Top 5 SEC Enforcement Developments for May 2023

In order to provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important SEC enforcement developments from the past month, with links to primary resources. This month we examine:

• A new SEC rule requiring certain buyback disclosures;
• The SEC’s first-ever Liquidity Rule action against an investment adviser;
• The first-ever approval for the custody of digital asset securities;
• A settled action against an investment adviser for failing to disclose conflicts of interest; and
• A settlement in SEC v. First Guaranty Bancshares, a buyback disclosure case.

1. SEC Introduces New Rules on Buyback Disclosures

On May 3, 2023, the SEC approved new rules that require public companies to provide more information about share repurchases. The rule mandates that companies disclose their daily repurchase activity on a quarterly basis, report the number of shares repurchased on a given day and at what average price, and indicate whether certain officers or directors traded in the relevant securities within four business days of the company announcing its repurchase plan. The rules come after growing concern that companies use buybacks to meet near-term earnings tied to executive compensation. According to SEC Chair Gensler, the rules will increase transparency and integrity by “help[ing] lessen some of the information asymmetries inherent between issuers and investors in buybacks.”

The new rules also require companies to explain their rationale for conducting buybacks on a new item to Regulation S-K. New item 408(d) will require companies to disclose their compliance efforts with Rule 10b5-1 trading arrangements that protect against insider-trading liability on Forms 10-Q and 10-K. The move to increase disclosures comes as stock buyback activity has been on the rise, with the SEC reporting that buyback activity amounted to $1.25 trillion in 2022.

The rules have been met with mixed reactions, with some acknowledging improvements but others raising concerns about the burden of disclosure for smaller issuers and emerging growth companies. The SEC claims that the new rule will promote transparency. Critics, on the other hand, claim that buybacks are a way for companies to return excess cash to shareholders and argue that the new rules will bury investors in an avalanche of trivial information.

On May 12, 2023, the U.S. Chamber of Commerce petitioned the Fifth Circuit Court of Appeals to block implementation of the newly finalized SEC rules. The suit alleges the SEC violated the Administrative Procedures Act by failing to properly weigh the costs and benefits of the rules or give the industry enough time to react to the proposals. The Chamber of Commerce also contends that the mandatory disclosure requirements violate the U.S. Constitution, because they compel speech in violation of the First Amendment.

Subject to the Chamber of Commerce’s lawsuit, the amendments are set to become effective on April 1, 2024. In the interim, companies should review and assess their buyback programs to examine, among other things, their authorization process, criteria for buybacks, and related corporate governance practices.

#BuyBackDisclosures  #TransparencyOrTooMuchInfo

2. SEC Files First-Ever “Liquidity Rule” Action

On May 5, 2023, the SEC announced its first enforcement action under Rule 22e-4 of the Investment Company Act of 1940 (the “Liquidity Rule”) against investment adviser Pinnacle Advisors LLC, two of its officers, and two independent trustees of a mutual fund it advised (the “NYSA Fund”).

The complaint alleges that Pinnacle Advisers, its officers Robert Cuculich and Benjamin Quilty, and independent trustees Mark Wadach and Lawton “Charlie” Williamson (collectively, “Defendants”) violated the Liquidity Rule by: (1) holding more than 15% of the fund’s net assets in illiquid investments; (2) failing to comply with reporting and filing requirements; (3) failing to reduce the fund’s illiquid investment to meet the 15% threshold, as required by the Liquidity Rule; (4) classifying the fund’s largest illiquid investment as “less liquid” and disregarding restrictions and advice from counsel and auditors; and (5) making false and misleading statements in delayed reports to the SEC and the fund’s board. The SEC seeks civil monetary penalties and a court order permanently enjoining Defendants from additional violations.

In addition to the enforcement action, the SEC announced that it had settled related claims with (1) Joseph Masella, another NYSA Fund independent trustee, for $20,000 and (2) Pinnacle Investments LLC, an affiliate of Pinnacle Advisors LLC, for approximately $476,000. According to the SEC, Masella worked with Pinnacle and its principals to classify the private placement shares as “less liquid” rather than “illiquid” and intentionally counseled the NYSA Fund that the “less liquid” classification was justified. The SEC alleged Pinnacle Investments LLC made false and misleading statements in its Form ADV brochure and failed to disclose certain conflicts of interest, adopt and implement related policies and procedures, and deliver required information about advisory personnel to clients.

In 2016, the SEC adopted Rule 22e-4 under the Investment Company Act “to promote effective liquidity risk management throughout the open-end investment company industry, thereby reducing the risk that funds will be unable to meet their redemption obligations and mitigating dilution of the interests of fund shareholders.” The action serves as a reminder that the SEC is actively monitoring compliance with its regulations and will take action against registered investment funds, their advisers, and their boards for failing to meet these obligations. Companies should take this as an opportunity to review and enhance their liquidity risk management programs and procedures.

#LiquidityRule #FirstEverLiquidityRuleAction #LiquidityAction

3. FINRA Grants First Approval to Broker-Dealer to Custody Digital Asset Securities

On May 23, 2023, Prometheum Ember Capital LLC (“Prometheum EC”), a subsidiary of Prometheum Inc., announced that it had made history by becoming the first company to receive Financial Industry Regulatory Authority (“FINRA”) approval to operate as a special purpose broker-dealer (SPBD) for digital asset securities. The approval enables the company to act as a qualified custodian, as defined in rule 206(4)-2 (the “Custody Rule”) under the Investment Advisers Act of 1940 and subjects Prometheum EC to Exchange Act Rule 15c3-3 (the Customer Protection Rule”).

FINRA’s approval comes at a crucial time, as the SEC recently proposed a new safekeeping rule that would replace the Custody Rule under the Investment Advisers Act. The proposal would require investment advisers to maintain certain records for client accounts and mandate that crypto assets managed by investment advisers be held by qualified custodians. By obtaining the SPBD designation, Prometheum EC represents a step forward for institutions seeking to address custody-related compliance concerns related to crypto assets and offers a viable pathway for registered investment advisers to manage crypto assets in a manner consistent with the federal securities laws.

The designation, however, does not resolve the question of which crypto assets will be deemed securities, leaving some uncertainty as to precisely what assets Prometheum EC may custody. Thus, Prometheum EC may find itself in the unusual position of wanting to characterize certain crypto assets as securities at a time when others in the industry are arguing against such treatment.

#Crypto #PathwayForward #DigitalAssets

4. SEC Fines Investment Adviser for Failing to Disclose SPAC Conflict of Interest

On May 30, 2023, the SEC imposed a $1.4 million fine on New York-based investment adviser RTW Investments, LP (“RTW”) for allegedly failing to disclose conflicts of interest related to two special purpose acquisition vehicles (SPACs) that RTW helped to bring public. According to the settled order, one of the SPACs, Health Sciences Acquisitions Corp. (HSAC) completed an IPO in 2019 and later formed the public company Immunovant, Inc. through a business combination agreement. The other SPAC, Health Sciences Acquisitions Corp. 2 (HSAC 2) completed an IPO in August 2020.

The SEC alleged that RTW-linked funds owned a majority of both SPACs and that RTW personnel owned undisclosed interests in the remaining shares of the SPACs. According to the SEC, RTW personnel caused the RTW-linked funds to purchase certain shares and warrants. However, due to their undisclosed ownership interests, RTW personnel were entitled to receive a portion of the SPAC sponsor compensation. “[B]ecause the sponsor compensation was contingent upon the SPAC’s completion of a business combination, RTW personnel had financial incentives to recommend that HSAC and HSAC 2 engage in business combination transactions, even if the transactions or their terms were not necessarily in the best interests [of RTW’s advisory clients.]”

The SEC contended that RTW failed to disclose such conflicts of interests to the board of directors of the RTW-linked funds in a timely manner and omitted material information about the SPACs in statements to investors. The SEC further alleged that RTW lacked written compliance policies and procedures to prevent violations and didn’t accurately report beneficial ownership information for itself and some of its advisory clients. Accordingly, the SEC found that RTW violated Sections 206(2) and (4) of the Investment Advisers Act and Rules 206(4)-7 and 8 thereunder and violated and/or caused violations of Section 13(d) of the Securities Exchange Act.

#SPACs #ConflictOfInterest

5. SEC Sues Louisiana Bank for Failing to Disclose Share Buybacks

On May 31, 2023, the SEC announced a settlement with First Guaranty Bancshares, Inc. (FGBI) the parent company of First Guaranty Bank (FGB), based on allegations of disclosure violations relating to stock repurchases that were used for employees’ stock grants and bonuses. According to the SEC, FGB engaged a third party who was not an employee of FGBI or FGB to execute stock repurchases on the open market, then failed to properly disclose such repurchases in its Forms 10-Q and 10-K. The SEC claims this third party worked with the bank’s administrative personnel from 2016 through 2019 to facilitate the purchase of shares using his own brokerage account and distributed the shares directly to: (1) employees as part of the company’s stock grant program; and (2) executives as annual stock bonus awards.

The third party purchased nearly 120,000 shares of FGBI shares for approximately $2.5 million between September 2016 and February 2021 in connection with the employee stock grant program and year-end executive bonuses. Item 703 of Regulation S-K (as it existed at the relevant time) required issuers to, among other things, report for all issuer repurchases of equity securities the total number of shares purchased on a quarterly basis, including those made “on behalf of the issuer or any affiliate purchaser.” The SEC found that FGBI failed to do so, and further found that FGBI failed to implement controls, policies, and procedures designed to ensure compliance with Item 703. Accordingly, the SEC found that FGBI violated Section 13(a) of the Exchange Act and Rules 13a-13 and 13a-15(e) thereunder.

FGBI has agreed to settle the matter by paying a civil monetary penalty of $600,000, without admitting or denying the allegations. Considered in conjunction with the newly approved buyback rules described above, this case underscores the SEC’s recent focus on buybacks, further highlighting the need for issuers to pay attention to disclosures and compliance measures in this space.

#BuyBackDisclosures #StockRepurchases