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Securities and Exchange Commission: a frustrated regulator

Honig_StephenCompanies and individuals need to stay attentive to the bouncing ball that is the Securities and Exchange Commission.

The commission has finally enacted a ridiculous regulation that the SEC itself never wanted, and suffered a substantial defeat before the U.S. Supreme Court.

Pay Ratios Rule

In the 2010 Dodd-Frank Act, Congress charged the SEC with adopting regulations requiring comparison of a public CEO’s earnings to the median earnings of all other employees. The SEC delayed and delayed. Criticism from the business community, and from Republicans on the commission itself, did nothing to speed the process.

It took the SEC until 2014 to propose the rule, with the proposing release itself raising all sorts of questions. The SEC finally promulgated its binding “rule” effective this fall.

Compliance with the rule is certain to be useless. If the idea was that disclosure would shame CEOs into lowering compensation, that expectation reflects an unsupported view of human nature. If the SEC’s “say-on-pay” requirement, demanding shareholder votes on C-suite compensation, failed to stem the upwards spiral of CEO compensation, then publishing a meaningless ratio is not going to get traction.

The SEC has done its best to meet its legislative mandate and nonetheless make this new rule as innocuous as possible.

First, no disclosure is required before completion of the first full fiscal year beginning on or after Jan. 1, 2017. This theoretically gives companies sufficient time to gather data. Since the rule was clearly imminent since last year’s formal proposal, and since advisors have told registrants to gather data already, this delay is nothing more than a further accommodation.

Who are employees? People who are full time, part time, seasonal or temporary, located inside or outside the United States. Independent contractors are excluded.

But, what is the definition of an employee? There is much non-SEC litigation on this. The government, for tax and employee-protection reasons, seeks to classify “independent contractors” as employees if they perform services central to an enterprise’s business.

What if a company files a disclosure excluding many people it classified as contractors, who are later legally reclassified as employees? No one is going to say in a disclosure: “Although we claim that many people who work with our company are independent contractors, we are including their earnings to avoid material misrepresentation.”

The rule addresses foreign employees. Certain foreign jurisdictions have privacy laws preventing collection of information necessary to determine the ratio. A registrant must seek exemption under foreign law in an effort to include those employees; if any employee is thereafter excluded under foreign law, then all employees in that country must be excluded. Specifics of such exclusion must be disclosed.

Some commentators on the rule also asked for relief if there are very few foreign employees. Although such argument is internally inconsistent (if there are so few, how hard could it be?), the rule permits exclusion of up to 5 percent of foreign employees in certain circumstances.

The ratio must disclose CEO compensation in relationship to a “median employee.” Registrants are entitled to gather data from an entire employee population, or use statistical sampling. Such methodology must be applied consistently across the enterprise.

Applicable factors include size and nature of work force; complexity of organization; stratification of pay levels; different forms of compensation; different currencies, tax and accounting regimes; and number of payroll systems. All the foregoing must be disclosed.

Cost of living adjustments can be included for all employees located in jurisdictions other than where the CEO resides, provided the adjustment is applied to all other employees. The registrant also must disclose the ratio with and without the cost of living adjustment.

In recognition of the complexity of the calculation, companies must define “median employee” only once every three years, but if any material change to the employment pool or compensation arrangements occurs that materially impacts the ratio, recalculation is required. If no recalculation is required, the company must state it believes its current determination is reasonable.

Although observers long believed the ratio meaningless, initially the requirement was met with shrugs: “We will calculate a ratio, drop a sentence into the compensation disclosures, and we will be done with it.”

Unfortunately, the SEC has required detailed disclosure whenever registrants have availed themselves of flexibility. Until marketplace practices become apparent, we will not know what best ratio disclosures look like; we only know they won’t be one sentence long.

Insider trading

The SEC also lost some power to punish practices that go to the core of its mission, when the Supreme Court in early October refused to grant certiorari (review) of a 2nd Circuit case (U.S. v. Newman and Chiasson), which severely limited insider trading prosecutions.

The basis for preventing traders from using inside information is SEC Rule 10b-5, which prohibits employing any device, scheme or artifice to defraud in connection with the purchase or sale of securities.

A trading market, where all investors have the same information, is essential to capital formation. If you cannot trade based on the value of the underlying company, no one is going to buy shares in the first place.

Newman defendants, portfolio managers, received confidential earnings information leaked by insiders. By the time the defendants received the information, it had passed through three or four other persons.

Although sentenced to substantial prison terms, the defendants’ convictions were overturned in 2014 by the 2nd Circuit based on government failure to establish all necessary elements of a criminal conviction: that the insider was entrusted with a fiduciary duty (clearly true); that the insider breached that fiduciary duty by disclosing confidential information (clearly true) in exchange for personal benefit; that the tippee knew of the tipper’s breach and that the information was confidential and divulged for personal benefit; and that the tippee used that information to trade.

One key prosecution contention was that tippees knew of the tippers’ breach. The circuit court said there was no evidence of that. This result is anomalous. The defendants were experienced traders receiving earnings information not publicly released. You don’t need to be Rockefeller to deduce that this confidential information was obtained from a fiduciary source.

There was much discussion whether it was appropriate to require that tippee know the personal benefit that the tipper received. The circuit court held it essential. Further, the personal benefit had to be something palpable and substantial; the government could not prove that benefit by inference from “casual or social” friendship between tipper and tippee.

I suspect the federal government, which won conviction below, was confident that it would prevail. The federal brief seeking Supreme Court review included references to the trial transcript, which were damning to the defendants:

• Information was passed during nights or weekends, when intermediaries were not at work;

• One tippee gave a tipper substantial career advice, making job introductions and proofing resumes;

• There was clear awareness that information came from inside sources;

• One defendant paid $175,000 to the wife of one tipper;

• One tippee paid $15,000 “for giving him non-public information” and wired $5,000 to a casino to cover the tipper’s gambling debt.

Notwithstanding these damning facts, the Supreme Court let stand the 2nd Circuit decision, which contained its robust list of requisite elements to establish an insider trading violation, and thus the defendants escaped liability.

The result is difficult to sustain from a policy standpoint. If your goal is an honest marketplace, and if confidential information clearly came from inside, why should it matter whether the tipper received personal benefit? The tippee makes profit from trading with the public, which does not have confidential information. The evil is the harm to the marketplace; it is not dependent on the tipper’s benefit.

There are numerous detailed legal arguments contained both in the circuit court opinion and in filings made before the Supreme Court. But perhaps the real heart of the case turns on criminal law concepts. Based on detailed recitation that the tips passed through many people before reaching the defendants, the circuit court opinion stated: “Our conclusion also comports with well-settled principles of substantive criminal law.” Conviction of a crime requires that the defendant know the facts making conduct illegal.

The bottom line is that the SEC now has an almost impossible task in prosecuting trading tippees, even when they profit from clearly material inside information. U.S. Attorney Preet Bharara, in his press conference call, said that prosecutors would have to “think long and hard” about bringing insider trading cases. The decision could lead to a “potential bonanza to friends and family of rich people with material non-public information.”

In early October, recognizing the sweeping policy implications of the Supreme Court refusal to upset the 2nd Circuit decision, presidential candidate Hillary Clinton made a campaign promise to attempt to reverse the ruling, presumably through legislation.

Conclusion

This fall has not been a stellar moment for the SEC. One useless regulation and one significant court defeat will not change the SEC’s game plan, but it certainly is not a great way to end summer vacation.

Stephen M. Honig practices at Duane Morris in Boston.

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