on Nasdaq's U.S. exchange to publicly disclose "consistent, transparent diversity statistics" regarding the composition of their boards. Under the proposal, new Rule 5605(f), Diverse Board Representation, would require Nasdaq-listed companies, subject to certain exceptions, to have at least one director who self-identifies as a female, and to have at least one director who self-identifies as an Underrepresented Minority or LGBTQ+. The term "Underrepresented Minority" reflects the EEOC's categories and would include Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, and two or more races or ethnicities. If a company did not satisfy the new diversity "expectations," it would be required to explain, in its annual proxy statement or on its website, why it "does not have at least two directors on its board who self-identify in the categories listed above." In addition, under new Rule 5606, Board Diversity Disclosure, Nasdaq-listed companies, subject to certain exceptions, would be required to provide annually, in a proposed Board Diversity Matrix format, statistical information regarding the company's board of directors related to a director's self-identified gender, race and self-identification as LGBTQ+. The disclosure would be required in either the company's proxy statement for its annual meeting or on the company's website. (See this PubCo post.)
While the Senators applauded board diversity as a concept, they believed that Nasdaq was, among other things, acting outside its proper scope as an SRO:
"it is not the role of NASDAQ, as a self-regulatory organization, to act as an arbitrator of social policy or force a prescriptive one-size-fits-all solution upon markets and investors. NASDAQ's narrow concept of mandated diversity, one that prioritizes race, gender, and sexual orientation, and pressured board diversity, misses the mark. It interferes with a board's duty to follow its legal obligations to govern in the best interest of the corporation and its shareholders. It violates central principles of materiality that govern securities disclosures, and finally, it harms economic growth by imposing costs on public corporations and discouraging private corporations from going public."
The Senators argued that the Nasdaq proposal would interfere with a board's fiduciary responsibility to govern in the best interests of shareholders because it "ignores the dictum, most famously articulated by Warren Buffett, that board members should be chosen on merit and ability to improve corporate performance. NASDAQ's proposal compels the prioritization of a narrowly defined concept of diversity in board membership over merit." They also viewed the voluminous research provided by Nasdaq in support of its proposal to be inadequate because it didn't show that diversity caused improved corporate performance or address sufficiently research that is contrary to Nasdaq's that showed little correlation with performance. In addition, they viewed the proposal as unnecessary because corporations are already seeking to diversify, and "the imposition of a mandate with strict deadlines may undermine the ability of corporations to find the best suited candidates for them." Further, Nasdaq's definition of diversity was, in their view, too narrow; it focused on gender and race to the exclusion of religion, age, political affiliation, geography, education, veteran's status and physical disability. Interestingly, the Senators also raised the issue of whether Nasdaq's board recruiting solution, albeit complimentary for the first year, might create potential conflicts of interest after that.
They also questioned whether Nasdaq's proposed disclosure requirement would elicit information that is truly material because, in their view, the required disclosures would not help a reasonable investor evaluate a company's performance. The materiality concept, they said, "preserves social policymaking for democratically elected representatives, not regulators, such as the SEC, or quasi-regulatory entities, such as NASDAQ" and "prevents the development of an unstable, politicized securities regime that would be ripe for abuse of power." Here, they contended, Nasdaq "appears to be motivated by an inappropriate desire to influence social policy."
Finally, they contended that Nasdaq's proposal "would harm economic growth by introducing unnecessary regulatory costs, decreasing the attractiveness of U.S. capital markets, and presenting an additional concern for corporations deciding to go and stay public." In addition, they maintained that the risks of the proposal "could cause some private corporations to avoid going public at all."
Although Lee's views on the Nasdaq proposal are not known, she has been a forceful proponent of diversity disclosure, including through an SEC mandate. In recent dissenting statements, she has been critical of the omission by the SEC of diversity disclosure mandates. For example, in her recent dissent in voting on proposals regarding amendments to Reg S-K disclosure requirements related to the descriptions of business, legal proceedings and risk factors (see this PubCo post), Lee did not hesitate to express her misgivings about the failure of the amendments to mandate disclosure regarding diversity.
And, in recent remarks to the Council of Institutional Investors Fall 2020 Conference, Diversity Matters, Disclosure Works, and the SEC Can Do More, Lee reinforced her view that the SEC needs to do more in terms of a specific mandate for diversity disclosure. In her view, if we are looking for "economic support for diversity and inclusion (instead of requiring economic support for the lack of diversity and exclusion), the evidence is in." For example, there is substantial research showing that "board diversity corresponds to lower stock volatility due to the adoption of less risky financial policies, and firms with more diverse boards invest more in research and development and therefore are better at fostering innovation." Similarly, McKinsey
"found that companies with the greatest ethnic diversity on executive teams outperformed those with the least by 36 percent in profitability. The same report found that companies with more than 30 percent women on their executive teams are significantly more likely to outperform those with fewer or no women executives. Fortune 500 firms with the highest proportion of women on their boards outperform those with the lowest. Companies with higher than average diversity on management teams report higher revenue from new products and services. More women in senior positions is associated with higher return on assets. The list of tangible performance benefits goes on."
That explains why investors now consider diversity in their voting decisions-even quant firms incorporate it into their algorithms, she said. It is also widely acknowledged that a lack of diversity may represent "a significant reputational risk for companies and may hamper their ability to recruit and retain top talent." Companies are also aware, with regard to the recent flood of public statements expressing commitments to racial justice, that "it may matter to their bottom line whether we as consumers perceive them to have a sincere commitment to racial justice." (See this PubCo post.)
Letter from Democratic Senators. On the other side of the aisle, three Democratic Senators, Elizabeth Warren, Sherrod Brown and Chris Van Hollen, all members of the same committee, the Senate Committee on Banking, Housing, and Urban Affairs, submitted a letter to Lee appealing for SEC action on an entirely different matter-Rule 10b5-1 plans. They contended that new evidence showed that executives were "abusing these plans to obtain huge windfalls at the expense of ordinary investors. These abuses, and the plans' lack of transparency, damage investors and risk undermining public confidence. We urge you to improve disclosure and enforcement of 10b5-1 plans and to consider further reforms that would prevent abusive practices."
Corporate executives are constantly exposed to material non-public information, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, Congress developed the Rule 10b5-1 safe harbor. In general, Rule 10b5-1 allows an insider, when not in possession of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms-that are not subject to the insider's further influence-for determining when the insider can sell shares, without the risk of insider trading. To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule. In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made "on the basis of" MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the insider had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established. After the plan has been established, the insider can modify it, so long as he or she is not aware of MNPI at the time of the modification, and can terminate it at any time-even if the insider is in possession of MNPI at the time-because the termination (and related cancellation of any planned trades) is not "in connection with the purchase or sale of any security."
In support of their request, these Senators cited research suggesting that initial trades set up by 10b5-1 plans often appear to be based on MNPI and that executives modify or cancel their plans "in response to inside information in order to increase their own profits." One recent study they cited "found that 'public companies disproportionately disclose positive news on days when corporate executives sell shares under predetermined 10b5-1 plans,' distorting stock prices for other investors." The Senators also observed that, while plans were intended to set the time for trades months in advance, "it is not unusual for the plans to be modified days or hours before a major public announcement." Another study "found that 'executives at over 100 companies used plans that executed a trade the same day the plan was adopted.' These short-term trades undermine the purpose of the 10b5-1 provision by eliminating the distance between the executive's access to inside information and their transactions. Concerns about this use of 10b5-1 plans led the SEC Chair to call for a 'cooling-off period' of four to six months between the adoption of a 10b5-1 plan and the execution of its first trade. But the SEC has yet to take action on such a cooling-off period, which would mark a significant change, affecting 70% of plans adopted from 2016 to 2019."
In a letter to Representative Brad Sherman in September 2020, then-SEC Chair Jay Clayton discussed the need for "good corporate hygiene" in connection with Rule 10b5-1 plans. Although well designed and administered 10b5-1 plans that eliminate "any suggestion of impropriety or unfairness" can advance good corporate governance, he said, some practices, even where legal, can "raise questions of interest alignment and fairness," especially issues surrounding trading/absence of trading in the context of plan implementation, amendment or termination. Clayton contended that inclusion in 10b5-1 plans of "mandatory seasoning"-waiting or "cooling-off" periods of perhaps four or six months-after adoption, amendment, suspension or termination and before trading can begin or resume is appropriate, demonstrates good faith and bolsters investor confidence in management and the markets. (See this PubCo post.)
The Senators also contended that 10b5-1 plan problems disadvantage other investors. According to experts, they said, many 10b5-1 plans operate by setting a trigger price that prompts a sale of shares when the price is met (apparently "one of the primary mechanisms leading to large stock sales on the days of 'good news' announcements"). While it may be not necessarily be an abuse of MNPI, the Senators argued that the lack of transparency adversely affected investors: large sell orders from the company's executives drag down the market price, but buyers are "unaware of this dynamic until, at the earliest, executives' trades are disclosed two days after the fact-if at all." Many are disclosed late, they observed.
In Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse from the Rock Center for Corporate Governance at Stanford, the authors examined data from over 20,000 Rule 10b5-1 plans to investigate the extent of insider trading abuse. The study found that some executives did use 10b5-1 plans to conduct "opportunistic, large-scale selling that appears to undermine the purpose of Rule 10b5-1" and highlighted three "red flags" that could be used to detect potentially improper exploitation of Rule 10b5-1. Although the authors acknowledged that they could not determine for certain whether any insiders that avoided losses or otherwise achieved "market-beating returns" actually traded on the basis of MNPI, they contended that average trading returns of the magnitude they found in the study "are highly suspect and, as such, these red flags are suggestive of potential abuse." The three "red flags" that the authors associated with opportunistic use of 10b5-1 plans were:
"1. Plans with a short cooling-off period
2. Plans that entail only a single trade
3. Plans adopted in a given quarter that begin trading before that quarter's earnings announcement."
(See this PubCo post.)
Recommendations identified in the letter that were offered by experts included requiring cooling-off periods, public disclosure of 10b5-1 plans and trades, better enforcement of filing deadlines and enforcement of penalties "when executives benefit from short-term windfalls that do not translate into long-term gains..The SEC could consider working with Congress to modify [Section 16] to cover profits obtained through 10b5-1 sales that follow disclosure of material information that cause share prices to fall in the period immediately following the disclosure."
The Senators also asked for responses to the following questions:
"1. What actions does the SEC currently take to ensure that 10b5-1 plans are compliant with the Commission's current rules and requirements?
2. How many enforcement actions has the agency taken with regard to 10b5-1 plans in the past five years? Please provide a list and summary of all such actions.
3. Has the SEC taken action to require a 'cooling off period' between the adoption or amendment of any 10b5-1 plan and any stock sales under that plan?
4. Does the agency intend to require that 10b5-1 plans are disclosed publicly and posted online in advance of any trades made under that plan?
5. Has the SEC considered or evaluated modifications of regulations to ensure that 10b5-1 adequately covers 'short-swing' purchases?
6. What other actions has the SEC taken or are under consideration to prevent the abuse of 10b5-1 plans?"
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.