Tuesday, at the CNBC Financial Advisor Summit, SEC Chair Jay Clayton was interviewed by CNBC's Bob Pisani, touching on a variety of issues, including SPACs, proposed changes to Form 13F, ESG ratings and investing, emerging market listings and other topics of interest. No breaking news, but some insight into the SEC's thinking on these subjects.
SPACs. Very loosely, SPACs are companies with no real operations formed to raise capital in an IPO that would be used to acquire an operating company after the IPO, essentially acting as vehicles for the acquired operating companies to go public through the acquisition transactions. With regard to SPACs and the need to monitor this innovative new "product" for going public, Clayton noted that, while he liked the concept of more competition in the distribution of stock, it was important that investors understand that SPACs are a different animal than an IPO, especially with regard to price discovery, diligence and motivations:
"I think what investors need to understand and what the professionals who are involved need to help them understand, is that it's not the same as an IPO. The motivations of the SPAC sponsors, the motivations of the company that they're purchasing and the de-SPACing transaction are different from the motivations of your traditional owners and management teams in an IPO. Not saying that's right or wrong, but they're different; investors should understand that. Also, there's something that happens in the IPO process that doesn't happen as much in the de-SPACing process, and that is institutional investors on your traditional road show kick the tires on the company. That doesn't happen to the same extent in the de-SPACing transaction."
In an interview on CNBC with Andrew Ross Sorkin conducted in September, Clayton had also addressed the recent SPAC frenzy, including the importance of good disclosure about the incentives and motivations of those involved. Right now, he said, the SEC is particularly focused on the compensation and incentives that go to the sponsors of the SPAC. (SPAC sponsors typically receive a portion of the SPAC's equity to provide compensation and incentives for their work in creating the SPAC, soliciting investors, identifying acquisition targets and, sometimes, assisting the surviving public company to meet its corporate objectives and goals post-merger.) For example, how much equity do they have initially? How much do they receive at the time of the acquisition transaction? The SEC wants to be sure that the investors understand the incentives involved and that, at the time of the investor vote on the acquisition transaction, the disclosure to investors is as rigorous as in an IPO.
Sorkin commented that it can be especially difficult to understand the SPAC compensation schemes. How did Clayton envision that it should look? Should there be full hypothetical examples provided showing the SPAC sponsor's compensation? Clayton responded that, if hypotheticals are necessary to explain the compensation and incentives, then the SPAC should provide them. Again he emphasized that the public needs to understand the motivations both at the point of initial distribution of the SPAC into the market and also when the acquisition transaction takes place with the operating company. The SEC can't dictate what the compensation structures should be, but it can require that they be fully disclosed.
Form 13F reports. Generally, institutional asset managers are required to make quarterly filings to reports their holdings if they exercise investment discretion over accounts aggregating $100 million. The SEC has recently proposed increasing the reporting threshold from $100 million, which has been the threshold for 40 years, to $3.5 billion, a change that was expected to capture about 90% of prior filings. To put it mildly, the proposal has been widely panned. Pisani asked whether the SEC planned to go forward with the proposal? Clayton's response: "Yeah, Bob. We learned a lot." Acknowledging that the proposal elicited substantial criticism, Clayton nevertheless seemed a bit nonplussed that the objections did not relate to the basic purpose of the form, but rather to other reasons that were "interesting" and "good," but perhaps not what he expected. For example, one objection was that commenters wanted "to see what strategies...fund managers were using, what are the professionals doing in their strategies." Clayton noted that the form was not designed for that purpose: it was "45 days late, it includes only long holdings, not all long holdings. So, to the extent you're using these to follow, as some people might call it the 'smart money,' understand that that's a very imperfect way to look at that. It's not what the form was designed for, but it's—I will say this, it is very interesting to me how many people seem to use it for that purpose."
Pisani observed that reporters also use the form and regularly complain about the timing. He wondered why the SEC doesn't "change it from 45 days to 15 days and make it shorter and make it more useful to people?" To that, Clayton responded that the question has long been debated as to whether shortening the filing deadline would allow others to take "unfair advantage" of proprietary strategies: "So how long of a delay do you have before that kind of trading information is no longer proprietary information or should no longer be protected as proprietary information? Good question."
In addition, in their comment letters, companies said that these forms were "the only way we have to effectively identify who our shareholders are," which Clayton viewed as "a problem. If we're using 45-day trailing filings of a select group of people to help companies figure out who their shareholders are in the day of electronic communication, that's something we've got to address. And I will throw these terms out there: OBO/NOBO, it's how we interact through the brokerage system with ultimate beneficial owners. But we need to look at that." Sounds like this might be a topic to be addressed in connection with potential changes to the proxy process?
At the SEC's proxy process roundtable in November 2018, one of the topics discussed was proxy voting mechanics and technology. There were many complaints about issuers' difficulty in communicating with beneficial owners. First, questions were raised about the ongoing retention of the NOBO/OBO distinction, particularly the apparent default to OBO status for clients at many brokers. One panelist partially attributed the decline in retail participation in the proxy process to the OBO default and suggested that the SEC attempt to survey why investors choose to be OBOs—are they confusing anonymity as an investor with anonymity as a proxy voter? If so are there other ways to address that issue? Some panelists questioned whether shareholders really understand the difference—or care. To facilitate engagement, issuers wanted the ability to communicate directly with all holders by email, and some noted that, even for NOBOs, email addresses were not available. In addition, there were costs associated with obtaining the NOBO names. Nevertheless, revelation of the shareholders' names and contact information, whether to companies or to activists, can be viewed as privacy issue—a hot topic these days. (See this PubCo post.)
So will the SEC move forward with the proposal, Pisani reiterated? Clayton responded that "where we are, Bob, is we need to examine this, and we need to examine all those issues." What is right threshold? Why are people using the form for unintended purposes? Pisani interpreted that as a "definite maybe."
According to the Financial Times, the SEC received "almost unanimous opposition from companies and investors against plans to allow most hedge funds to obscure their stock holdings." Strategists at a major investment bank "said that of the 2,262 letters submitted to the SEC during its consultation period, 99 per cent opposed the new rule, reflecting concerns that the switch could allow activist investors to quietly build up stakes and seek to force companies into new strategies. 'No recount necessary,' the bank wrote. 'After it reviews all the comments, we expect the SEC will withdraw the proposal.'" According to the article, the proposal would require reporting by "only the world's largest 550 investment managers," allowing most hedge fund activists to "keep their portfolios secret." Clayton had argued that the reporting requirements were unnecessarily burdensome for "smaller fund managers—a claim met with skepticism by small funds as well as industry bodies, some of which say the cost of filing 13Fs is negligible and the process is now largely automated." Comments in opposition were submitted by, among others, the Business Roundtable, the U.S. Chamber of Commerce, CalPERS, the NYSE, Nasdaq and the CFA Institute. Commenters objected that companies would be unable to monitor exempt activist investors and that many smaller companies "would be particularly hard hit" and unable to determine the holders of large proportions of their shares.
ESG investing. Pisani remarked that there have been "massive inflows this year" into ESG investing, but that there has also been pushback from some groups "that view this as pushing a social agenda; that climate change, boardroom practices, clean energy are really social agendas and is it sort of an appropriate thing for financial advisors to be pushing or asset managers." First, Clayton questioned whether ESG scores are really too subjective to convey valuable investment information and whether, to the extent that scores are used for marketing to investors, investors really understand "what that means from a return perspective and investment philosophy perspective?" On the question of values versus value, Clayton asked whether the decision was really about capital allocation:
"It is terrific if somebody says, 'Look, I think that our economy is going to go through a transition. I want to be in front of that transition, and I want to know how to do it.' That's a fundamentally, you know, valid way to invest, absolutely. But if somebody is sitting there saying, 'I want to drive the transition of our economy using SEC rules,' that's a different story. And trying to, you know, handle the difference between those two and convey investment decision information to people as effectively as practical, that's our job."
Where a problem can arise in touting ESG, he said, is when an investment is marketed as, for example, "environmentally friendly or something else, and there's no rigor behind whether it actually does that." The marketing and the substance need to "line up."
Emerging market listings. For over a decade, the PCAOB has been unable to fulfill its SOX mandate to inspect audit firms in "Non-Cooperating Jurisdictions," or "NCJs," including China, and there have been various legislative and regulatory efforts to address that issue, including potential de-listing. Asked the status of these efforts, Clayton responded that dialogue with regulatory counterparts in China is continuing; however, the issue regarding PCAOB inspections has been around a long time. Clayton viewed that as "a problem, because this is a fundamental part of our investor protection. And what we're working on is whether we're going to continue to allow companies that do not allow PCAOB inspections to list their securities in the U.S. It's a recommendation from the President's Working Group, and the staff here at the SEC is moving forward on proposals that would implement that, that would go out for public notice and comment."
The President's Working Group developed five recommendations designed to "protect investors by ensuring a level playing field for all companies listed on U. S. exchanges":
"(1) Enhanced Listing Standards for Access to Audit Work Papers. Enhancing the listing standards of U.S. exchanges to require as a condition to initial and continued exchange listing:
(a) PCAOB access to work papers of the principal audit firm for the audit of the listed company; or
(b) Companies that are unable to satisfy the 1(a) standard as a result of governmental restrictions on access to audit work papers and practices in NCJs may satisfy this standard by providing a co-audit from an audit firm with comparable resources and experience where the PCAOB determines it has sufficient access to audit work papers and practices to conduct an appropriate inspection of the co-audit firm.
To reduce market disruption, the new listing standards could provide for a transition period until January 1, 2022 for currently listed companies from NCJs to come into compliance. The new listing standards would apply immediately to new company listings once the necessary rulemakings and/or standard-setting are effective.
(2) Enhanced Issuer Disclosures. Requiring enhanced and prominent issuer disclosures of the risks of investing in NCJs, including issuing interpretive guidance to clarify these disclosure requirements to increase investor awareness, and more general awareness of the risks of investing in such companies.
(3) Enhanced Fund Disclosures. Reviewing the risk disclosures of registered funds that have exposures to issuers from NCJs to enhance the disclosures by these funds, including issuing interpretive guidance to clarify the disclosure requirements to increase investor awareness of the risks of investing in such funds.
(4) Greater Due Diligence of Indexes and Index Providers. Encouraging or requiring registered funds that track indexes to perform greater due diligence on an index and its index provider, prior to the selection of the index to implement a particular investment strategy or objective.
(5) Guidance for Investment Advisers. Issuing guidance to investment advisers with respect to fiduciary obligations when considering investments in NCJs, including China."
With regard to the enhanced listing standards, if a company is unable to meet the requirement of PCAOB access to audit work papers of the principal audit firm, the Report recommends that the company be able to satisfy this standard with a "co-audit from an audit firm with comparable resources and experience where the PCAOB determines it has sufficient access to audit work papers and practices to conduct an appropriate inspection of the co-audit firm." That is, the company would be required to engage an affiliated U.S.-member registered public accounting firm that would serve as the principal auditor of the company's financials through a co-audit arrangement. While the PCAOB currently permits a principal auditor "to use the work and reports of other independent audit firms that have audited the financial statements of one or more subsidiaries, divisions, branches, components or investments included in the consolidated financial statements," the "co-audit" concept would apparently require the U.S. firm to "supervise the work of the NCJ Firm, such that the NCJ Firm's work is performed under the U.S. Firm's guidance and control." Accordingly, new SEC rulemaking or PCAOB standard-setting would be required. (See this PubCo post.)
Retail investors. After acknowledging the benefits of broader participation of retail investors in the markets, Pisani asked whether, with regard to investments that may be very dicey, the SEC should do more than just require disclosure: "I know you're very big on disclosure, warning people. But I'm wondering if, in certain circumstances, the SEC might not be able to do a little bit more than just warn people and write something in big crayon on the form saying, 'This is a risky investment.'...But I'm wondering if there are situations where the SEC could just jump in and say—clearly define what is suitable, what is not suitable, without getting into the nanny state where you're telling people what to invest in?" Clayton agreed that more long-term investing by the public is "terrific," but added that "there are a number of products that just aren't appropriate for most retail investors, and we're doing a lot more to make it clear what those types of products are.... We don't want our long-term retail investors being exposed to those without a great deal of dialogue with the financial professional." Different products are right for different people and, with new Reg Best Interest, among other things, "we're making it clear that financial professionals need to think about those types of things and only recommend those products in those idiosyncratic circumstances where they're appropriate."
Cybersecurity. Finally, on his own initiative, Clayton raised the issue of cybersecurity, cautioning the audience to make sure that their systems are protected. Incidents will happen, he said, but what's important is "how we deal with them. But keeping the confidence in the system is crucial. Part of keeping that confidence is maintaining good cyber hygiene and what I would say is being able to react quickly in the event of an issue."
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