Thank you, Keir [Gumbs], for that kind introduction. It is nice to see you, Meredith [Cross] and Joan [McKown], all of whom I have known for most, if not all, of my time at the Commission. Congratulations to each of you for chairing what is one of the premier securities regulation conferences in the country.

Yesterday at this conference, leading practitioners and members of the Commission staff discussed a variety of issues affecting public companies. Today, I will add my thoughts. As you might expect, my remarks today reflect my individual views as a Commissioner of the SEC and do not necessarily reflect the views of the full Commission or my fellow Commissioners.

Since becoming Commissioner sixteen months ago, the SEC has finalized five rulemakings affecting public company disclosure – pay versus performance,[1] clawbacks,[2] amendments to rule 10b5-1,[3] share repurchases,[4] and cybersecurity.[5] The Commission also has climate-related disclosure and SPACs as pending proposals[6] and human capital management[7] and corporate board diversity[8] on the rulemaking agenda. Given the current emphasis on additional public company disclosure, I will share four thoughts about disclosure rulemaking.

1. 1. Determining the Purpose of Rules

First, the initial first step of any rulemaking is to answer the question: what problem is the Commission trying to solve?[9] Sometimes, Congress may have directed the Commission to issue a rule. Other times, market events may raise new concerns or vulnerabilities that have not been previously addressed. More recently, for public company disclosure rulemakings, the answer is often that investors desire the additional information.

Protecting investors is part of the Commission’s mission and we should listen to them. However, such demands for disclosure should not be taken at face value. In that respect, the Commission should undertake at least two forms of critical analysis before proceeding.

First, the Commission should evaluate the costs for disclosing the additional information. These costs include direct costs, such as fees paid to attorneys and other outside advisors, as well as opportunity costs, such as management’s time and efforts that could have been focused on other projects accretive to the bottom line. These costs ultimately reduce the company’s earnings that are available to shareholders. The question should not merely be whether investors want the information, but rather to what extent are investors willing to pay for that information.

Investor demand for specific types of information tends not to be universal. Hence, a free rider problem exists when only a few investors desire such information, but the cost of disclosing that information is borne by all shareholders. As a result, the investors who did not seek the information are effectively subsidizing the investors who requested that information.

This free rider problem is worsened when there is a desire to have consistent and comparable information across all public companies.[10] For instance, investors at one company may find certain information important when making an investment decision. However, at a different company, investors might find that type of information to be meaningless because of differences in the company’s industry, business model, or regulatory environment, among other reasons. While consistency and comparability may be nice ideals when considered in a vacuum, the costs to achieve such ideals can be exorbitant.

In rulemaking, the Commission has statutory obligations to consider costs and any effects on efficiency, competition, and capital formation.[11] These obligations are especially important where the costs to prepare the disclosure are significant and mutualized among all investors, but the benefits would accrue only to a select subset.

Second, when considering investors’ demand for disclosure, the Commission should analyze why they are requesting the information from public companies. Being an investor simply means owning stock in a company, but an investor does not necessarily seek certain information to help it value the company’s stock. Investors may have different purposes or reasons for asking for the information. For example, an investor may want the information in order to sell investment products or services based on it. Or an investor may want the information to use in private negotiations with the company. Or an investor may want the information because it seeks to use the disclosure as a means to drive social change.

Using the Commission’s disclosure regime to address social issues under the guise of stock ownership raises concerns. The Commission is an independent regulatory agency, and none of the Commissioners have been elected by the American people. On the other hand, the legislative branch, elected by the voters, has a broad range of powers and authorities for addressing society’s problems. Using the Commission’s disclosure rules to address these social problems is not only ineffective and inefficient, it is also outside of the Commission’s statutory authority and expertise. The Commission must be especially mindful of how it exercises its rulemaking authority due to its limited political accountability.

While it may be difficult to determine the reasons for why certain investors demand particular information from public companies, the Commission has tools to conduct this analysis, including investor testing as authorized by the Dodd-Frank Act.[12] This analysis, together with consideration of the costs of providing the information, can help the Commission identify the specific problem that it is trying to solve at the outset of a rulemaking.

1. 1. Re-proposing Rules

Once the Commission has answered the question of what problem it is trying to solve, it then must conduct an effective rulemaking process. In my view, the notice and comment process of a rulemaking is an invitation to have a conversation between the regulator and the public. Rules should not be adopted without informed engagement with stakeholders. Sometimes, this process starts through public roundtables, requests for information, or an advance notice of proposed rulemaking, before the Commission issues a proposing release. But most times, the engagement does not start until the proposal is posted to the Commission’s website.

This brings me to the second topic. The Commission does not always get the original proposal right and sometimes must contemplate making significant changes to the proposal — a version 2.0 so to speak. In this situation, an important decision to make is whether to re-propose a rule and provide a revised economic analysis. Re-proposing a rule is also appropriate when significant time has passed since the original proposal.[13] However, the Commission has rarely re-proposed rules in recent years, even when both conditions were present. As a case study, let us examine the pay versus performance rule.

The Dodd-Frank Act directed the Commission to adopt a rule requiring public companies to disclose “the relationship between executive compensation actually paid and the financial performance of the [company].”[14] The Commission finalized this rule in August 2022, about two months after I became a Commissioner. As it so happens, I had previously reviewed the proposed rule in April 2015,[15] when I was counsel to Commissioner [Michael] Piwowar. Despite the seven-plus years between proposal and adoption, the only step taken by the Commission in the interim was to reopen the comment period in January 2022 for a brief 30 days.[16] The lack of an updated economic analysis in the reopening notice was notable and not consistent with the Commission’s stated focus on obtaining robust data.[17] Just as troubling is how the final rule significantly changed the calculation of “compensation actually paid” and the treatment of equity awards, without seeking public feedback on this revised methodology.

The implications of this change were reflected in the pay versus performance disclosure during the past proxy season, which was the first one following the rule’s effective date. Approximately 34% of companies subject to the new rule reported a negative amount for the principal executive officer’s “compensation actually paid” in one of the three years included in the new pay versus performance table. [18] Although the statute’s focus is on the relationship between an executive’s “compensation actually paid” and the company’s financial performance, it is hard to believe that Congress would have expected the Commission to adopt a rule where more than one-third of companies explain this relationship by reporting a negative number.

How did these negative numbers come to be? The answer lies in how equity awards are valued as part of the “compensation actually paid.” Under the proposed rule, companies would have used the fair value, as of the vesting date, of any awards that vested during the year.[19] This amount could not have been negative. However, the final rule required companies to use the change in fair value of awards from the beginning of the year though the end of the year or the vest date during the year.[20] If a company’s stock price were to decline during that period, then any associated decline in fair value could result in negative “compensation actually paid.”

In the 2015 proposing release, the Commission discussed the approach of including equity awards based on changes in fair value and noted that such changes could result in a negative number.[21] Of the more than 150 comments received on the rulemaking,[22] only two commenters supported this approach.[23] The only mention of this approach in the 2015 proposing release was as an “implementation alternative”[24] in the economic analysis section.[25] When an alternative is buried deep in the economic analysis, I wonder how widely it was noticed by the public. More importantly, because the 2022 reopening notice lacked an updated economic analysis, commenters were not reminded of this alternative from nearly seven years before. Unsurprisingly, the Commission did not receive a lot of feedback on this alternative during the reopened comment period.

If the Commission had re-proposed the rule in 2022 with the modified calculation of “compensation actually paid” based on changes in fair value, would things have come out differently? While we may never know, doing so would have at least offered market participants an opportunity to focus on the issue. The Commission would then have had a broader set of views on the approach’s advantages and disadvantages. Some commenters might have discussed whether the potential for disclosure of negative “compensation actually paid” is useful to investors.

The takeaway from the Commission’s process for proposing and adopting the pay versus performance rule is a stark reminder not to take procedural shortcuts. This process was far from rulemaking best practices[26] and the consequences are apparent in the results. In reporting on pay versus performance disclosure, one publication questioned whether shareholders might interpret negative “compensation actually paid” as if the CEOs theoretically owed their companies money[27] and another observed that “the new ‘compensation actually paid’ in not compensation actually paid.”[28]

It is bad enough that the disclosure may not be understandable or material,[29] but even worse, preparing the disclosure may impose significant costs on companies. Much of these costs arise from hiring consultants to make the equity award fair value calculations not otherwise required by the Commission’s prior executive compensation rules. According to one trade association survey, over 50% of companies expect to spend at least $40,000 on consultants to make these calculations.[30] A rule that is both costly and ineffective is something that a regulator must avoid.[31]

Hopefully, the Commission will consider learning from the lesson of the pay versus performance rulemaking as it moves forward with other rulemakings, including climate-related disclosure. This proposal has received over 16,000 comments.[32] The volume of comments is not surprising given the proposal’s expansive nature and the hundreds of requests for feedback contained in it. Most commenters did not focus on, or address, every single issue or alternative raised in the proposal. Before the Commission adopts any final rule that significantly deviates from the proposal, it should seriously consider re-proposing the rule with revised rule text and an updated economic analysis. Doing so would provide the public with an opportunity to focus on aspects of the proposal that they did not initially consider, and perhaps more importantly, submit feedback on any revised requirements. Such a re-proposal may ultimately help the Commission craft a better rule for all market participants. The Commission should do everything possible to not promulgate a rule that is costly and ineffective, as doing so might be indicative of a flawed process that raises the question of whether the rule is arbitrary and capricious under the Administrative Procedure Act.

1. 1. Scaling Rules

In the rulemaking process, appropriately scaling the rule’s application to companies based on their size and maturity as a public company is as important as not taking procedural shortcuts. Hence, scaling rules is the third topic.

The Commission introduced scaled disclosure based on a company’s size in 1992 with a category of companies called “small business issuers.”[33] In 2007, the Commission replaced the concept of “small business issuer” with “smaller reporting company.”[34] Currently, a company qualifies as a smaller reporting company if its public float is less than $250 million.[35] A company can also qualify if it generated less than $100 million in annual revenues and had a public float of less than $700 million.[36]

In its 1992 proposal to provide scaled disclosure requirements, the Commission recognized that smaller companies “are disproportionately affected by the complexities in the disclosure requirements.”[37] Despite this longstanding view and commenters’ concerns about outsized costs, the Commission did not provide scaled disclosure relief in its recent rulemakings for cybersecurity,[38] share repurchases,[39] amendments to rule 10b5-1,[40] and clawbacks.[41]

Even if disclosure requirements are not scaled, the Commission could stagger a rule’s compliance date for smaller reporting companies. This approach allows such companies to benefit from the time and efforts of larger companies to comply with the new rules. For example, law firms, auditors, and other advisors may have already gained familiarity with new policies or new disclosure language used by larger clients. Smaller reporting companies using those same advisors may be able to reference those policies and disclosures when they begin to comply with the new rule, thereby reducing costs. Despite these potential benefits, the Commission did not provide staggered compliance dates in the share repurchase[42] and clawbacks[43] rulemakings.

Similar to smaller reporting companies, emerging growth companies can benefit from scaled disclosure requirements. Generally, an emerging growth company is a company that has been public for not more than five fiscal years and has not exceeded $1.235 billion in annual revenues.[44] The primary rationale for scaled disclosure for emerging growth companies is to give them an “on-ramp” for compliance with disclosure requirements as they mature into seasoned public companies.[45] Despite this rationale and past bipartisan Congressional support[46] for emerging growth companies, the Commission similarly did not provide any scaled disclosure in its rulemakings for cybersecurity,[47] share repurchases,[48] amendments to rule 10b5-1,[49] and clawbacks.[50]

While scaling disclosure for smaller reporting companies and emerging growth companies is an important consideration, the Commission should think about whether further scaling is appropriate for other public companies as well. For instance, the Commission should consider applying scaled disclosure using the model of a triangle. Companies at the base of the triangle would be the smallest and least seasoned public companies. The companies in the middle are larger and more seasoned. Finally, the companies at the top of the triangle are the largest seasoned companies. As a company ascends the triangle, it should provide more disclosure to investors.

Using the Commission’s current categories for public companies, smaller reporting companies and emerging growth companies would be at the triangle’s base, accelerated filers would be in the middle, and large accelerated filers would be at the top. This approach considers the disproportionate costs affecting smaller companies and the need to provide an “on-ramp” to newly public companies. It also recognizes that not all seasoned companies are equal in terms of legal and financial reporting personnel, budgets for outside counsel, auditors, and advisors, and board and management time to devote to the Commission’s ever-growing disclosure requirements.

Today, an accelerated filer with a $250 million public float would be subject to the same disclosure requirements as a large accelerated filer with a $250 billion public float. However, the accelerated filer is likely to have much fewer resources to comply with those requirements. By mandating certain disclosure from only large accelerated filers, the triangle approach creates a new “middle class” of public companies. From an investor protection perspective, all public companies would continue to be subject to the Commission’s antifraud rules,[51] as well as the requirement to disclose material information necessary to make any required statement not misleading.[52]

To create this triangular model, the Commission would need to make two changes to existing rules. First, based on the number of companies in each category, the current pool of public companies does not form a triangle. Rather, it forms a distorted hourglass. Approximately 56% of companies are smaller reporting companies or emerging growth companies, 7% are accelerated filers, and 34% are large accelerated filers. [53]

These percentages are not surprising given that the public float threshold of $700 million for qualifying as a large accelerated filer[54] was established in 2005.[55] At the time, approximately 18% of reporting companies had a public float of at least $700 million.[56] Today, the top 18^th percentile for reporting companies’ public float is approximately $3.2 billion; if the threshold was adjusted to that amount, over 50% of the current large accelerated filers would no longer be treated as such. [57] Accordingly, to create a triangular structure, the Commission should increase the threshold so that the number of accelerated filers is relatively higher than the number of large accelerated filers.

Additionally, the Commission should evaluate whether to limit certain disclosure only to large accelerated filers. Currently, only one requirement differentiates large accelerated filers – the 60 day deadline for filing Form 10-K.[58] The Commission should review its disclosure requirements and identify rules that should apply only to the largest seasoned companies.

A triangular approach to scaled disclosure reflects the idea that the public markets should not be simplistically divided between small companies and large companies. Establishing a meaningful “middle class” of companies that are subject to many, but not all, of the Commission’s disclosure requirements recognizes the resource constraints that these companies have relative to the largest companies, without sacrificing the federal securities laws’ antifraud protections afforded to all investors.

1. 1. Considering the Cumulative Costs of Rules

The fourth topic is the importance of assessing the cumulative costs – both human and financial – of the Commission’s rules with respect to public company disclosure. When the Commission makes this assessment, it does so in a vacuum and considers only the rulemaking at issue. To obtain a true sense of how much the new regulations will cost public companies, there should be a review of the cumulative costs of all rules.

For public companies with a December 31 year-end, the compliance date of rulemakings covering pay versus performance, clawbacks, amendments to rule 10b5-1, share repurchases, and cybersecurity will take effect between the 2023 proxy season and the 2025 proxy season. Here is a summary of what companies are facing:

• • 2023 proxy season: pay versus performance began to apply;[59]
  • February 2023: the new requirements for rule 10b5-1 plans and reporting of dispositions by gift on Form 4 began to apply;[60]
  • April 2023: the new requirements for Section 16 reporting of rule 10b5-1 plan trades commenced;[61]
  • July 2023: disclosure of rule 10b5-1 plans and “non-Rule 10b5-1 trading arrangements” that were adopted or terminated during the prior quarter must be included in Form 10-Q or 10-K;[62]
  • December 1, 2023: companies listed on the NYSE and Nasdaq must have adopted their clawback policies;[63]
  • December 18, 2023: Form 8-K reporting for material cybersecurity incidents begins;[64]
  • 2024 proxy season, including the 2023 Form 10-K:
    • New disclosure of cybersecurity risk management, strategy, and governance;[65]
    • New disclosure of share repurchases, including adoption or termination of rule 10b5-1 plans for issuer share repurchases and reporting of daily repurchase data;[66] and
    • New disclosure of any efforts to claw back compensation and filing of the clawback policy;[67]
  • 2025 proxy season, including the 2024 Form 10-K:
    • New disclosure of insider trading policies and procedures and filing of the insider trading policy;[68] and
    • New disclosure of policies relating to the timing of stock option grants and associated tabular disclosure for potential spring-loading and bullet-dodging grants.[69]

If that were not enough for public companies and their advisors, changes to long-standing Commission staff positions on rule 14a-8[70] contributed, in part, to a significant increase in shareholder proposals during the 2023 proxy season,[71] and there may be even more proposals for the upcoming season.

For each rulemaking, the Commission estimates the additional hours that the new requirements will impose on preparing a filing and allocates those hours between internal resources and outside professionals. When computing the costs for outside professionals like law firms, the Commission uses an hourly rate of $600,[72] which I view as unrealistically low. This rate was increased last year, starting with the clawbacks rule adoption.[73] For the sixteen prior years, the hourly rate for computing costs for outside professionals was $400.[74]

Aggregating the hours and costs across the five recently adopted rulemakings, the Commission estimates that the new rules will impose a mere 120 additional internal hours and about $24,000 of outside advisor fees, annually per company.[75] These estimates represent a worst-case scenario where all possible disclosure requirements are triggered, including having a material cybersecurity incident required to be reported on Form 8-K, engaging in share repurchases, adopting or terminating rule 10b5-1 plans, and clawing back compensation. Obtaining an accurate hours and cost estimate across all companies is extremely difficult. However, based on anecdotal feedback from public companies and their advisors, the actual internal hours and outside advisor fees for these rulemakings are likely to be much higher.

Just as the omakase menu at a Michelin-starred sushi restaurant will take longer and cost more to prepare than the mass-produced packages of sushi sold at a grocery store, drafting high-quality disclosure also imposes more time and costs on companies compared to preparing boilerplate disclosure. If the Commission expects to be served non-boilerplate disclosure[76] akin to the same care and attention to detail as a master sushi chef selecting the freshest ingredients at the Toyosu fish market,[77] then it should ensure that its disclosure rules’ hours and cost estimates reflect that quality.

Another way that the Commission may be overwhelming companies’ ability to produce quality disclosure is by setting compliance dates for multiple new disclosure rules over the same one or two proxy seasons. Drafting such disclosure, especially for the first time, requires significant involvement from in-house counsel and other personnel within the company. The Commission estimates that 75% of the hours required to prepare new disclosure falls on company personnel,[78] whose time is generally already constrained during proxy season.[79] When the Commission imposes multiple new disclosure requirements on top of those existing demands, company personnel may be hamstrung in their ability to craft the new disclosure without boilerplate language. Given the tight deadlines and resource constraints, it would not be surprising if companies rely more on boilerplate disclosure that provides little or no benefit to investors.

1. 1. Conclusion

To conclude, the Commission might better accomplish its mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation by re-evaluating its approach to rulemaking for public company disclosure. By applying one or more of the considerations I discussed, the Commission can hopefully adopt rules that are effective, not costly, and of benefit to investors, markets, and issuers alike.

Thank you.

[1] Pay Versus Performance, Release No. 34-94074 (Aug. 25, 2022) [87 FR 55134 (Sept. 8, 2022)] (the “Pay Versus Performance Adopting Release”), available at https://www.sec.gov/files/rules/final/2022/34-95607.pdf.

Good morning and thank you, Jim [Burns], for that introduction. I am pleased to be part of the 2023 conference on SEC Regulation Outside the United States to deliver the Fifth Annual Scott Friestad Memorial Lecture.

I had the privilege of working with Scott Friestad at the Securities and Exchange Commission for nearly a dozen years. I arrived at the SEC in October 2006 to serve as counsel to Commissioner Paul Atkins. This was about 18 months after Scott had been promoted to Associate Director in our Division of Enforcement. At the time, each Commissioner had three counsels and, in our office, each one of us handled a third of the Enforcement recommendations.

I was first introduced to Scott by one of my fellow counsels – Dan Gallagher, who would later serve as an SEC Commissioner from 2011 to 2015. From time to time, Scott’s enforcement cases would be assigned to me. Scott would patiently explain the enforcement process as well as the limitations on what enforcement could do. Most importantly, Scott stressed the need to exercise appropriate judgment and discretion in exercising the Commission’s enforcement authority. 

Subsequently, I returned to the executive staff in 2013 as counsel to Commissioner Michael Piwowar. Once again, I worked with Scott on enforcement recommendations from his group. It was during this period that I became aware of his illness and I was greatly saddened by his passing in 2018. My favorite memory of Scott is crossing paths on the way to or from getting lunch in Union Station, where Scott was often accompanied by his close friends and co-workers Tom Sporkin, Greg Faragasso, and John Polise.

With Scott’s legacy in mind, it would be appropriate to share some thoughts about the use of the Commission’s enforcement authority. These remarks reflect my individual views as a Commissioner of the SEC and do not necessarily reflect those of the full Commission or my fellow Commissioners.

The focus on enforcement, however, should not be viewed as diminishing a variety of important SEC issues facing global market participants. For example, foreign investment advisers have faced numerous hurdles in registering with the SEC, the pending move to T+1 settlement in the equity markets raises potential mismatches with foreign jurisdictions that will need to be resolved, and some of the SEC’s shortened filing deadlines may present challenges for those in foreign time zones.

The legal system of the United States has its roots in the laws of England. Most notably, the Magna Carta, issued in 1215, expressed the idea that a country should be governed by the rule of law.[1] The declaration that “no free man shall be seized, imprisoned, dispossessed, outlawed, exiled or ruined in any way, nor in any way proceeded against, except by the lawful judgment of his peers and the law of the land” runs through key parts of the U.S. Constitution, including the Fourth, Fifth, Sixth, Seventh, Eighth, and Fourteenth Amendments.

As the civil regulator for the federal securities laws, the SEC invokes the sovereign power of the United States in administering and enforcing such laws and the regulations thereunder. Indeed, enforcement is one of the SEC’s major activities and the Division of Enforcement is one of its largest operating units. The Enforcement staff, which consists of more than 1,300 individuals, conducts investigations into possible violations of the federal securities laws and litigates the Commission’s civil enforcement proceedings. The U.S. Congress has given the SEC a robust set of investigatory tools and the power to seek a variety of remedies, including injunctions, disgorgement, bars, and civil penalties.

The power and role of the SEC in carrying out enforcement actions cannot be understated. For example, the legal standard for a government regulator like the SEC to issue an administrative subpoena is “official curiosity.”[2] Unlike criminal prosecutors and the police, civil regulators do not need to have any evidence, akin to probable cause, before issuing subpoenas. According to a 1950 decision of the U.S. Supreme Court, administrative agencies have a “power of inquisition” whereby they can “investigate merely on suspicion that the law is being violated, or even just because it wants assurance that it is not.”[3] This is a low threshold and, thus, the protection against potential abuse is largely left to the discretion and judgment of the investigating agency.

While it is important for government regulators to pursue bad actors, the ease at which an official investigation can be launched suggests that there ought to be objective and articulable standards to guide the exercise of such power by enforcement staff.

A key concept under the rule of law is that similarly situated people should be treated similarly. However, when there is a low threshold to launching an investigation that lacks sufficient guardrails, the potential for abuse increases. For instance, it would be inappropriate to single out otherwise lawful financial products that might be viewed disfavorably. Targeting lawful, but disfavored, products and conduct with investigations and administrative subpoenas based on the “official curiosity” standard runs the risk of turning the SEC into a merit regulator – which was an approach that the U.S. Congress did not take in enacting the federal securities laws. 

At times, it may be appealing to set regulatory policy through enforcement actions. But the SEC ought to be reluctant to pursue that approach, especially when it effectively creates new definitions or interpretations that affect conduct not previously deemed unlawful. If there are regulatory provisions that are unclear and/or ambiguous, the Commission and its staff can and should provide clarity to market participants, which can occur in the form of rules, interpretations, guidance, and no-action letters. This clarity should be provided before resorting to enforcement actions. The SEC’s enforcement efforts should be limited to enforcing the rules as written, and should not create novel and innovative interpretations that broaden the scope of these rules and the Commission’s jurisdiction over markets and their participants.

In addition, U.S. law generally requires that, when engaging in rulemaking, a federal agency must give notice of the proposed rulemaking and solicit comment from interested parties on the proposed rule.[4] This process has been described as “notice and comment.” 

However, enforcement actions are not subject to notice and comment. The only individuals involved in the discussions are the enforcement staff, the defendants, and their counsel. The language of enforcement orders is negotiated among them, and the full context of those discussions may not be included. While some may view an order as providing guidance on the SEC’s views, it may be difficult to ascertain how the order might apply to other situations as it is limited in scope to the facts and circumstances of the specific case. Thus, using enforcement actions as a method to set regulatory policy means that the public is denied a chance to provide input. 

Today, I want to discuss three areas where insufficient clarity may result in a lack of understanding, and potentially fair notice, of novel interpretations that the SEC has undertaken in recent enforcement actions. These areas are: (1) the scope of the definition of a dealer under the Securities Exchange Act of 1934; (2) cryptocurrencies; and (3) off-channel communications by broker-dealers.

Definition of a “Dealer” Under the Securities Exchange Act

Section 3(a)(5)(a) of the Exchange Act defines a dealer as, “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” If a person is a dealer, then that person must register with the SEC as a dealer and become a member of a self-regulatory organization like FINRA unless an exception otherwise applies. In addition, the person must become a member of SIPC, adhere to a comprehensive regulatory regime, including the net capital rule[5] and Consolidated Audit Trail reporting, and be subject to examination by the SEC and FINRA. For individuals, the compliance costs could be disproportionately large relative to their financial activity.

Traders are specifically excluded from the dealer definition and are defined as “a person who buys and sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business.”[6] Thus, it is important for a person to know whether he or she is a dealer and, if so, whether an exception like the trader exclusion is applicable.

In August 2022, the Commission filed a case against Crown Bridge Partners, LLC (“Crown Bridge”) and its two members, who were brothers, alleging that they “engaged in the buying and selling large volumes of penny stocks for their own account.”[7] Crown Bridge would purchase convertible notes from penny stock issuers, hold the notes for a period of time, and subsequently convert the notes into unrestricted, newly issued shares of stock at a discount to the prevailing market price and resell those shares into the market.

In an effort to comply with the registration requirements under the Securities Act of 1933, Crown Bridge conducted its activities in accordance with Rule 144. This rule provided Crown Bridge with a safe harbor from the statutory definition of being an “underwriter,”[8] which allowed the firm to resell shares from converted notes without the need to register the resales under the Securities Act.

Having taken apparent care with its regulatory obligations for the resales of shares under the Securities Act, it is unclear whether Crown Bridge also assessed whether it needed to register as a dealer under the Exchange Act. Had the members of Crown Bridge searched the SEC’s website, they might have come across a document posted as the “SEC’s Guide to Broker Dealer Registration.”[9] The Guide notes that individuals who buy and sell securities for themselves generally are considered traders and not dealers.[10] The Guide says that the following individuals and business may need to register as a dealer depending on a number of factors: a person who holds themselves out as being willing to buy or sell a particular security on a continuous basis; a person who runs a matched book of repurchase agreements; or a person who issues or originates securities that he also buys and sells. The Guide also includes a list of questions one should ask themselves to determine whether they are acting as a dealer, including:

Do you advertise that you are in the business of buying or selling securities?

Do you do business with the public – either retail or institutional?

Do you make a market in, or quote prices for both purchases and sales of, one or more securities? 

Do you provide services to investors, such as handling money and securities, extending credit or giving investment advice?

Do you write derivative contracts that are securities?

It would be understandable if Crown Bridge, after reviewing the Guide, were to conclude that their conduct did not require them to register with the Commission as a dealer since they were using their own money and did not provide services to clients or do business with the public.

Nonetheless, the SEC sued Crown Bridge for unregistered dealer activity. The case was ultimately settled.[11] Was fair notice of this interpretation given to market participants? Would there have been better ways to communicate the SEC’s views prior to instituting an enforcement action? Questions and challenges to this approach have been raised. The Crown Bridge case is only one of a number of similar cases brought by the SEC in recent years, some of which are currently pending in the judicial system.[12]

Cryptocurrencies

Let’s turn to one of the most discussed areas of the U.S. federal securities laws when someone mentions regulation by enforcement: cryptocurrencies and digital assets. For years, market participants have expressed concern about a lack of regulatory guidance in the crypto space. Let’s be clear about it – enforcement actions are not well-suited for providing guidance. By their very nature, enforcement actions are post hoc actions. However, one of the primary responsibilities of a regulator is to set clear expectations on permitted and prohibited conduct in advance so that law-abiding market participants can comply ex ante. 

Accordingly, the Commission should consider proposing rules or issuing interpretive guidance with respect to cryptocurrencies and digital assets. It’s unfortunate that, despite the large number of rule proposals issued by the SEC during the last two years, cryptocurrency was not among them. A responsible regulator considers how the laws and rules apply to new types of securities and then develops or modifies those provisions so that the regulatory requirements can be satisfied. 

Importantly, the federal securities laws only apply when the instrument at issue is a security; therefore, providing clarity on the jurisdictional status is imperative. What is, and what is not, a security can be a difficult analysis – not just for market participants, but also for the courts who must analyze the investment contract test described by the U.S. Supreme Court in a 1946 decision.[13] In SEC v. W.J. Howey Co., the U.S. Supreme Court held that an investment contract means a contract, transaction, or scheme whereby a person invests money in a common enterprise and is led to expect profits from the efforts of the promoter or a third party.

The SEC could have proactively contributed to the creation of a body of law regarding cryptocurrencies and digital assets. Unfortunately, the SEC did not take this approach and instead is pursuing a case-by-case approach through enforcement actions. As a result, it will take years to reach any type of legally-binding precedent, as matters will need to wind their way through the courts before reaching the court of appeals level.

Off-Channel Communications

The third area is the large number of off-channel communications cases that have been brought over the last two years under Section 17(a) of the Exchange Act and Rule 17a-4(b)(4) thereunder. This rule requires broker-dealers to create, and preserve in an easily accessible place, originals of all communications received and copies of all communications sent relating to the firm’s business. This is an area where market participants, regulators, and investors might have benefitted had the SEC issued additional guidance on what is included in the phrase “communications…relating to the firm’s business.” The world is very different from a technological perspective today than it was when these rules were first adopted in 1997.[14]

There was a time not too long ago when employees, for the most part, physically sat in offices and spoke to their co-workers in person. Almost all communications, as Bloomberg columnist Matt Levine points out, were informal and not recorded and the SEC, therefore, only had access to a limited portion of communications by brokerage firms.[15] None of those verbal communications were business records that were required to be maintained. 

The question becomes, what is considered to be a business communication? A paragraph from one SEC settlement order says that “a senior executive of [the Firm’s] broker-dealer entity exchanged text messages with over two dozen other [Firm] employees, including superiors and at least five employees who reported to him.”[16] In a separate order, a paragraph reads, “a managing director and head of trading communicated by text message and WhatsApp with at least 14 other [Firm] employees, including at least five whom he supervised.”[17] Notable is that neither of these paragraphs discloses the content of the communications the firms are alleged to have sent that ultimately caused a violation of recordkeeping provisions.

If co-workers text each other about having lunch – is that a business record? What if they discuss business at lunch but the text message makes no mention of the business to be discussed? Ensuring that the SEC’s rulebook evolves with technological developments would help management and compliance professionals know what standards they need to meet and will help prevent enforcement actions going forward.

The civil penalties associated with these settled actions have been astonishing, particularly since no investor harm has been identified. In September 2022, the Commission announced civil penalties against a small number of firms for $1.1 billion.[18] Given the size of these amounts, perhaps there should have been more transparency on how the penalty amounts were calculated. The penalties are not the only cost to the firms entering into settlement agreements, because detailed undertakings were also included and those will impose significant costs as well.

Conclusion

“With great power comes great responsibility.”[19] Regulators with enforcement power would do well to remember that. Effective deterrence requires persons to understand what conduct is prohibited. The mere fact that the law might allow the SEC to do something, does not mean that the SEC should. Regulators should be expected to exercise appropriate judgement in carrying out its investigative and sanctioning authority and to have an articulable basis for those decisions. Simply citing “official curiosity” should not be sufficient for jumping to enforcement actions when laws are unclear or have been reinterpreted.

Determining whether a person’s conduct violates the federal securities laws should not be akin to the Hogwart’s sorting hat from Harry Potter, where one’s fate is predicted, sometimes wrongly, based on which rule or law the SEC plans to enforce in a way that it has not been interpreted before. Market participants should not be engaged in a game of chance – waiting for rules to be retroactively reinterpreted to include their conduct and then being subject to an investigation years later. The SEC requires disclosures and transparency from market participants. Perhaps the SEC owes that same level of transparency to the market with respect to how it interprets its own rules. That transparency will help ensure the rules are applied fairly and evenly to everyone or – as inscribed on the U.S. Supreme Court building nearly 720 years after the Magna Carta – “equal justice under law.”

Thank you for listening and enjoy the rest of the conference. YYY