SEC CORNER

SEC RELEASES LIST OF INVESTMENT ADVISERS CHARGED WITH VIOLATIONS 

The U.S. Securities and Exchange Commission (“SEC”) has announced charges against several investment advisers for failing to comply with SEC regulations regarding reporting as well as deficient filings. In particular, the SEC noted violation of the Investment Advisers Act for the failure of the advisers to perform impromptu exams of client custodial assets annually by an independent public accountant or an annual audit of client investment financial statements prepared by an independent public accounting firm. In addition, advisers must distribute audited financial statements to investors by fiscal year end. Failure to advise of receipt of audited financials and amend financials to reflect same was another problem cited. One investment adviser was charged not only for failing to obtain unannounced reviews of client assets over which it had custody but also for failing to implement written policies and procedures in order to prevent such violations. 


The advisers charged by the SEC were found to have performed the audits improperly, failed to provide investors with timely audited financials, or failed to provide amended financial statements as necessary. As a result, the advisers were investigated, censured, sanctioned, required to cease and desist from the violations, and required to pay hefty civil monetary penalties.

 

The Takeaway

The SEC is increasing its focus on enforcement. As the agency ramps up to flag issues that merit examination or investigation, advisers must be cautious to comply with the rules or suffer the consequences.  

 

SEC ADOPTS PAY VERSUS PERFORMANCE DISCLOSURE RULES

Recently, the U.S. Securities and Exchange Commission (“SEC”) adopted the Congress-mandated “pay versus performance” rule in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The rule requires companies to clearly set out the relationship between executive compensation paid as of September 22, 2022, and the financial performance of the company. It further mandates disclosure of five years of data in proxy and information statements in which executive compensation information is required to be included for fiscal years ending on or after December 16, 2022, impacting the 2023 proxy season.


There are some notable exceptions to these reporting requirements, such as emerging growth companies ("EGCs"), foreign private issuers ("FPIs"), and registered investments, but smaller reporting companies ("SRCs") that have ceased to be EGCs are required to comply. The new rules also do not demand the new disclosure be included in Annual Reports on Form 10-K and registration statements. Additionally, the new disclosure will not be deemed to be incorporated by reference into any existing filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that the registrant does so intentionally. 


These new rules represent the most sweeping change to executive compensation rules since 2006, when the current Compensation Discussion & Analysis and accompanying tables were established. The rules build upon the SEC's recent approach towards more rigid and expansive rulemaking and impose significant new disclosure requirements on domestic public companies. Among other items, the new rules create a completely new method for calculating executive compensation and require companies to re-tabulate new fair values for their equity awards. Further, the new rules create brand new prerequisites for disclosure of company performance targets by requiring: (1) a list of at three to seven financial performance measures that, in the company's assessment, represent the “most important” measures used to ascertain executive compensation, and (2) “clear descriptions” (either “graphically, narratively, or a combination of the two”) of the relationship between the compensation actually paid and specific financial performance measures, including total return to shareholders and net income.

 

The Takeaway

Affected companies would do well to get a head-start on what promises to be an onerous and data-heavy reporting and filing process. Although the full effect of this process and the impact on investor voting is yet unknown, what is known is that the new disclosures are not deemed incorporated by reference into any Securities Act or Exchange Act filing. They are still subject to “proxy fraud” liability under Rule 14a-9 and other provisions of the federal securities laws that are liability based, as are all other proxy-specific disclosures. 

THE RETURN OF SCHEME LIABILITY

SEC v. Rio Tinto plc, No. 21-2042 (2nd Cir. Jul. 15, 2022) 

The federal securities laws cover a wide range of topics and often lack clear-cut rules. The scope of scheme liability is a prime example, and the framework for analyzing it lies in the crossroads between “misstatement subsections” and “scheme subsections” provisions of the Securities Act of 1933 (“’33 Act”).


The case at hand arose when the U.S. Securities and Exchange Commission (“SEC”) accused a mining company, as well as its former CEO and CFO, of misstating value impairments related to the purchase of a coal mine. The district court dismissed the SEC’s claims, but only a few days later, the U.S. Supreme Court ruled in Lorenzo v. SEC that disseminating a false statement could be a basis for liability under scheme subsections of the ’33 Act. In light of the Court’s decision, the SEC asked the district court to reconsider its order favoring the mining company; however, the judge denied the request and explained that scheme liability requires something more than just statements or omissions—a dissemination allegation, for example.


The SEC appealed, and the Second Circuit agreed with the district court’s narrow reading of Lorenzo. According to the Second Circuit, “misstatements and omissions can form part of a scheme liability claim, but an actionable scheme liability claim also requires something beyond misstatements and omissions.” The court rejected the SEC’s argument that Lorenzo expanded the scope of scheme liability to make misstatements and omissions alone sufficient to state a scheme liability claim. The court explained that the SEC’s argument undermined the primary liability’s limitation to the maker of the statement and the heightened pleadings requirement of the Private Securities Litigation Reform Act.

 

The Takeaway

This case suggests that in order to prevail in a similar action, a plaintiff must point to individuals who possess the requisite authority over making the allegedly misleading statements. More litigation may follow to clarify what qualifies as sufficiently beyond mere misstatements and omissions.  


For insurance purposes, this case indicates that the once dormant scheme liability defense is slowly making its way back. It is therefore crucial that entities making statements upon which the public relies, especially banks, obtain efficient scheme liability coverage.

SEC PROPOSES NEW RULES FOR OUTSOURCING AND RECORD KEEPING FOR INVESTMENT ADVISERS  

The U.S. Securities and Exchange Commission (“SEC”) has proposed new rules imposing specific due diligence and monitoring on registered investment advisers who outsource certain functions to service providers as well as record keeping requirements when engaging third parties as record-keepers. The rules extend to “covered functions,” which are defined as advisory services as well as those services necessary for performance of investment advisory services. Pursuant to the proposed rules, prior to outsourcing, investment advisors would need to determine both the appropriateness of outsourcing as well as the provider to perform the service. That would include the evaluation of the nature and scope of services, potential risk of outsourcing, mitigation of risk, competence of the provider, as well as coordination with the provider regarding compliance with securities laws and termination of the provider’s services. The investment adviser would be expected to monitor the service provider thereafter. 

In addition, investment advisers would be required to maintain a list of “covered functions,” the names of the outsourced providers, documentation of due diligence, and monitoring and written agreement with the service providers. If a third party is maintaining the records, the investment adviser would also be required to perform due diligence and monitoring of the third party as well as obtain assurances that they will implement and maintain a process of record keeping and provide electronic access to the SEC. A written agreement between the adviser and third party is advisable.    
 

SEC’S EFFICIENCY MEASURE – ELECTRONIC FILING OF 144 FORMS 

 
Recently, the U.S. Securities and Exchange Commission (“SEC”) accepted last year’s proposal and mandated change concerning the filing procedure of various forms and documents. Before the amendment, the SEC rules favored paper filing on most occasions. However, in its attempt to expand efficiency and document availability, the SEC required all Forms 144 and other reports to be filed electronically through online fillable document forms that do not need personally identifiable information. The change will make the EDGAR system more user-friendly while making information about executives, directors, and others readily available to the public.  

SEC REMAINS COMMITTED TO INCREASING ESG REGULATIONS

 
Companies and shareholders have become increasingly concerned about environmental, social, and governance (“ESG”) practices. Environment, human rights, diversity and inclusion, equity, and ethics are just a few of the many topics covered by the ESG label. As consumers’ motivation to support such initiatives has risen, the SEC’s incentive to regulate ESG practices was elevated to the top of the priority list for businesses and shareholders. For instance, one of the SEC’s proposals focused on facilitating disclosures of climate-related information in public filings. Last year, the SEC focused on spotting ESG-related violations through the Climate and ESG Task Force, and since then, filed at least five enforcement actions related to it. By doing so, the SEC has incentivized companies to devote resources to ESG initiatives and avoid “greenwashing,” or, in other words, intentionally or unintentionally deceiving consumers into believing that a company’s products are environmentally friendly. 

The Takeaway

For insurance purposes, it is important to note that ESG-compliant companies have begun to face increased D&O risks.  

October 2022 Noteworthy Enforcement Actions Filed

Director/Officer Role Company
 Richard Lee Ramirez  President, CEO  JMJ Capital Group
 Michael Ross Kane  CEO  The Hydrogen Technology Corporation
 Brent David Willis  CEO  NewAge, Inc.

 

October 2022 Noteworthy Settlements and Judgments 

Amount Director/Officer Role Company
 $ 294,889.86  Mark Goldberg  CEO  In Ovations Holdings, Inc.
 $ 41,868.00  Tyler Ostern  CEO  Moonwalkers Trading Limited

 

Source: U.S. Securities and Exchange Commission