[Senate Hearing 115-406]
[From the U.S. Government Publishing Office]
S. Hrg. 115-406
LEGISLATIVE PROPOSALS TO EXAMINE CORPORATE GOVERNANCE
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HEARING
BEFORE THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FIFTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING LEGISLATIVE PROPOSALS ON CORPORATE GOVERNANCE
__________
JUNE 28, 2018
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Available at: https: //www.govinfo.gov/
___________
U.S. GOVERNMENT PUBLISHING OFFICE
33-408 PDF WASHINGTON : 2020
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
MIKE CRAPO, Idaho, Chairman
RICHARD C. SHELBY, Alabama SHERROD BROWN, Ohio
BOB CORKER, Tennessee JACK REED, Rhode Island
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
DEAN HELLER, Nevada JON TESTER, Montana
TIM SCOTT, South Carolina MARK R. WARNER, Virginia
BEN SASSE, Nebraska ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota JOE DONNELLY, Indiana
DAVID PERDUE, Georgia BRIAN SCHATZ, Hawaii
THOM TILLIS, North Carolina CHRIS VAN HOLLEN, Maryland
JOHN KENNEDY, Louisiana CATHERINE CORTEZ MASTO, Nevada
JERRY MORAN, Kansas DOUG JONES, Alabama
Gregg Richard, Staff Director
Mark Powden, Democratic Staff Director
Elad Roisman, Chief Counsel
Kristine Johnson, Economist
Jonathan Gould, Senior Counsel
Elisha Tuku, Democratic Chief Counsel
Laura Swanson, Democratic Deputy Staff Director
Dawn Ratliff, Chief Clerk
Cameron Ricker, Deputy Clerk
James Guiliano, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, JUNE 28, 2018
Page
Opening statement of Chairman Crapo.............................. 1
Prepared statement........................................... 33
Opening statements, comments, or prepared statements of:
Senator Brown................................................ 1
WITNESSES
Thomas Quaadman, Executive Vice President, Center of Capital
Markets Competitiveness, U.S. Chamber of Congress.............. 3
Prepared statement........................................... 33
Responses to written questions of:
Senator Brown............................................ 59
Senator Sasse............................................ 62
Senator Cortez Masto..................................... 66
Darla C. Stuckey, President and CEO, Society for Corporate
Governance..................................................... 5
Prepared statement........................................... 41
Responses to written questions of:
Senator Brown............................................ 70
Senator Cortez Masto..................................... 108
John C. Coates IV, John F. Cogan, Jr. Professor of Law and
Economics, Harvard Law School.................................. 7
Prepared statement........................................... 48
Responses to written questions of:
Senator Brown............................................ 108
Senator Van Hollen....................................... 109
Senator Cortez Masto..................................... 110
Damon A. Silvers, Director of Policy and Special Counsel, AFL-CIO 8
Prepared statement........................................... 53
Additional Material Supplied for the Record
Letter, report, and email submitted by Thomas Quaadman........... 112
Letters, statements, and reports submitted by Chairman Crapo..... 193
Letters, statements, and reports submitted by Senator Brown...... 251
Letter submitted by Senator Toomey............................... 380
Letters submitted by Senator Scott............................... 382
Article, letters, and statements submitted by Senator Reed....... 390
News article submitted by Senator Tillis......................... 416
(iii)
LEGISLATIVE PROPOSALS TO EXAMINE CORPORATE GOVERNANCE
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THURSDAY, JUNE 28, 2018
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:02 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Mike Crapo, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN MIKE CRAPO
Chairman Crapo. The Committee will come to order.
Today's hearing will focus on several legislative proposals
to improve corporate governance.
As with Tuesday's hearing on capital formation proposals, I
intend to work with Senator Brown and with other Senators on
the Banking Committee to identify and move legislative
proposals through the Senate. Although some of the bills which
we have been discussing today have also been discussed and
considered in the House, most have not.
Today's hearing will mark a first step for those we have
not yet considered or were recently introduced.
Among other things, the bills that we will discuss today
would expand the definition of accredited investor, shorten the
Schedule 13D filing window and increase disclosure of short
positions, require FINRA to create a relief fund to cover
unpaid arbitration awards to investors, draw attention to
cybersecurity experience at the board level, address concerns
that a gap exists between the time a firm learns of material
nonpublic information and its disclosure, and highlight the
unique challenges to rural area small businesses.
Finally, several Members have expressed interest in
addressing the role of proxy advisory firms, and we will
discuss a bill which the House has already considered and
passed.
I look forward to hearing from our witnesses on these
legislative proposals, and if there are ways to modify these
bills to gain bipartisan support, I encourage it.
We have received some initial feedback on these bills,
which will be entered into the record, without objection.
Chairman Crapo. Senator Brown.
STATEMENT OF SENATOR SHERROD BROWN
Senator Brown. Thank you, Mr. Chairman.
Welcome, all four of you as witnesses. Thank you for
joining us. We will continue our discussion of bills sponsored
by Banking, Housing, and Urban Affairs Committee Members, this
time focusing on corporate governance.
All too often, it seems corporate boards and executives
focus more on preserving their job and maximizing and enhancing
their compensation than on investing in their companies and
their workers, and their communities.
Instead of investing in real businesses in real towns that
create jobs and build communities, they spend billions buying
back stocks and handing out CEO bonuses.
Take Wells Fargo, despite being continually mired in spin,
controversy, and scandal, they boosted their CEO's pay by 36
percent last year to $17 million. That is 291 times the median
worker's salary at the bank, as tellers, on the average,
nationally still make less than $13 an hour.
The short-term focus is painfully obvious when you consider
that last year's tax bill sparked a record level of stock
buybacks, $480 billion since it passed. Think about that,
almost half a trillion dollars, $480 billion.
The record level of buybacks is troubling on its own, but I
am even more concerned in light of SEC Commissioner Jackson's
recent findings that executives were much more likely to sell
their stock right after a buyback announcement than at other
times. That does not sound like building long-term value to me.
This is where shareholders play a key oversight role over
public companies, and institutional investors, those with the
strongest voice, can be essential in holding company management
accountable. Shareholders of all sizes deserve to have every
tool available to make sure executives are thinking beyond
their self-interest and managing for the long-term good of the
company.
But we cannot just depend on shareholders. The system needs
protections to ensure corporate managers are honest and address
difficult issues.
I am particularly concerned about a proposed bill, the
Corporate Governance Reform and Transparency Act, which would
create structural obstacles for shareholders to hold corporate
management accountable. The bill would make it harder for
public retirement systems, including some in my State of Ohio,
to use research and analysis from proxy advisors to manage
investments for hardworking Americans. Why would we want to do
that if we really care about those investors and those
communities and those retirement systems?
It is ironic, Mr. Chairman, that some of the same people
who want to expand the definition of accredited investor,
confident that somebody with a million dollars in assets can
make good investment decisions on startup companies, do not
think the very sophisticated managers of tens of billions of
dollars of assets, pension plans, for instance, can tell
whether the investment advice they are buying is worth what
they are paying.
I have letters opposing that bill, Mr. Chairman. I would
like to submit them for the record, the bill H.R. 4015 letters
from the Ohio Public Employees Retirement System, the State
Teachers Retirement System of Ohio, and others, if I----
Chairman Crapo. Without objection.
Senator Brown. Thank you, Mr. Chairman.
We should be pushing for more shareholder engagement and
oversight, for more transparency, not less. Some of the
proposals we will discuss today improve transparency.
Senator Jack Reed's bill would promote more disclosure on
cybersecurity. I thank the Senator from Rhode Island for that.
Senator Van Hollen's proposal would require companies to
close loopholes to prevent insider trading. I thank the Senator
from Maryland for that.
These types of measures require company management to
upgrade their practices and disclosures to the markets. As I
said at our earlier hearing this week, if we focus on passing
laws that enhance investor confidence instead of undermining
it, we end up helping those businesses too. It is good for
shareholders, good for workers, good for communities.
Thank you, Mr. Chairman.
Chairman Crapo. Thank you, Senator Brown.
And today's witnesses are Mr. Thomas Quaadman, Executive
Vice President of the U.S. Chamber Center of Capital Markets
Competitiveness; Ms. Darla C. Stuckey, President and CEO of the
Society for Corporate Governance; Professor John C. Coates IV,
John F. Cogan Jr. Professor of Law and Economics at Harvard Law
School; and Mr. Damon A. Silvers, Policy Director and Special
Counsel at the American Federation of Labor and Congress of
Industrial Organizations.
I appreciate all of you being here with us today. Your
written testimony has been entered into the record, and we
encourage you each to pay close attention to the clock as the
Senators will have lots of questions they want to ask you.
With that, Mr. Quaadman, you may proceed.
STATEMENT OF THOMAS QUAADMAN, EXECUTIVE VICE PRESIDENT, CENTER
OF CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF CONGRESS
Mr. Quaadman. Thank you, Chairman Crapo, Ranking Member
Brown, Members of the Committee. Thank you for holding this
hearing today.
We have a crisis of entrepreneurship in the United States,
and indeed, we have a calcification of startups in the United
States. Business creating rates have not rebounded from the
Great Recession. Three counties in the United States have more
businesses that go out of business than are created, and 50
percent of all startups in the United States occur in 20
counties. We are literally missing hundreds of thousands of
businesses that we historically would have created had this not
happened.
But we also have a precipitous decline in number of public
companies that started in 1996. We have less than half the
number of public companies today than we did then. We have
relatively the same as we did in 1982. In other words, the
gains of the Reagan and Clinton administrations have been wiped
out.
More needs to--the JOBS Act has arrested the decline of the
number of public companies, but more needs to be done to
reverse these trends, and we need to put in place policies that
will help businesses start and grow from small to large. The
hearing this week are an important step forward; however, the
recent reports about the rise of Chinese venture capital show
that we do not have luxury of time.
The Chamber strongly supports the Corporate Governance
Reform and Transparency Act. We have two proxy advisory firms
that control 97 percent of the business. They are, de facto,
standard setters of corporate governance. Each has a unique
conflict of interest. Both have black box processes and systems
and a failure to fix errors. All of this combines to materially
impact the ability of investors to get the essential
information that they need.
Firms have even, in one case, overturned the express rule
of Congress and silenced investors for their own pecuniary
interests. Advice should be accurate and linked to a client's
fiduciary duty and economic return. While the 2014 guidance was
helpful, the SEC has not exerted oversight, and we think it is
important for Congress to mandate it.
We have some concerns with the Cybersecurity Disclosure
Act. Cybersecurity is a top priority for businesses; however,
businesses get very conflicting messages from different
Government agencies. The SEC guidance on disclosure is somewhat
helpful. We think that there is more that needs to be done
there. However, this bill would require board expertise in
cyber. It would start to pigeonhole different types of
expertise in boards. It conflates the role of management and a
board of directors, and indeed, it lacks the recognition that
there is a relatively small number of people with cyber
experience, and we do not even know if they can perform the
other fiduciary duties of a board member.
We also have some concerns with the Brokaw Act. Short
selling is a necessary market function for liquidity purposes.
We have raised issues before with abuses to short selling, such
as naked short selling or short-and-distort campaigns.
13D filings, we understand the desire to maybe modernize
those; however, modernization of 13D filings can also bleed
into 13F and 13G filings, which can directly, adversely impact
401(k)s. Therefore, we believe it is important for both of
these issues that maybe there should be an SEC study rather
than mandated requirements.
We also understand and want to work with Senator Van Hollen
on the 8-K Trading Gap Act of 2018. We also agree that there
needs to be strong policies to combat insider training;
however, we have some concerns on the window between when an
event happens and when it is deemed to be material. We want to
work with Senator Van Hollen on how to clarify that.
We strongly support the Fair Investment Opportunities for
Professional Experts Act. We believe that these rules should be
modernized. It is long overdue, and the SEC is not active.
We have some concerns with the Compensation for Cheated
Investors Act. We understand the issue and agree that those who
receive an arbitration award should be able to collect on that;
however, this is a small problem related to the larger picture.
And that we believe that there should be some time elapsed
to allow for the FINRA transparency rules to take hold;
however, we would be willing to work with both Senators Warren
and Kennedy to maybe see if SIPC would ben alternative.
We also strongly support the Expanded Access to Capital for
Rural Job Creators Act, introduced by Senator Jones. We think
this would be an important step forward to help bring
entrepreneurship to rural areas.
Thank you, Mr. Chairman. I am happy to take any questions
you may have.
Chairman Crapo. Thank you.
Ms. Stuckey.
STATEMENT OF DARLA C. STUCKEY, PRESIDENT AND CEO, SOCIETY FOR
CORPORATE GOVERNANCE
Ms. Stuckey. Chairman Crapo, Ranking Member Brown, Members
of the Committee, my name is Darla Stuckey. I am the President
and CEO of the Society for Corporate Governance. We appreciate
the opportunity to present our views on legislation before this
Committee.
We are a professional membership association of corporate
secretaries and in-house counsel, and other governance
professionals, representing about a thousand public companies.
As Tom said, public company ownership is on the decline. In
1997, there were about 7,100 U.S. public companies, now fewer
than 3,600.
While there are a range of factors causing this, two of the
bills this Committee has before it can improve the climate for
public ownership--H.R. 4015, the Corporate Governance Reform
and Transparency Act, and S. 1744, the Brokaw Act.
H.R. 4015, which has passed the House, addresses the role
of proxy advisory firms who serve institutional investors. They
operate with very little oversight. H.R. 4015 would provide
badly needed improvements to the accuracy and transparency of
these firms.
The proxy advisory market is dominated by two firms--
Institutional Shareholder Services, or ISS, and Glass Lewis.
For the uninitiated, these firms advise investors on how they
should vote their shares at annual meetings as well as in
corporate contests.
While recommending how an investor should vote may sound
unimportant, the reality is far different. ISS and Glass Lewis
analyze and recommend, for example, on composition of the
board, executive compensation, and a diverse range of
shareholder proposals. In fact, our members report that as much
as 20 to 30 percent of their total shareholder votes are swayed
by ISS and Glass Lewis.
These firms also own and control the software platforms
that investors actually use to vote. They are indispensable to
the institutional proxy voters.
But summarizing proxy statements in a short period of time
makes errors inevitable. You may have heard that real factual
errors do not exist because companies do not complain about
them to the SEC. I am here to tell you that is not the case.
They do exist. ISS is the dominant provider of these services,
but only S&P 500 companies see their reports before they are
issued. They have typically 2 days to review and correct any
mistakes. The rest of the 2,500-plus companies that exist do
not see them.
Glass Lewis recommendations are not made available in
advance at all. The inability to see draft reports in advance
can have dire consequences. Once a firm issues its
recommendation to its
investor clients, the vote is in within a matter of days, and
the changing of a vote is almost impossible.
I have a story about a small-cap transportation company, it
happens to have a union, that highlights many problems that
H.R. 4015 would fix. In May 2016, 2 weeks before their annual
meeting, this company received an ISS report with an against
recommendation on its say-on-pay. It was based on a factual
error in their bonus plan calculation. Because the company is a
small cap, it did not see the ISS report before it went to
shareholders. The company scrambled to get the error corrected
and a positive recommendation. ISS acknowledged the error but
refused to correct it.
Despite the company's effort to contact their actual
shareholders about the recommendation, they failed. Their vote
was 49.8 percent. After the vote, the company did more
shareholder outreach, but no shareholder asked for changes to
the bonus plan. The company then disclosed its outreach efforts
in its next year's proxy.
That next season, ISS issued another report, again,
incredibly recommending against the company's say-on-pay. ISS
simply did not believe the disclosure in the proxy that no
shareholders had asked for changes to their bonus plan when it
was based on a mistake, anyway.
To add insult to injury, ISS also recommended a vote
against four directors on the compensation committee, one of
whom was the only female board member at the time, and another
of whom was one of two racially diverse members.
Thanks to above-and-beyond shareholder outreach that
spring, the company got their four directors reelected at a 60
to 70 percent rate, but for the second year in a row, they lost
say-on-pay at a very low rate of 32 percent.
This year, after extensive outreach to shareholders and
with ISS and Glass Lewis, their say-on-pay vote was recommended
in favor, and it was approved. And their directors were
overwhelmingly reelected at 97 to 99 percent, so there is the
gap.
This story demonstrates the influence of proxy advisory
firms and the need for crucial regulation. We support its
passage. We do understand that institutional investors and the
proxy advisory firms themselves oppose the bill because of cost
concerns for their clients. We are willing to work with the
Committee to improve the legislation in a manner that
accomplishes these goals.
Let me now turn to S.R. 1744, the Brokaw Act. There is no
doubt that some activists create shareholder value, and the
Society is not seeking to stifle activist investing. However,
we do seek to level the playing field on the disclosure rules.
Activists have 10 days to file a 13D after they have
accumulated 5 percent of a company's stock. This means 10 days
more to accumulate as much as they want, and sometimes through
derivative positions that are unknown to the company.
S.R. 1744 shortens the time to 4 days and ensures that
securities positions taken by activists are transparent. This
is good public policy. We support the bill and the
modernization.
There are two other bills before the Committee that could
discourage companies from going and remaining public, and the
Society opposes them in their current form--S. 536 and the 8-K
Training Gap Act.
I see I am running out of time, but I am happy to answer
questions. Thank you.
Chairman Crapo. Thank you very much.
Professor Coates.
STATEMENT OF JOHN C. COATES IV, JOHN F. COGAN, JR. PROFESSOR OF
LAW AND ECONOMICS, HARVARD LAW SCHOOL
Mr. Coates. Chairman Crapo, Ranking Member Brown, and
Members, thank you for the opportunity to be able to comment
on, I am happy to see, a bipartisan set of fairly focused
proposals on how to improve corporate governance, and I commend
the overall agenda for that reason.
One word about me. Before I came to Harvard, I practiced as
a partner at Wachtell Lipton Rosen & Katz in New York, where I
wrote 8-K proxies, 13Ds, and I only mention that because I want
to emphasize that my views here are based in part on my
research and teaching, but also on personal experience. I have
some familiarity directly with the law's effects in this area.
Endorsements. I endorse the cybersecurity bill. It is a
real problem. It is getting worse. We are playing catchup
across the board, big companies and Government alike. This is
the gentlest of disclosure obligations. It is hard to think of
something that could be more gentle. It simply asks boards to
say, ``Do you have a cyber expert or not? And if not, why
not?'' So, contrary to suggestions to the contrary, it does not
mandate experts on the board. It simply asks boards to explain
why they do not have one. The answer could be because there are
none available, or it could be because we have other resources
that are better.
So if it is given to be gentle why do I have favor, why is
it going to have any impact, well, here is something to know
about proxy statements. Proxy statements are read by boards.
Among all the SEC documents that the boards nominally have
oversight of, they are among the most carefully read. The
reason is because the proxy statements are about the board
members. So they, being human, read them carefully because it
is about them.
So that slight tweak to what they have to engage in, in the
disclosure process, I think will help nudge those companies
that have not already begun to take cyber seriously, and
unfortunately, there still are some companies out there that
are not facing up to the risks that they face.
One last word on this bill, there is maybe going to be some
suggestion that there is a slippery slope and there is all
kinds of risks and that cyber is one of them and so on. I
really do want to emphasize that cyber is unique. Other than
financial risk, where we already have an obligation for boards
to say do they have financial expertise on the board or not,
other than financial risk, cyber risk is, I believe, the one
type of risk that is almost universal among public companies.
It is very hard to think of a public company in this network
age that is not at least somewhat exposed to cyber risk.
Unlike environmental risks, labor risks that my friend here
cares about, which do affect some sectors significantly, I
think cyber affects the entirety. So that is why this is not a
slippery slope to every kind of risk being addressed in the
proxy statement. So that is my endorsement.
I also endorse the 8-K bill. I can talk more about that in
Q&A.
I also very much endorse adding the voice of rural small
business to the SEC's advisory community. I grew up in Virginia
and spent a lot of time on farms in South Central Virginia, and
I think there is a distinct voice that is missing at the SEC.
I also endorse the Brokaw Act. I have the same concern
about discouraging shorts. I think there is a tradeoff
involving short sales, and adding disclosure obligations is
going to burden the ability of some shorts to function, to
unveil fraud and find real problems at companies.
On the other hand, it is a little hard to understand why if
you have a fairly big net short position and you are disclosing
your long people, you do not have to disclose the short
position.
So I would recommend adopting this bill but adding a sunset
to it and forcing the SEC to study the effects on shorts over
the next couple of years, and then the bill would die at that
point, unless the SEC came back to you and said it was working
the way we expect it to. So that would be my recommendation
there.
Last minute. I endorse the goal also of the FINRA bill. It
is outrageous that investors who have proven fraud can still
not get recoveries, particularly if the targets of the fraud
action simply quit the brokerage industry and moved over to
investment and advisory industry where FINRA has no oversight.
And that is a real problem.
Again, I have a slight concern that I would suggest the
Committee think about, which is FINRA alone does not have full
power over this industry, and I would suggest giving it to the
SEC rather than to FINRA. If you want to stick with FINRA, then
at least allow the SEC a year to come up with its own solution
before the FINRA solution kicks in.
I oppose H.R. 4015. I think it flunks a cost-benefit test,
as written. I am happy to take questions about why in the
remaining time.
Thank you.
Chairman Crapo. Thank you.
Mr. Silvers.
STATEMENT OF DAMON A. SILVERS, DIRECTOR OF POLICY AND SPECIAL
COUNSEL, AFL-CIO
Mr. Silvers. Thank you, Chairman Crapo, and good morning,
Mr. Chairman, Ranking Member Brown, and Members of the
Committee. My name is Damon Silvers. I am the Policy Director
and Special Counsel for the AFL-CIO, America's labor
federation. We represent 55 national unions, over 12 million
people, on behalf of which $7 trillion of benefit funds are
invested in the world's capital markets.
Like my fellow witnesses, it is an honor to be here with
you and in particular to take up such a thoughtful and
carefully structured agenda.
Each of the bills under consideration in this hearing fits
with-
in the following three questions: one, how to effectively
protect
investors from the threat of self-dealing by the experts they
hire to help them manage their money; two, how to ensure a
level playing field for all investors in capital markets where
information moves instantaneously and where big data means big
power and big money; three, how to prevent the recurrence of
the dynamic that led to the financial crisis of 2007 and 2008
where large parts of the financial system became unregulated
and/or opaque with catastrophic consequences.
With those three issues and goals in mind, the remainder of
my testimony will address each of the bills under consideration
in turn, briefly.
First, and most importantly on the agenda this morning,
H.R. 4015, the Corporate Governance Reform and Transparency
Act, effectively gives corporations, CEOs, and boards the
ability to control the people who are supposed to be holding
them accountable. This is a very serious threat to any
possibility of addressing the dynamics that Ranking Member
Brown spoke to in his opening remarks.
The way this bill would do this would be, A, by creating a
set of substantive regulatory obligations of a kind that no
other investment advisor has to live within, and, B, by
enabling companies to delay the vote recommendations and, thus,
be able to essentially engage in coercive processes with the
proxy advisory firms around any recommendation that was
contrary to what the executives wanted, including votes on
their own executive pay packages.
The AFL-CIO does believe that proxy advisors should be
regulated like other investment advisors, and we would not
oppose a bill that required them to register, which is not
currently the law. But we do very much oppose the notion that
they should be subject to a separate and punitive set of
regulations, which is exactly what this bill does. It seeks to
punish them for doing their jobs and to impose upon them a
regulatory scheme designed to make them disloyal to their
clients, among which are our members' pension funds.
Moving on to S. 2756, the Fair Investment Opportunities for
Professional Experts Act, this addresses the issue of who is an
accredited investor, who is allowed to invest in substantially
unregulated private offerings.
The $1 million asset threshold that is core to this,
together with several income thresholds, was originally set by
rule in 1982 and has not been updated since then.
The bill does have an indexing provision, which we agree
with, but the current baseline of the bill is far too low to
act as a starting point and essentially would add to the
problems that some of the other witnesses talked about in the
public markets, so we oppose this bill.
The Brokaw Act, S. 1744, shortens the window between when
an investor acquires a 5 percent stake and when they have to
file and requires short selling to be disclosed. This makes
eminent sense, and we support this bill. It prevents
manipulation.
The Compensation for Cheated Investors Act, S. 2499,
requires FINRA to ensure that the damage awards made to
investors are actually paid, and if necessary, to use FINRA's
revenue from fines to do so.
Between 2012 and 2016, there were almost $200 million in
unpaid damage awards from FINRA.
This would make sure investors defrauded by brokers are
actually able to collect the full amount of the award and would
increase accountability and public trust in the financial
system and broker-dealers. Passing S. 2499 is in the interest
of investors and in the interest of maintaining and improving
the integrity of our securities laws.
The S. 536, the Cybersecurity Disclosure Act, was discussed
in some detail by my colleague, Professor Coates, and we view
this as, again, a commonsense thing. The commission should have
addressed this. In their absence, we support the bill.
We also support adding a language encouraging the Investor
Advocate to think about rural issues, particularly in light of
rising natural disasters and the cost of climate change.
Finally, the 8-K Trading Gap Act of 2018 is similar to the
Brokaw Act. It really addresses the ability to engage in
manipulations, given modern-day data around 8-K filings. It is
very much in investors' interest. We support it.
So, in conclusion, you have in front of you a group of
bills that are thoughtful and protect investors, and you have
two bills that are dangerous. And one in particular, the one
addressing proxy firms, is essentially--would--essentially
defeat the corporate governance system, and we very strongly
urge the defeat of that bill.
Thank you very much.
Chairman Crapo. Thank you very much, Mr. Silvers.
I will begin the questioning, and I would like to start
with you, Mr. Quaadman. The Brokaw Act would require investors
to disclose short positions, and several of you have mentioned
this issue with regard to it. Many institutional investors,
such as pension funds, endowments, and foundations use short
selling as a tool to manage risk and reduce the overall
economic exposure of an investment portfolio. Short selling
also plays an important role in providing market liquidity and
facilitating price discovery.
Could you comment a little further on the likely impact of
such disclosures on the markets and the use of short selling as
a risk management tool?
Mr. Quaadman. Sure. Short selling is an extremely important
tool for participants in the marketplace to be able to hedge
their positions, and it is also important for liquidity
purposes as well.
The challenge that there is in terms of the disclosures
that are outlined here is that there are proprietary trading
platforms that would be exposed. There are a variety of
different methods, then, that could potentially harm investors.
So that is why we think if there is abuses, that is where
we need to make sure that there is a light shined there, but we
think it is more important for the SEC maybe to take a closer
look at this rather than to start to mandate disclosures
themselves.
Chairman Crapo. Thank you.
Professor Coates, you mentioned you had some thoughts on
the short selling aspect of the Brokaw Act. Could you clarify
those as well?
Mr. Coates. Yes. I agree generally, although I will note
the short disclosures would principally be in the 13D
component, which most institutional investors would not need to
comply with because their positions are passive and not
intended to influence companies.
I do agree. Still, even in the very active space, I worry
that disclosure could discourage some shorts from taking
aggressive short positions against companies that do have
problems, and shorts have played a major role in uncovering
serious frauds in the past 5 years.
But having said that, I honestly do not think the SEC
currently is equipped to learn much more than we could discuss
today. So I would encourage a deliberate attempt to see what
happened and, again, sunset the rules so that it is not going
to remain there permanently if it is causing problems, but to
proceed and direct the SEC to study in fact what happens.
Cost-benefit analysis, which I told you I endorse and the
Chamber is very much in favor of, is a great idea in theory,
but in order to really learn about the markets, you actually
have to be willing to change sometimes. And I think this is a
change worth making.
Chairman Crapo. Thank you.
Ms. Stuckey, a question on proxy advisors. In testimony
before the House Financial Services Committee last week, SEC
Chairman Clayton discussed shareholder engagement and the proxy
process. In that context, he stated that the SEC should analyze
whether the voices of long-term retail investors are being
underrepresented, misrepresented, or selectively represented in
corporate governance.
What is your view on whether and how long-term retail
investors are being represented on corporate governance matters
and the role of proxy advisory firms in that representation?
Ms. Stuckey. Thank you, Chairman Crapo. Thank you, Chairman
Crapo.
Chairman Crapo. It will come on.
Ms. Stuckey. Is it on?
Chairman Crapo. Yes.
Ms. Stuckey. Thank you. Sorry for that.
If you are talking about Mr. and Mrs. 401(k) as long-term
retail shareholders, they are represented by investment
managers who largely vote with ISS and Glass Lewis. So they are
being swept up in everything we talked about with proxy
advisory firms.
They do not particularly want their companies wasting time
trying to fix mistakes after the company has already written
its own regulated SEC proxy statement.
I think that long-term retail shareholders really want
their companies focused on strategy, competition, and
innovation and cyber.
So the only other way that sort of the whole problem with
proxy advisor, if it a disincentive to companies going public,
then you have got long-term retail shareholders that do not
have the same investment opportunity to invest in more
companies, which we think is a problem.
Public, State, and private pension beneficiaries as well
have no individual voice. Does any pension fund check with
their beneficial owners before they vote, how they should vote
on a particular shareholder proposal, say climate-related? I do
not know if they check with their teachers and their firemen
and their policemen, but I can imagine that there are many
individuals that would be appalled at the way their votes are
being cast. Basically, they are disintermediated.
Chairman Crapo. Thank you.
Senator Brown.
Senator Brown. Thank you.
Professor Coates, I would like to ask you about proxy
advisors. Your testimony suggests the Corporate Governance
Reform and Transparency Act should be renamed the ``Proxy
Advisor Regulation Act.'' Describe, if you would, briefly the
procedural barriers the bill would create for shareholders and
the proxy advisors that they have hired.
Mr. Coates. Sure. I think with a high-level admirable goal
of trying to address potential conflicts at the proxy advisors,
the way the bill was written, however, somewhat remarkably,
given its origins, it expects Government to fix this problem by
creating a bureaucracy at the SEC that would have fairly
significant costs that it would pass along in the form of
regulation, compliance officers, required ombudsmen, need to
prove the efficacy and knowledge base of the advice that is
being given, which is a type of regulatory requirement that is
found nowhere else in the securities markets. Broker-dealers do
not have to prove that they have an adequate basis for every
recommendation they have.
There is significant cost associated with--and fixed cost.
Let me emphasize fixed minimum cost associated with complying
with the regime that is envisioned by this bill, which would
discourage competition, not enhance it. So if you do not like
there only being two, this would only make things worse.
And more basically, it is surprising to me that the
sponsors of the bill do not recognize that under existing law,
State law, and existing SEC law, the advisors could be sued by
their clients if they are committing fraud or otherwise
breaching their duties to their clients. And so this is a place
where I am kind of inclined with the Chamber's normal position,
which is we should really find the problem with the existing
legal regime before adding more regulatory burdens on the
system.
Senator Brown. Thank you.
And following, Mr. Silvers, describe how the changes in the
bill, what impact it would have on a large shareholder like the
Ohio Public Employees Retirement System and its ability to hold
management accountable.
Mr. Silvers. Senator, the issue that pension funds face is
that they are fully diversified in generally very long-term
holdings in the equities market. They hold typically hundreds
of stocks, and they have a fiduciary duty under both ERISA, the
tax laws, and the relevant State laws to manage their assets.
And the proxy vote is an asset. They have a fiduciary duty to
manage their assets with expert advice.
Proxy voting firms are like other forms of investment
management, provide expert advice on corporate governance to
pension funds, enabling them to fulfill their duties.
Critical to that process is that the advisors have to be
loyal to the pension fund. Expertise is one part of the
fiduciary duty; the other part is loyalty. This bill
compromises the loyalty issue significantly by enmeshing the
advisor in a process of interacting with the very people whom
the corporate governance process is designed to hold
accountable. It puts the proxy advisory firm on both sides of
the principal-agent problem.
On the one hand, it compromises the substance of the
relationship between the advisor and the client.
Second, as Professor Coates said, it adds a layer of
significant cost to what is otherwise a de minimis expense and
one that provides substantial value in terms of votes that
could affect the overall value of the securities involved, and
so there is a cost issue.
There is finally an issue that Professor Coates raised
briefly but I think is really worth hammering on here, which is
that our entire securities law system and our pension law
system, no one is required to get it right substantively as a
legal matter. This is also true in corporate law. No one is
held legally responsible for not making a mistake. People are
held responsible for due care, and they are held responsible
for loyalty, but not for perfection. And the fact that that
kind of standard is sort of weaved into this bill is really
telling you that the purpose of this bill is to prevent the
corporate governance system from functioning.
Senator Brown. Thank you.
I have only a few seconds. I want to ask for very short
answers from Professor Coates and Mr. Silvers on the Brokaw
Act. The Act put in place 50 years ago requires shareholders to
report when they own a significant stake in a company. How will
this bill help with transparency?
Let's start with you, Professor Coates, and I apologize,
but as briefly as you can and then Mr. Silvers.
Mr. Coates. So 10 days, which is how long you have to file
a 13D, is in today's environment an eternity, and it will
shorten the amount of time before a filing has to be made.
Derivatives economically are equivalent to the positions that
normal stockownership provides, and right now, they are left
out of 13D. So those two ways are the ways that it would
enhance transparency.
Senator Brown. Mr. Silvers.
Mr. Silvers. Senator, I agree with what John said. I just
want to talk to the short-selling issue.
The whole point of this regime is to give investors who are
not 5 percent holders, who are not in a potentially control
position, knowledge about what is going on and what people are
doing potentially to control the company that they have
invested in.
There is no way to understand what is going on if you do
not understand what the short position is of the potentially
controlling investor.
In my view, the concerns that have been raised, to wit
about in general will this provision affect the ability of
short sellers to operate and the ability of short sellers to
play their legitimate function, I think is misplaced.
Senator Brown. Thank you.
Chairman Crapo. Thank you.
Senator Toomey.
Senator Toomey. Thanks, Mr. Chairman.
I just since returned, but I would just point out that
there are some significant differences between a short position
and a long position. A short position, for instance, you are
subject to unlimited price risk, whereas a long position, you
cannot go below zero. But there is no limit to how high a short
position can go against someone.
Also, a short needs to be able to borrow the security. A
long position does not have that problem.
And then, finally, I would point out that a short position
does not entitle you to voting rights. So they are
qualitatively very different, and I think we should proceed
pretty cautiously for those reasons and others.
Let me touch on a few of the bills, and I appreciate this
hearing. I think we have got some very worthwhile legislation
to consider. One of them is S. 2756. That is a bipartisan bill,
and the idea here is that we would acknowledge knowledge and
expertise as grounds for being an accredited investor.
Let us be clear, right? The asset test and the income test
that we currently use is a proxy for understanding the risk
that you are going to be taking. Well, if you are a financial
industry expert because it is your job, then that certainly is
relevant experience. So I support this legislation.
The Family Office Technical Corrections Act is in a similar
vein. What it would simply do is ensure that family members
whose savings are managed through a family office are treated
as accredited investors, and I think this just makes sense. It
is not one of the bills under consideration at this hearing
directly, but it has passed the House with a voice vote.
And I have got a letter from Private Investor Coalition in
support of this. I would ask that that be included in the
record.
Chairman Crapo. Without objection.
Senator Toomey. And I would ask the Chairman to consider
including this really important technical change in any package
we might advance.
I do want to talk a little bit about S. 2499, the
Compensation for Cheated Investors Act. My understanding is
this legislation would create a fund funded by broker-dealers'
fines, which are currently used to fund FINRA. So if that money
were no longer available for that purpose and were instead used
to compensate victims of fraud, then presumably the fees would
have to go up that the innocent broker-dealers would have to
pay into FINRA.
So I am sympathetic to the problem. Obviously, if somebody
has been cheated, they ought to be made whole, but I am a
little concerned that socializing this cost means spreading it
among perfectly upstanding firms that have not done anything
wrong to cover that which is done by bad actors.
And I further worry that this legislation could put a
target on the backs, especially of smaller broker-dealers that
may not have the funds to effectively defend themselves because
there would be a backstop that somebody could go after that
could encourage a wave of litigation.
And so, Mr. Quaadman, I would just ask, are these--do you
share any of these concerns, or do you have other concerns
about this legislation?
Mr. Quaadman. No. We share those concerns.
First off, we also have to recognize we are talking about a
relatively small number of cases, I think 44, and even if you
then take out those cases that maybe had gotten compensated
somewhere else, we are talking about less than 30. So we are
concerned that, one, if you start to use fines in this way, you
are going to start to incentivize for more fines. It is going
to take some resources away from FINRA.
We also share your concerns as well that if you are going
to socialize the cost of good actors, it is going to subsidize
bad actors, and that is why we think it might be more
appropriate to use the SIPC as maybe a vehicle to maybe take
care of this.
But we also think, too, that while it has taken a while to
take care of these issues, FINRA has taken some actions here,
and we need to see how those take hold.
Senator Toomey. Thank you.
Let me just move on quickly to the proxy advisory firms, of
which really are two that dominate the marketplace. One, ISS
generates considerable revenue from the consulting services it
provides to companies about proxy votes, while at the same time
advising institutional investors how to vote on those very same
issues.
It seems like a glaring conflict of interest if in fact
they are receiving revenue or seeking revenue from a business,
while at the same time advising investors how to vote the
shares of a proxy.
Question. Do you see it as a fundamental conflict that is
problematic?
Mr. Quaadman. Yes, we do. And, in fact, I have an email
here--I will be happy to submit it for the record--of a
solicitation for a company where the consulting service
basically approaches a company to say, ``You are going to get a
better score if you use us as your consultants.''
I think, too, we also have to understand that Glass Lewis
has a separate conflict of interest as well because they are
actually owned by two activist pension funds as well.
So we have to understand that proxy advice at its very core
is to provide data to those investors so that they can make
that independent judgment. They are not going to--but it has
been used by others just to totally outsource their corporate
governance functions.
We have addressed issues like this before credit rating
agencies and financial analysts, and we should do it here.
Senator Toomey. [Presiding.] Thank you.
Senator Reed. I guess you are in charge.
Senator Toomey. Am I in charge? Are you up next?
Senator Reed. I am.
Senator Toomey. Well, I see I have run out of town. The
Senator from Rhode Island.
Senator Reed. Well, thank you, the Senator from
Pennsylvania by way of Rhode Island. Thank you.
I want to just take a few moments to talk about my bill. I
have talked to the Chairman. He has given me a little
discretion, which is basically cybersecurity is I believe the
most significant and universal threat that every company and
enterprise in this country faces, and it is going to get worse.
And it is not just a threat to the bottom line of companies. It
is a national security threat.
I serve on the Armed Services Committee as a Ranking
Member. I was stunned when we had General McDew, who is
commander of Transportation Command. Transportation Command is
the major agency in DoD that contracts with all the aircraft,
all the ships, all the logistical to move men and material and
personnel into war zones and to anyplace in the world.
And here is what General McDew said:
Cyber is the number one threat to the U.S. Transportation
Command, but I believe it is the number one threat to the
Nation. In our headquarters, cyber is the commander's business,
but not everywhere across our country is cyber a CEO's
business. In our cyber roundtables, which is one of the things
we are doing to raise our level of awareness, some of the CEOs,
chief security officers, cannot even get to see the board. They
cannot even see the CEO. So that is a problem.
In the essence of this legislation, which is the mildest
form of disclosure, it is not mandatory. It does not require a
person to be on the board with a cyber degree. It asks the
company in two lines to describe what they are doing.
We have companies today that we will depend upon in an
emergency that may have been fully infiltrated by a cyber
threat, and they are completely unaware. And their CEOs are not
aware because there is nothing to make them sit down and say,
``Hey, I've got to pay attention to cyber.'' This is the
mildest form, when they read that proxy statement and say,
``Oh, yeah. Boy, we have to think about cyber,'' otherwise it
will not happen. It is not happening.
That is why you have Equifax problems. By the way, it has
just been announced today that Equifax has settled with State
Attorney Generals, and one of the things they have agreed to
do, boost board oversight of cybersecurity because they failed,
and they are not the only company that has failed and that is
failing right now. And we are simply saying tell your
shareholders what you are doing. You can do anything you like.
You can hire a company. You can have a director, et cetera,
this is not mandatory. This is disclosure.
This Act is bipartisan. Senator Collins, Senator McCain,
Senator Warner, this is something that is absolutely critical.
And I should say Senator Warner is the Ranking Member of the
Intelligence Committee, and I think he brings that expertise to
this support for this bill also.
The Cybersecurity Disclosure Act is supported by not only
Professor Coates and Mr. Silvers--thank you--but the Alabama
Securities Director Joseph P. Borg on behalf of the National--
or North American Securities Administrators Association, the
National Association of State Treasurers, the California Public
Employees Retirement System, the Bipartisan Policy Center,
Professor Jack Coffee of Columbia, and the law firm of K&L
Gates, which is a very distinguished Washington firm. And I
would like, whoever is the Ranking Member, to include those
letters in the record.
Senator Cotton. [Presiding.] Sure.
Senator Reed. Thank you.
[Laughter.]
Senator Reed. Thank you, Senator.
Senator Cotton. Watch out. I am driving the bus now.
Senator Reed. Yeah, OK.
So I just think this is incredibly important. You know, I
fear that months, weeks, years from now, there is going to be a
cyber disaster, and we are all going to look back and say,
``Gee, if only we had done something.'' Now is the chance to do
it.
Now, Ms. Stuckey, in your written testimony you say even
the Council of Institutional Investors does not subscribe to
the idea that all boards need a resident cyber expert. Is that
correct? Are You aware that the Council of Institutional
Investors supports my legislation?
Ms. Stuckey. I was not.
Senator Reed. Well, you should be.
Ms. Stuckey. You are right.
Senator Reed. Yes, you should because your testimony seems
a little illogical when you are citing someone criticizing the
bill that actually supports, and in fact, yesterday they sent a
letter that said the Council of Institutional Investors
strongly supports the stated goal of a bill to promote
transparency and the oversight of cybersecurity risk of
publicly traded companies. We are optimistic that S. 536 may
have the potential of being pursued in a thoughtful bipartisan
manner that is responsive to views of investors.
So your source is one of my biggest boosters. Thank you.
And we make that part of the record too, Mr. Chairman?
Senator Cotton. Sure.
Senator Reed. Thank you.
Now, Mr. Quaadman, you have made the point that this
effectively mandates a director. That is wrong. This does not.
Professor Coates pointed out, with his experience, not as an
attorney, but in fact a lawyer.
I think it is interesting to note that in February 2018,
the report by the Trump Council of Economic of Advisors, they
said, and I quote, ``Mandatory disclosure requirements were
previously shown to incentivize firms to adopt better
cybersecurity measures,'' and that is precisely what we are
going today. So I would hope you would take that back for the
record.
Professor Coates, you have been listening. Can you comment
any further about your views on the bill?
Mr. Coates. Just to reiterate that the boards in this
country are, in my experience, reasonably firm and strong-
willed, and if they do not think they need a cyber expert on
their board, I do not think this bill, which only requires them
to say do they or do they not, and if not, why not, will force
them to take one on.
I will note that a similar type of encouragement in
Sarbanes-Oxley addressed financial experts, and there are 90 or
so New York Stock Exchange companies that still are happy to
not have a financial expert on their board, and they will
explain why in their proxy statement.
So it is not as if this really does force a one-size-fits-
all solution. There are one-size-fits-all solutions, and I
really do worry that if there is another Equifax or similar
event, we will end up with a one-size-fits-all regulatory
regime. This bill, I would like to think, would head that off.
Thank you.
Senator Reed. Well, I appreciate that, and again,
unfortunately, based on an experience that Senator Cotton and I
share position on the Armed Services Committee and also on the
Intelligence Committee, and cybersecurity is something that is
not a passing fancy. And as you pointed out previously,
Professor Coates, it affects every enterprise in this country.
It is not like a labor issue or environmental issue where the
company has nothing to do with that. So this would be a waste
of their time.
Every company--I mean, look back at some of the big
intrusions, the Target intrusion of a few years ago. It was an
HVAC contractor who they got in through. In fact, frankly, my
sense is if they are coming after us, they will not be right
through the front door of the companies that are doing all the
right things. It will be the companies that need the reminder
to think about cybersecurity.
So, with that, Mr. Chairman, I would yield my time. Thank
you.
Senator Cotton. Thank you, Senator Reed.
I will just continue on that topic. Abstracting away from
any particular legislation, though, Mr. Coates, I want to
address a point you made in your testimony where you said that
you think based not only on your experience as a scholar, but
as a practicing lawyer and someone who still advises Government
agencies that the cyber threat is nearly unique among all
threats that our companies and investors face. Could you
elaborate a little bit more on that?
Mr. Coates. Sure. There are a variety of other kinds of
risks that some investors would like boards to take on;
environment, for example. And they are real, and they are
important, but they only do affect a subset of public
companies. There are many companies that really do not have a
meaningful exposure to climate change risk, other than the way
that we all do as humans on the planet.
Cyber is different than that in the sense that it is
practically impossible to function as a meaningful business
without your employees using these things, these cell phones,
and these cell phones expose you. Your perimeter of security
around your basic information systems is exposed every time one
of your employees communicates to and from outside the company,
and inside the company. So it is very difficult actually to
come up with examples of companies that are not exposed to
cyber risk, and it is a core risk. It is the kind of risk that
can produce theft. It can produce fraud. It can produce
longstanding corruption of data, and all of those things are
going to have direct financial impacts on the company, its
investors, and its customers.
So, as I say, I am mindful that there is a worry that
disclosure-based governance can start to cover more and more
and more, and there is a worry that where do we stop and where
do we draw lines. And really, the point I am trying to make on
cyber is, this is a clear difference for this type of risk for
many other kinds of governance concerns that other people might
have. That is all.
Senator Cotton. Thank you for that.
I want to turn now to legislation I have introduced with
Senator Jones, the Small Business Audit Correction Act. It was
not on the list of bills today, but, Mr. Quaadman, your
organization, the Chamber, sent a letter just in the last day
or two about our legislation. So I would just like to say a few
words about it and get your thoughts. The bill would correct
what I think are one of the unintended consequences of the
Dodd-Frank Law, namely the massive increase in audit costs for
small noncustodial broker-dealers. In response to the Madoff
scandal, Congress decided to extend public company accounting
oversight board audit requirements to all broker-dealers. In
hindsight, I think Congress pretty clearly overshot the mark
when they included small noncustodial firms, that is, firms
that do not hold customer assets, and thus, could not even pull
off a Madoff-like scam if they wanted to.
This requirement may seem harmless or obscure, but in fact
it has increased the cost for small broker-dealers quite a bit.
One Arkansas broker has told me that his audit costs have
gone from $6,000 to $30,000, and he only has five employees.
That is why our legislation would make a simple change. It
would exempt these small privately held noncustodial firms in
good standing from the board audit requirement and allow them
to file their financial statements according to the GAAS
standards they used just a few years ago. I think the current
audit requirements are like trying to put a square peg into a
round hole, which is to say they do not fit, and they will
always be high-priced.
It is true that regulators at the SEC and FINRA could
relieve some of the compliance burdens themselves, but they
could also reverse that decision later on. Our small brokers
deserve regulatory certainty. They can only come with a change
in the law, and these regulators have acknowledged that aspects
of the problem can really only be solved by changing that law.
They have told us that our hands are somewhat tied by the
statute.
So, as I said, Mr. Quaadman, your organization sent a
letter earlier this week to our Committee to support the
legislation. Could you talk about why you feel these small
noncustodial firms and, more importantly, their customers would
benefit from the passage of this legislation and the return of
right-size auditing standards?
Mr. Quaadman. Thank you, Senator Cotton. Thank you for
introducing the bill.
I think it is important to remember, first off, that the
PCOB, the first two acronym letters are for public company.
Most of the broker-dealers you are talking about are not public
companies, and there has always been a problem when you try and
put public company controls on to private companies.
So if your bill were to pass, those broker-dealers would
still be subject to GAAS, as you mentioned, and that those
standards are specifically designed for private companies.
Additionally, those that have custodial accounts are going
to be treated differently.
And furthermore, I would also say, too, the easiest way to
find a Ponzi scheme is to take the bank records and to take the
revenue statements of a firm and to match them up, and that
information is still going to be available for the regulators.
So we think this is a good way to rebalance the system.
Senator Cotton. Thank you for that answer.
My time has expired. I want to thank the witnesses for
their testimony. I particularly want to thank Professor John
Coates, who was my teacher in law school. I hope that my
performance does not reflect poorly on your teaching skills,
Mr. Coates, and let the record reflect he was an outstanding
professor.
Senator Jones.
Senator Jones. Thank you, Mr. Chairman, and thank you for
bringing up our bill that is not part of this hearing today,
but I think is a very, very important bill. And I am pleased to
be working with you on that.
I would like to talk just a moment. We briefly mentioned a
little bit--I think everybody is generally in support of a bill
that I introduced with Senators Heller, Heitkamp, and Kennedy
concerning the Expanding Access to Capital for Rural Job
Creators. That is, I believe, another one of those niches that
often gets overlooked.
We have so much rural businesses in my State or rural areas
for businesses that are not capitalizing, and, Mr. Quaadman, I
noticed that in your testimony, I was struck--I did not know
the specific statistic--that since the financial crisis, half
of the new business creation has occurred over 20 counties out
of just literally thousands of counties in the United States.
So this bill is going to create a spot, and I would like
to--you know, particularly if you could maybe just expand a
little bit and talk about the unique challenges for raising
capital that our rural and small businesses face today.
I think just anyone can do that. I will start with you, Mr.
Quaadman, but I really want to kind of get this on the record a
little bit about why this is an important bill.
Mr. Quaadman. Sure. I think, number one, I think it is a
credit to this Committee that, first off, the passive of S.
2155, which provided regulatory relief to large community banks
and regional banks, is important because those banks are very
important liquidity providers in rural areas.
However, we are still seeing a dearth of business
creation--when we talk about the Heartland of the country and
the rural areas, I mean the coastlines are doing fine. Those 20
counties, you could sort of figure out where they are. It is
not a surprise.
So we think it is important to incentivize the ability of
capital to go out into the different areas of the country. We
think some of the work that Steve Case and J.D. Vance are doing
in this area are very important, but I think your bill will
help to make sure that this gets the appropriate policy
discussion within the SEC and that we could start to make sure
that the policies are not going to benignly ignore business
owners in rural areas.
So we think this is an important step forward, and we are
happy to support it and work with you on it.
Senator Jones. Great. Thank you.
Professor Coates, do you have anything, or Ms. Stuckey, do
you want to----
Mr. Coates. So I endorse your bill. I think the SEC does
have a tendency, for understandable reasons, to focus on the
major capital markets and the major centers of capital
formation, which mostly are not rural, and yet the laws and
regulations that it passes and the bodies that it oversees,
like FINRA, regulate the entire country. And I do think there
are probably ways in which the laws and regulations could be
better tailored for businesses trying to raise capital in
remote areas.
I would say the network that creates cyber risk actually
does create the potential for small and relatively
geographically remote companies to go global, and as a result,
I do think there is the possibility of a resurgence in rural
job creation, but it will take some effort and some time. And I
suspect it is going to need more than the SEC, but I do think
having the SEC think about it will help.
Senator Jones. Ms. Stuckey, I did not mean to skip over
you. If you want to briefly mention that, anything that you
need to add.
Ms. Stuckey. I did not include this in my testimony, purely
because I did not have time to raise it with my members. So we
do not have a--the Society does not have an official position,
but we were generally for capital formation. And I cannot
really imagine why we would oppose this, so long as the SEC has
the bandwidth to deal with it.
Senator Jones. Mr. Silvers, do you got any thoughts?
Mr. Silvers. Just, well, we think this is a good idea, but
in doing so, I think, Senator, we would suggest both to you and
to the Advocate, whom this bill was directed toward, that it is
very hard to do anything really helpful for small business and
small business in rural areas without taking into account
issues of market concentration, both in the markets that
issuers are in and in the financial markets themselves.
There has been dramatic concentration in the financial
markets, and it is our somewhat uninformed guess that that has
not been a good thing for rural business.
Senator Jones. All right. Thank you.
I want to just in my remaining time just thank Senators
Heller and Heitkamp for their work creating this Advocate
position, but also noting that the SEC has yet to fill that. So
I am hoping that we can do that.
And just one quick follow-up, Professor Coates, to what you
said. We have been--especially in my office, we have been
strongly, strongly trying to push for more rural broadband and
internet, high-speed internet access, because to be able to get
global, you are not going to be able to do that if you still
have dial-up, which so many counties in this country still
have. So thank you for that comment as well as in reinforcing
the need of rural broadband.
So thank you all for your testimony today. It was very
informative.
Thank you, Mr. Chairman.
Senator Toomey. [Presiding.] I think Senator Cortez Masto
is up.
Senator Cortez Masto. Thank you. And also, I want to thank
all of you. This has been a great conversation this morning.
I also want to thank the Chair and Ranking Member for
considering S. 2756, the Fair Investment Opportunities for
Professional Experts Act.
I was pleased to lead this bill with Senator Tillis, and I
also want to thank Senators Heitkamp, Peters, Toomey, and
Heller, who cosponsored it.
The bill--and I would like to talk a little bit about it
because it tries to establish a balance. Change policy to
expand the overall pool of accredited investors, but also
reduce the proportion, qualifying solely by virtue of income
and wealth alone.
I know, Professor Coates, you have concerns about this
bill, but I also know--and thank you for your service on the
SEC's Investor Advisory Committee. Do you know why the SEC did
not follow the IAC's recommendation to raise the threshold?
Because I know that is what you and Mr. Silvers talked about.
That was your concern. So can you address that? Why was it
not--because it has not been looked at since 1982, and I think
you said that in your testimony as well. So I would be curious
if you have any insight into that.
And then also, if you have any thoughts on what income and
wealth thresholds do you think would--it should be increased to
that would protect unsophisticated but wealthy people from
being ripped off.
Mr. Coates. So I can only speculate about the SEC. I will
say that for reasons--it may not seem like a politically
fraught topic, but actually, it really is because the precise
scope of who can be an accredited investor will directly affect
business models. And the precise decision about what kinds of
education and practice experience will count will directly
affect business models. So there is a real financial interest
in exactly where the lines are drawn, and I think the SEC has
had a lot on its plate over the last 10 years, and that was one
battle they--I am speculating--decided to defer on and let you
guys who are specialists at resolving political disputes
resolve.
So, on your second question--and by the way, I actually am
very much in favor of moving more toward experience and
education----
Senator Cortez Masto. OK.
Mr. Coates.----rather than relying on, as Senator Toomey
said, the crude rule of net worth and income as the basis for
it because it really does not match very well in practice
sophistication.
So I am all in favor of expanding the pool, but I do think
we need to recognize that when the dollar thresholds were set a
long time ago, we have now basically expanded by--I forget
exactly the number, but something from less than 2 percent to
more than 6 percent of the population.
So my suggestion would be just to go back to the
percentage, which can easily be derived--actually, the SEC
report gives you the numbers, and so expand on the professional
side, but contract on the pure net worth side would be my
suggestion and then index it. So, anyway, that is my
suggestion.
Senator Cortez Masto. Thank you.
Mr. Silvers, do you--because I know you had concerns
similarly.
Mr. Silvers. Yes. Well, two points about this, Senator.
First, my view is very similar to John's in terms of both how
you might address the thresholds and the directionality we
should be going in here.
At the current threshold level, it picks up a fair number
of union members that I can tell you would absolutely say ``we
are not experts.''
Senator Cortez Masto. Right.
Mr. Silvers. Right. But there is a second point here,
Senator, that I think is really worth thinking hard about, and
it goes back to something that Mr. Quaadman talked about in his
testimony, which is the balance between the private markets and
the public markets as sources of capital for our firms.
There has been a notable shift toward the private markets,
and that has consequences in terms of how much information is
available to investors and to the general public and the
policymakers.
And the question of whether or not investors are really
getting the level of protection, transparency, and market
efficiency out of private markets that traditionally they have
gotten out of public markets is a question that has not gotten
enough attention.
Part of the reason why this shift has occurred is because
we have made the private markets much more like the public
markets in terms of the ability to access capital. Whether that
is a good idea in the absence of comparable levels of investor
protection and transparency, again, I think is an under-
investigated question.
If you move these numbers or if you lock them in, if you
lock them in by statute at levels that are pretty low or if you
have measures of expertise that are not real measures--and we
know that qualitative things can sometimes be easily gamed. If
you do that, you are enhancing this aspect of the imbalance
between public and private markets, and if our concern is that
we want more companies moving into public markets, that is
probably not--we are pushing in the opposite direction.
The precise answers here, they are not obvious, but it is
important to understand the stakes involved and some of the
considerations that this Committee might want to look at.
Senator Cortez Masto. But you would agree that the wealth
threshold is too low?
Mr. Silvers. Oh, absolutely. As Professor Coates said and
as in my written testimony, it has not moved since 1982.
Senator Cortez Masto. Right.
Mr. Silvers. It is a third--it is picking up three times
the percentage of the population, and I would just note
anecdotally, the kinds of people whom it is picking up are not
experts.
Senator Cortez Masto. Right, right. Thank you.
And I notice my time is up.
Let me just say this, looking at the bills that we have
talked about today, as I review them and will continue to. I
can tell you right now I have concerns for the conversation
that we had with H.R. 4015, but do support the Cybersecurity
Disclosure Act of 2017 and Expanding Access to Capital for
Rural Job Creators Act.
Thank you again for the conversation.
Chairman Crapo. [Presiding.] Senator Scott, you are up.
Senator Scott. Oh. Thank you, Mr. Chairman. Good timing.
Thank you, Mr. Chairman.
Good morning to the panel. I hope you guys are doing well.
Management at publicly owned companies should be held
accountable by their shareholders. That said, I think it is
important to maintain the balance between both sides, and I
question whether those scales are beginning to tip.
But two proxy advisors control up to 38 percent on average
of shareholder votes in the United States. That is a massive
choke hold that would seem to deserve an increased level of
oversight, and that is not to mention one of the proxy advisors
offering consulting services.
It seems obvious that a firm that overwhelmingly dictates
how investors vote their shares should not also be pitching
companies on how to improve their corporate governance results.
I will go to Ms. Stuckey first and then Mr. Quaadman. Can
you expand upon the conflict of interest presented by ISS doing
recommendations for one side and consulting for the other side?
Ms. Stuckey. Thank you, Senator. Yes, I can.
You are right. The conflicts are legion with ISS. For a
fee, you can have ISS help you draft your proxy if you are an
issuer. If you are an investor, you buy their research and
recommendations. If you are a hedge fund, you can also buy
their consulting services, and then they will vote on your
proxy contest.
If you are a shareholder proponent that needs to make sure
they can get a proposal and that will pass muster under the SEC
rules, there are even people at ISS that will help you write
that, and then they also vote on those shareholder proposals.
I do not know how to say it any more clearly. It is a nice
business.
Senator Scott. Mr. Quaadman.
Mr. Quaadman. Senator Scott, I would echo Ms. Stuckey's
answer.
I would also say--and I mentioned this in an early answer.
You know, we will submit for the record an email which many of
our members get, where from the consulting side of ISS, it
says, you know, if you use our service, you will get a better
score.
I would also want to add as well, Glass Lewis also has a
significant conflict of interest. They are owned by two
activist pension funds, and I think it is important to note
that neither firm issues any statements as to whether or not a
client is a shareholder proponent.
And neither does Glass Lewis, you know, disclose if they
have a financial interest in a firm, which they said recently
in a letter back to this Committee, they would only do if it is
a publicly disclosed position.
So I think there is significant conflicts of interest here.
As I said earlier, this is something that we have dealt with,
with credit rating agencies, with financial analysts, and it is
long, long overdue for this to be addressed here as well.
Senator Scott. Thank you for your answers.
Thank you, Mr. Chairman.
Chairman Crapo. Thank you, Senator.
Senator Van Hollen.
Senator Van Hollen. Thank you, Mr. Chairman. Thank all of
you for being here. I had to leave, but I heard your original
testimony. I have some questions on the 8-K Trading Gap bill.
Professor Coates and Mr. Silvers, thank you for your
support for that bill and your testimony.
Mr. Quaadman, I appreciate you also willing to work with
us. You raised an issue in your statement, which I do not think
is really part of the bill. You said that you want to make sure
that we clarify when an event happens and when it becomes
material, and here is the thing. This bill does not get into
this, into that question. Maybe we should as a Committee; maybe
we should not. But this bill does not do that.
What this bill says is once the company has made the
determination that something is material, that is when the 4-
day clock starts ticking for the filing of the disclosure. And
what this bill says is during that period of time, there should
not be people trading because they have already made the
decision that this is relevant information, and they should not
be taking advantage of that with insider trading. Do you agree
with me on that?
Mr. Quaadman. Yes.
The issue that we raised was that if there is an event that
happens, the company has 4 business days then to make a
decision as to whether an issue is material.
Now, you have some companies where you have 10b-15
automatic stock selling or purchasing. You have others that do
not. So, in our view, in reading the bill, at least in the
version that we received, that we think that there needs to be
maybe some clarity because you could have senior executives who
are a part of that decisionmaking process, where we think there
might be something that needs to be addressed. There are other
senior executives who are not a part of that decisionmaking
process as well.
So we think there is just some--there is a little bit of a
gray area that we would like to sit down and maybe talk to you
about.
Senator Van Hollen. Well, I am always happy to talk.
It seems to me that once the decision has been made--and as
I understand the 8-K disclosure requirement, that there is a 4-
day time period between the actual determination by the company
that is obviously material and then they have to disclose it.
I am not sure, and I--when Mr. Clayton was before the
Committee, he agreed that he did not see any reason why during
that 4-day period any executives should be trading stock,
unless they had sort of a prescheduled purchase agreement. And
the bill addresses that issue. It specifically carves out an
exemption for people who had already had a scheduled plan. Is
there any problem----
Mr. Quaadman. No, no. And, as I said, no, we recognize
that.
I think where there maybe needs to be some clarity, because
it also talks about material nonpublic information as well, and
every company is always in control of material nonpublic
information, right? If you are Apple and you have your plans
for your next phone, that is material nonpublic information. So
I think that is why there is just a matter of clarity because
you can have an event that happens that you do not--that there
is a decision made that it is not material.
So the question is, do you then create such a limited
period of time that people can sell their stocks or not? So
that is why I said we perfectly agree if there is a decision
made, there should not be any sort of trading going on, but I
think there is just that little bit of a vague area during that
4-day period that we would just like to maybe sit down and go
over.
Senator Van Hollen. I am happy to do that. I mean, the
intent here is once the determination has been made that it is
material----
Mr. Quaadman. We agree with----
Senator Van Hollen. You agree with that?
Mr. Quaadman. We agree with your intent and want to work
with you on it.
Senator Van Hollen. Ms. Stuckey, do you agree as well?
Ms. Stuckey. Yes, I agree with your intent, and my only
basis for not supporting it at this point is because we are of
the view that the trading windows are closed. As soon as a
company decides that they have material nonpublic information,
like you said, there may be outlier companies. The brief time I
had and the members I spoke to, they said, ``We always close
our trading window, and this does not happen.'' However, we are
happy to work with you because there may be companies where
that does not happen.
Senator Van Hollen. Yes. I think there may be folks who may
not be your members where this is happening.
There have been a number of studies that show that there--
trading does happen during this 4-day period, and that clearly
is trading at a time when the company executives are privy to
information that the public does not have. So I look forward to
working with you on that.
The last thing I will say, Mr. Chairman, is that Senator
Baldwin and I and the Ranking Member Brown and other Members
are going to be asking Mr. Clayton and the SEC to look into the
issue of the 10b-18 safe harbor protection that was put in
place many years ago with regard to stock buybacks.
There is obviously--you know, there can be good reasons
sometimes for stock buybacks. We understand that, but we have
seen like a trillion dollars of stock buybacks, and there are a
lot of concerns raised about the potential for a conflict of
interest and again insider information with respect to stock
buybacks.
And I may pose a question for the record for all of you to
respond.
Thank you.
Chairman Crapo. Thank you.
Senator Tillis.
Senator Tillis. Thank you, Mr. Chairman.
Thank you all for being here, and I think Senator Cortez
Masto asked some questions related to one area, so I will not
go back to that.
One question that I had were the no-action letters that
were issued, the two in question by the SEC in 2004. Ms.
Stuckey or Mr. Quaadman--did I pronounce that right?
Mr. Quaadman. Yes.
Senator Tillis. Can you give me your opinion on the--
whether or not the withdrawal of those would be positive and
why?
Ms. Stuckey. I think they would be positive, and let me
just mention that as Mr. Silvers seemed to indicate that--well,
those letters are what created the proxy advisory firms as they
exist today. Those letters were put out to rid companies of
another kind of conflict. Instead, they have created the
conflicts that we now have.
The other important part of those letters is it gave
investment managers an out if they hired an independent third
party, but what happens is it seems like--it seems like the
view of some people that the proxy advisory firms are there
solely to hold the companies to account. I thought that was the
role of the SEC, and that is where the line is blurring. The
proxy advisory firms have become the de facto regulators. So I
just wanted to make that point from the earlier testimony. It
is really troublesome.
Withdrawing the letters, we believe would really help the
situation and force the investment advisors that do have the
wherewithal to vote shares like they do, which is many of the
large companies already vote. They are not actually the people
that rely so heavily on proxy advisory firms, and it would go
back to the system before these proxy advisors existed.
Mr. Quaadman. Senator Tillis, that is a great question.
Number one, we believe that proxy advice should be data-driven.
It should be related to the fiduciary duty of their clients,
and it should also be based on shareholder return. That means
it needs to be objective.
The issue with the no-action letters is that the proxy
advisory firms do not have to disclose a conflict of interest.
Their clients do not have to ask about a conflict of interest.
So this actually allows for the firms to operate in a way that
they do.
We believe this has created very serious problems with
proxy advice. I have letters I can submit for the record. One
is from Abbott Labs, where they provided a 22-page letter to
ISS citing material shortfalls in their reports, and they
refused to want to even meet with Abbott Labs or to even issue
a corrected report.
I have a list of 130 supplemental filings filed with the
SEC listing shortfalls in ISS and Glass Lewis reports that were
not addressed.
So we think that the withdrawal to no-action letters will
put more teeth into SB20, and that that will then actually
allow for efficient and appropriate SEC oversight over the
advisory firms.
Senator Tillis. Thank you.
Another piece--and I think some of the Members have
expressed their concerns over--you are familiar with CFIUS, I
assume?
Mr. Quaadman. Yep.
Senator Tillis. Some of their concerns about this being
another pathway into influencing U.S. firms through moves to
affect who is the CEO, who is on the board, certain policies.
Do you have any insights you can give me where you think that
is a valid concern and what we should do about it?
Mr. Quaadman. Yes. So proxy advice--you know, proxy advisor
reports are--for some firms, some of the larger firms, they
have their independent due diligent systems, so it is one data
piece as many.
However, the reason why we always are talking about the
academic reports, it is to show that there is 38 percent
control, is that there are some firms that just totally
outsource.
The reason why I think--the point that you raise is a very
interesting one, and I want to reflect on that some more--is
that we have one of the advisory firms that is owned by two
Canadian active pension funds.
Senator Tillis. Right.
Mr. Quaadman. So that one is if we are talking about the
total mix of information as being provided to investors and
there are shortfalls or there are problems in putting that
together, that then becomes a problem that we have one that is
controlled by foreign entities.
Senator Tillis. Yes. You know, the CFIUS construct does not
apply directly to this.
Mr. Quaadman. Yes.
Senator Tillis. But once we implement CFIUS, which will be
negotiated out in the NDA conference and you close some of the
gateways through the CFIUS process, then people are going to be
looking for other ways to actually influence U.S. businesses.
That is why I think we do need to actually consider it.
The only other thing is that I know that in the written
testimony, there was some comment made about how the bill that
we are trying to get support for here that had support in the
House affects competition. Is not it really true that right now
we have a duopoly between Glass Lewis and ISS? Do we have any
real concept of competition in this space?
Mr. Quaadman. There was an effort made 10 years ago or so
where PGI tried to come in as an entrant, and they only lasted
a couple years. A couple years ago, there was Proxy Mosaic also
tried to enter in and failed. There are a couple of smaller
firms.
That is one of the reasons why I have raised this in the
hearing, that this is very similar to credit rating agencies
and why we need to take a very close look at it because if they
are going to be the de facto standard setters of corporate
governance, we need to make sure there is appropriate
oversight.
Senator Tillis. Thank you, Mr. Chair.
Chairman Crapo. Thank you.
Senator Heitkamp.
Senator Heitkamp. Thank you, Mr. Chairman.
I want to just comment a little bit about the requirement
for SEC to include someone with rural business experience.
We have not yet gotten a nominee for that position. One of
the reasons is I probably have put a lot of pressure on the
Chairman to look not just at the coast, but look at the
Midwest. And I think they are searching to try and get not only
that big-to-little experience, but also a regional experience
as well. And so I know that he is working hard to make that
happen.
I want to go ahead and turn now to, again, the issue of
proxy advisory firms. Where I think that there may be Members
here who have reservations about the House bill, I do not think
that you can listen to this testimony and not think that we
need to have a discussion about some of the flaws that are
embedded in the current system.
And so I am just going to ask some of the kind of baseline
questions to just get the facts out there, and a lot of this
discussion has already taken place. But we know that right now,
there is no regulatory apparatus that applies to all proxy
advisory firms. They are functionally unregulated in many ways
like the rating agencies before----
Mr. Silvers. Senator, I think that is not quite right.
While they are not required to register as investment advisors
and, thus, are not in that frame--and as I said in my
testimony, we would actually be supportive of requiring them to
be in that space because that is what they do. They provide
investment advice. That they are enmeshed, as Professor Coates
said earlier--they are enmeshed in both a variety of State law
regimes and in the--and to the extent that they are providing
advice and guidance to pension funds, they are enmeshed in the
regime of fiduciary duty involving pension funds.
Senator Heitkamp. OK. So maybe looking broader beyond
Federal regulation, looking to State regulation, looking at
what their roles are depending upon who they are functioning
for. So that is a fair point, I think.
Let us go beyond the fiduciary relationships that you just
discussed. Broadly, is it not true that proxy advisory firms do
not owe a fiduciary obligation to shareholders writ large? Is
that not--anyone want to disagree with that?
Mr. Quaadman. Senator Heitkamp, I would just say that the
clients to the advisory firms do, and that the advice that they
are providing to clients is important for that. And if those
clients are going to outsource their voting functions to those
firms, then there is a much larger issue at play there.
Senator Heitkamp. OK.
Mr. Silvers?
Mr. Silvers. Senator, I think you are raising a really
critical question that has to be carefully parsed. The proxy
advisory firms typically, either by contract or through
operation of State law or pension law, they typically owe some
kind of duty to their client.
Their clients, to the extent that they are institutions,
obviously owe fiduciary duties to their underlying investors,
and in their relationship with the proxy advisory firm, they
have to be compliant with their fiduciary duties to their
ultimate investors.
What this bill, I think, really confuses in a very
dangerous way, it suggests that the investors somehow owe a
duty to or are required to consult with the corporation in the
course of fulfilling their fiduciary duties to their beneficial
holders.
The only investors that owe a fiduciary duty to the firms
they invest in are controlling investors--so, for example,
Fidelity invests in Exxon. Fidelity does not owe a fiduciary
duty to Exxon, and people who give advice to Fidelity do not
owe a fiduciary duty to Exxon.
Senator Heitkamp. I understand what you are saying, but I
think that no one benefits when the advice is not vetted, when
the advice is not accurate, when the information and dialogue
that is being provided has no way of being corrected when
mistakes are made. That does not benefit anyone in this system
to not--I mean, I think Mr. Quaadman gave an example of Abbott
Labs. I think anyone who might be on the other side of that
thinks that what we ought to be talking about is how do we make
sure the correct information enters the marketplace as people
are making investment decisions. That is really the whole
reason for this entire regulatory regime that we have created,
is to give accurate information to people who are investors.
Professor Coates, I think you wanted to share a comment
here.
Mr. Coates. Yes, just very briefly. Abbott has its own
mouth too, and they put out a proxy statement. And the normal
way in which we have disputes resolved about certain kinds of
information is to have more speech.
Anyone giving advice in a public way, soliciting proxies is
subject to anti-fraud rules enforced by the SEC. So if ISS were
to put out a report knowingly falsely or negligently falsely,
they would have liability for it. So I just want to be clear
that if they deliberately misrepresent facts, they are going to
be subject to liability.
Senator Heitkamp. Yes.
Mr. Coates. Now, I do think the conflict problems are a
different issue, but I think on basic factual disputes, we have
an amply
robust system for getting the information out there for
investors, in my opinion.
Senator Heitkamp. Do you mind, Mr. Chairman, if Mr.
Quaadman responds to that?
Mr. Quaadman. I think--look, the issue here is you have the
two firms control about 38 percent of the vote. So if you talk
to CEOs or those--once the ISS or Glass Lewis recommendation
comes out, 30 percent of the votes come in in 24 hours. So that
means that there is a high correlation, which has been showed
academically that there are a number of investment firms that
are just outsourcing their votes to those firms. And this is
what ISS and Glass Lewis in some of the response to the Banking
Committee here were saying were custom policies.
So if you have an instance where--and I think the Abbott
Labs' letter is instructive, but as I said, we have got about
130 other examples. If there are 22 pages of material
misstatements and they are brought to the attention of an
advisory firm and that advisory firm refuses to meet on it,
refuses to issue a new report on it, then those investment
advisors that are outsourcing their entire voting function to
an advisory firm are actually endangering what their fiduciary
duties are to their clients or to their investors.
So this is where there is a--you know, there is a
tremendous shortfall in oversight of corporate governance.
Senator Heitkamp. Yes.
Thank you, Mr. Chairman, for indulging some additional
answers.
But, I mean, I guess the point that I want to make is that
this is an area that I think needs to be reviewed. I do not
know that we have the right solution, but I think there is an
opportunity here to find that commonality of interest and at
least figure out what part of this we can all agree on needs to
be fixed and then what part we need to have more transparency
on.
And so I look forward to an ongoing discussion about this
issue into the future, but very complicated, but also an
opportunity, I think, to look at some mutual reforms that we
could all agree on across the spectrum.
Chairman Crapo. Thank you.
And Senator Toomey has asked for one last opportunity to
ask a few questions.
Senator Toomey. Second round.
Chairman Crapo. Yes.
Senator Toomey. Thank you, Mr. Chairman.
Chairman Crapo. Quick, quick, quick.
Senator Toomey. I will be quick. Thank you.
Though we had some brief discussion and at times we have
touched on this idea that there has been a relative shift in
funding to private markets and away from public markets, and it
strikes me that it is entirely possible that a contributing
factor to this shift could be a really substantial increase in
the challenges and risks and pitfalls of being a public company
now and the corporate governance that comes with that.
And so what I think might be a case in point--and I want to
raise this issue--is what seems to be a movement in the
direction on the part of some in this environmental, social,
and corporate governance investing or known as ESG investing.
Now, let me be very clear. I have absolutely no
reservations whatsoever with somebody who decides that they are
going to create a fund dedicated to a particular type of
investment, and if that is investment that is motivated by
social or cultural goals and it is fully disclosed to investors
and investors choose to participate, then knock yourself out. I
have absolutely no reservations.
What concerns me is cases where maybe advisors or fund
managers or minority activist investors are trying to use the
corporate governance voting mechanism as a way to advance a
social and cultural agenda that may be inconsistent with many
investors' wishes and may be inconsistent with maximizing what
is best for the investors generally.
For instance, the Manhattan Institute published a report in
September of 2015, and they found that pension funds that
engaged in social issues, shareholder proposal activism, that
those investments are associated with lower values for the
firms in which they invest.
Likewise, there was a 2017 academic study commissioned by
the National Association of Manufacturers that found that
activist proposals detract from shareholder value.
So I guess my question--I will start with Mr. Quaadman.
First of all, as just a sort of subjective question is the
proxy--is that the appropriate place to litigate what can be
contentious social and cultural issues in America?
Mr. Quaadman. No. The duty of the board is to--they have a
fiduciary duty to their investors. So the problem with--you
know, you have to break down ESG into its component parts.
Governance is always an issue. Environmental depends on the
business or the industry can be an issue. The problem is social
because if we are going to allow for broad-based social issues
to be debated in directors--and there is a school of thought
that is emerging that if Washington cannot handle a problem,
let us go to the public companies, and then let us start to
debate it--you know, let us start to push is there--that means
we are going to take boards away from that fiduciary duty. They
are going to become debating societies.
And if we look as split as our country is on many important
issues, that is going to be thrown right into the board room,
and they are not going to be focused on what they should be
focused on.
Senator Toomey. I would just say I can imagine--and I know
of issues that are in the environmental and governance space
that are also really ultimately social and culturally debated
issues.
But, Ms. Stuckey, I wonder if you have any thoughts on
this.
Ms. Stuckey. I agree with Tom on that.
We also see our private company members growing and our
public company members shrinking, but you are absolutely right.
And Tom is right. Why should a board be spending time on the
social issues when they should be dealing with cybersecurity?
And, also, why--there clearly is a competitive disadvantage
to be a public company these days because of all the
regulation. I mean, you think of activism. You think of more
and more disclosure, so I would agree.
Senator Toomey. So if there is documented evidence that
suggests that there is a category of criteria that promoting--
promoting this category results in a lower return to investors,
then anybody advising that would be failing to live up to their
fiduciary obligations, would not they?
Mr. Quaadman. Yes. And I would say if you also take a look
at the issue of public pension plans, those that have the
lowest--the lowest performing, the taxpayer has to make up that
difference.
Senator Toomey. Right.
Mr. Quaadman. And, you know, what we are also seeing here--
because I agree with your statement earlier. Look, there is a
market-driven--there could be a market-driven approach here. If
you want to have an ESG fund, go ahead. Go right at it. Well, I
think we should also be very cognizant of the European Union is
actively looking at a sustainable finance directive that will
look to place ESG from a top-down approach and do it very
broadly.
And the reason why I raise this in terms of concern, as we
looked at with GDPR and other areas, the European Union is
looking to be a global standards setter. So I think we need to
be very concerned here that public companies in Europe are a
much different animal than they are here in the United States,
and if we start to see that migrate, ESG migrate because of the
European Union, I think we are going to be in some--we are
going to be in a pretty difficult--we are going to see more and
more public companies become private.
Senator Toomey. Thank you very much.
Thank you, Mr. Chairman.
Chairman Crapo. Thank you, Senator Toomey. I agree with the
concern you raise, and it is obviously one among many that we
are trying to address here.
I also want to thank the witnesses. I thought we had a very
good and thoughtful discussion, and I personally got a lot of
helpful insights into the legislation we are looking at. And
you definitely helped us as we try to put together a package of
corporate governance reforms that will improve and strengthen
circumstances in the United States.
With that, I would note for all the Senators who wish to
submit additional questions--and you may get some questions
from the Senators who were not here and even those who were--
that they need to submit those questions by Friday, July 6th.
And I encourage the witnesses to respond to those questions, if
you please would, as quickly as you can.
And, again, thank you very much for giving us your time and
your expertise and advice here, and with that, this hearing is
adjourned.
[Whereupon, at 11:38 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN CRAPO
Today's hearing will focus on several legislative proposals to
improve corporate governance.
As with Tuesday's hearing on capital formation proposals, I intend
to work with Ranking Member Brown and with other Senators on the
Banking Committee to identify and move legislative proposals through
the Senate.
Although some of the bills which we will be discussing today have
also been discussed and considered in the House, most have not.
Today's hearing will mark a first step for those we have not yet
considered or were recently introduced. Among other things, the bills
that we will discuss today would:
expand the definition of accredited investor;
shorten the Schedule 13D filing window and increase
disclosure of short positions;
require FINRA to create a relief fund to cover unpaid
arbitration awards to investors;
draw attention to cybersecurity experience at the board
level;
address concerns that a gap exists between the time a firm
learns of material nonpublic information and its disclosure;
and
highlight the unique challenges to rural area small
businesses.
Finally, several Members have expressed interest in addressing the role
of proxy advisory firms, and we will discuss a bill which the House has
already considered and passed.
I look forward to hearing from our witnesses on these legislative
proposals, and whether there are ways to modify these bills to gain
bipartisan support.
We have received some initial feedback on these bills, which will
be entered into the record.
______
PREPARED STATEMENT OF THOMAS QUAADMAN
Executive Vice President, Center for Capital Markets Competitiveness,
U.S. Chamber of Commerce
June 28, 2018
The U.S. Chamber of Commerce is the world's largest business
federation, representing the interests of more than three
million businesses of all sizes, sectors, and regions, as well
as State and local chambers and industry associations. The
Chamber is dedicated to promoting, protecting, and defending
America's free enterprise system.
More than 96 percent of Chamber member companies have fewer
than 100 employees, and many of the Nation's largest companies
are also active members. We are therefore cognizant not only of
the challenges facing smaller businesses, but also those facing
the business community at large.
Besides representing a cross-section of the American business
community with respect to the number of employees, major
classifications of American business--e.g., manufacturing,
retailing, services, construction, wholesalers, and finance--
are represented. The Chamber has membership in all 50 States.
The Chamber's international reach is substantial as well. We
believe that global interdependence provides opportunities, not
threats. In addition to the American Chambers of Commerce
abroad, an increasing number of our members engage in the
export and import of both goods and services and have ongoing
investment activities. The Chamber favors strengthened
international competitiveness and opposes artificial U.S. and
foreign barriers to international business.
______
Chairman Crapo, Ranking Member Brown, and Members of the Committee
on Banking, Housing and Urban Affairs: my name is Tom Quaadman,
Executive Vice President of the Center for Capital Markets
Competitiveness (``CCMC'') at the U.S. Chamber of Commerce
(``Chamber''). Thank you for the opportunity to testify today regarding
the important topic of corporate governance and to discuss the
Chamber's views regarding a number of legislative proposals.
The Chamber has long been concerned that the public company
regulatory model in the United States has failed to keep up with the
times, as evidenced by the significant drop in the number of public
companies over the last two decades. The United States is now home to
roughly half the number of public companies than those that existed in
the mid-1990s, and the overall number of public listings has little
changed from 1983.\1\ While there is no single reason behind this
decline, what is clear is that the overall regulatory burden--coupled
with a steady rise in special interest activism--has made an initial
public offering (``IPO'') increasingly unattractive. In short, we need
new policies that will make it more attractive for businesses to go and
stay public.
---------------------------------------------------------------------------
\1\ ``America's Roster of Public Companies is Shrinking Before our
Eyes.'' Wall Street Journal, January 6, 2017. https://www.wsj.com/
articles/americas-roster-of-public-companies-is-shrinking-before-our-
eyes-1483545879.
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The public company model has been a key source of strength and
growth, which has made the American economy the strongest and most
prosperous in world history. When businesses go public, jobs are
created and new centers of wealth are formed. During the 1980s and
1990s, stories of the Microsoft executive assistant or the UPS driver
becoming a millionaire were not uncommon after a company went through
the IPO process. A 2012 study done by the Kaufmann Foundation found
that for the 2,766 companies that went through the IPO process between
1996 and 2010, employment cumulatively increased by 2.2 million
jobs.\2\ Other benefits also accrue to companies when they go public,
such as revenue growth.
---------------------------------------------------------------------------
\2\ Post-IPO Employment and Revenue Growth for U.S. IPOs June 1996-
2010, http://innovation.ucdavis.edu/people/publications/kenney-m.-
patton-d.-ritter-j.-2012.-post-ipo-employment-and-revenue-growth.
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The public capital markets are also not static and help to support
innovation. Only about 12 percent of the Fortune 500 companies in 1955
were still on the list in 2014, while the other 88 percent have either
gone bankrupt, merged, or fallen out of the Fortune 500.\3\ This system
of creative destruction has forced businesses to change with the times,
or be replaced by new entrants with innovative ideas and products to
meet the needs of consumers and an ever changing market place.
---------------------------------------------------------------------------
\3\ Mark Perry, AEIdeas, August 18, 2014.
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From 1996-2016, the number of public companies dropped in 19 of 20
years. The 1 year where there was an increase is attributable to the
passage of the Jumpstart our Business Startups Act of 2012 (``JOBS
Act''). Title I of the JOBS Act included provisions known as the IPO
``on-ramp,'' consisting of scaled disclosure and other requirements for
emerging growth companies (EGCs). These provisions had an immediate
effect on the IPO market: in 2013--the first full calendar year after
the JOBS Act was passed--226 IPOs were listed in the United States (the
highest number since 2004), followed by 291 in 2014.\4\ Importantly,
the JOBS Act has demonstrated that the rules that apply to public
companies can be scaled appropriately without compromising important
investor protections.
---------------------------------------------------------------------------
\4\ https://www.sec.gov/info/smallbus/acsec/giovannetti-
presentation-acsec-021517.pdf.
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However, the JOBS Act was just a start. In recent years, the
Chamber has issued a number of reports and recommendations calling upon
the Securities and Exchange Commission (SEC) and Congress to do more to
help companies go public. Many of these reports and recommendations
involve fundamental issues of corporate governance including
disclosure, proxy voting, and shareholder proposals. The Chamber's
reports include:
2013: Best Practices and Core Principles for the
Development, Dispensation, and Receipt of Proxy Advice, a
report that helped kick-start an important debate over the
broken proxy advisory system in the United States;
2014: Corporate Disclosure Effectiveness: Ensuring a
Balanced System that Informs and Protects Investors and
Facilitates Capital Formation, a report that included two dozen
specific recommendations to modernize the SEC's disclosure
regime;
2017: Essential Information: Modernizing Our Corporate
Disclosure System, which emphasized the importance of the
longstanding ``materiality'' standard for corporate disclosure;
2017: Shareholder Proposal Reform: The Need to Protect
Investors and Promote the Long-Term Value of Public Companies,
which outlined seven recommendations on how to fix the outdated
shareholder proposal system under Rule 14a-8 of the Securities
Exchange Act.
And most recently, the Chamber--along with seven other organizations--
issued a report entitled Expanding the On-Ramp: Recommendations to Help
More Companies Go and Stay Public, which included 22 recommendations
that would expand upon the success of the JOBS Act. While the Chamber
is pleased that many of our recommendations have been acted upon either
by Congress or the SEC, there is still much room for progress.
Sarbanes-Oxley, Dodd-Frank, and the ``Federalization'' of Corporate
Governance
Traditionally, corporate governance was structured under the State
laws where a business is incorporated, as well as the by-laws of the
corporation. This system allowed directors and shareholders to create
governance structures that fit the needs of individual businesses and
its investors.
From the time of the New Deal up until the passage of the 2002
Sarbanes-Oxley Act, with some exception in the area of compensation,
the role of securities laws was a disclosure-based regime intended for
investors to have the material information needed to make informed
investment decisions.
Sarbanes-Oxley started a trend toward ``Federalizing'' corporate
governance by placing the Federal Government in a more predominant
role. For example, Sarbanes-Oxley created specific requirements for the
composition of a company's audit committee as well as its operation. It
also created a quasi-regulatory body in the Public Company Accounting
Oversight Board (``PCAOB''), an entity with expansive authority and
tremendous influence over the manner in which public companies are
operated.
This trend was exacerbated by the Dodd-Frank Wall Street Reform and
Consumer Protection Act (``Dodd-Frank''), which mandated new rules on
compensation committee independence, pay versus performance,
compensation disclosures, claw-back policies, incentive compensation
rules for financial firms, ``say-on-pay'' votes, new disclosure
regarding the Chairman and CEO structures, conflict minerals
disclosures, resource extraction disclosures, and mine safety report
disclosures. Furthermore, the Investor Advisory Committee at the SEC--
created by Dodd-Frank--has produced recommendations that would further
expand the use of Federal mandates, such as the mandated use of
universal proxy ballots in contested director elections.
In a post-Dodd-Frank world, some groups have sought to exploit
Federal securities laws to advance social or political objectives.
Bills have been introduced--though not passed--to require human
trafficking disclosures, political and lobbying spending disclosures,
and other issues that are best left addressed outside the securities
laws. Policymakers should take steps to ensure that disclosure
requirements always meet the test of the Supreme Court-articulated
materiality standard, otherwise investors risk becoming inundated with
information that does not inform their voting and investment decisions.
The Challenges of Being Public Today
The legislative mandates of Sarbanes-Oxley and the Dodd-Frank Act
have been coupled with the exponential growth of the proxy statement
and corporate disclosures. Furthermore, the SEC has largely failed or
been unable to provide oversight over proxy advisory firms, modernize
corporate disclosures, and update information delivery systems, or
reform proxy plumbing systems. The SEC has also gradually receded from
its duty as a gate keeper of shareholder proposals under Rule 14a-8,
which has allowed agenda-driven items to work their way into board
rooms and shareholder meetings. This condition has allowed a small
group of special interests to dominate the shareholder proposal process
and frustrate the views of a majority of shareholders. Concurrently,
businesses are facing increasing pressure to disclose and engage
shareholders on environmental, social, and governance issues, many of
which investors have deemed immaterial.
It is little wonder why companies that are deciding to go public
are increasingly doing so in nontraditional ways. For example, many
companies have recently decided to go public under a dual-share class
structure that limits voting rights to only certain investors. While
such corporate structures have generated criticisms, many of these
companies have completed successful IPOs with heavy investor interest,
and some offerings have been oversubscribed. Instead of requiring
businesses to submit to a myopic view of how a corporation should be
structured, companies should be free to choose their own structure, and
investors should be free to choose where they want to place their
money. If you don't like the corporate structure, don't buy the stock.
The markets will help determine if the business got it right or not.
Under the more Federalized system, rather than a company's board
determining the long-term strategy of success, boards are increasingly
bogged down with
mandated regulatory compliance issues. Corporations are being forced
into a ``one size fits all'' model that is more expensive, provides
less opportunity to grow, and makes it more difficult to run a
business.
There have been beneficial developments that have occurred over the
past several decades. Shareholders are more empowered and
communications between businesses and investors have increased.
Businesses are understanding that they must increase board diversity on
their own rather than have a mandate imposed upon them.
Nevertheless, the U.S. public company system--which is still the
global gold standard by far, has been increasingly turning into a net
negative. As a result, businesses and investors are walking away from
an ever shrinking public company pie. America's entrepreneurs are just
as comfortable staying private, or being acquired as they are going
through the IPO process.
We appreciate that the Committee has called today's hearing to
gather thoughts on a number of bills related to corporate governance.
Our comments on these legislative proposals are included below.
H.R. 4015, the Corporate Governance Reform and Transparency Act
Effective and transparent corporate governance systems that
encourage shareholder communication and participation are a key
ingredient for public companies to grow, and for their investors and
workers to prosper. Institutional investors may invest in large numbers
of public companies. Therefore, the due diligence associated with proxy
voting--learning and understanding the issues around director elections
or shareholder proposals--is costly, complex, and burdensome. The proxy
advisory industry emerged to help institutional investors fulfill these
obligations by researching proxy matters and providing voting
recommendations to clients.
The proxy advisory industry has been dominated for some time by
only two firms: Institutional Shareholder Services (``ISS'') and Glass
Lewis. These two firms control roughly 97 percent of the proxy advice
market and by some estimates can ``control'' up to 38 percent of the
shareholder vote,\5\ because some clients of ISS and Glass Lewis
automatically follow their recommendations. As a result, ISS and Glass
Lewis are in many ways the de facto standard setters for corporate
governance in the United States.
---------------------------------------------------------------------------
\5\ ISS 24.7 percent Glass Lewis 12.9 percent Source: Ertimur,
Yonca, Ferri, Fabrizio and Oesch, David Shareholder Votes and Proxy
Advisors: Estimates from Say-on-Pay (February 25, 2013).
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Notwithstanding their influence and market power, both ISS and
Glass Lewis operate with a startling lack of transparency, rampant
conflicts of interest, and have been prone to make significant errors
when developing vote recommendations. The Chamber's 2013 report, Best
Practices and Core Principles for the Development, Dispensation, and
Receipt of Proxy Advice, was intended to address many of these
fundamental flaws of the two firms. The Chamber developed these best
practices and core principles to improve corporate governance by
ensuring that proxy advisory firms:
Are free of conflicts of interest that could influence vote
recommendations;
Ensure that reports are factually correct and establish a
fair and reasonable process for correcting errors;
Produce vote recommendations and policy standards that are
supported by data driven procedures and methodologies that tie
recommendations to shareholder value;
Allow for a robust dialogue between proxy advisory firms
and stakeholders when developing policy standards and vote
recommendations;
Provide vote recommendations to reflect the individual
condition, status, and structure for each company and not
employ ``one size fits all'' voting advice; and
Provide for communication with public companies to prevent
factual errors and better understand the facts surrounding the
financial condition and governance of a company.
Following the release of this report, congressional hearings were
held and the SEC held a roundtable on proxy advisory firms on December
5, 2013. In June 2014, the SEC's staff issued Staff Legal Bulletin 20
\6\ which marked the first time that the SEC exerted oversight over
proxy advisory firms while providing institutional investors with
valuable guidance on how to use proxy advice.
---------------------------------------------------------------------------
\6\ https://www.sec.gov/interps/legal/cfslb20.htm.
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However, the Chamber has found that many of the longstanding issues
with these two firms remain. For example, ISS continues to operate a
consulting division to provide advice to companies as to how they can
achieve better ISS corporate governance ratings. ISS's ownership of
both a research division and a consulting arm--accepting fees from both
the institutional investors who receive their proxy voting advice as
well as from the public companies that are the subject of their voting
advice--has been a focal point for criticism that conflicts of interest
inherent in this business model.
While Glass Lewis does not operate a consulting division, its
ownership structure presents a unique conflict of interest. Glass Lewis
is owned by an activist institutional investor--the Ontario Teachers'
Pension Plan and the Alberta Investment Management Corporation. The
Chamber brought to the attention of the SEC examples of where this
ownership structure has presented conflicts related to Glass Lewis
voting recommendations.\7\
---------------------------------------------------------------------------
\7\ See e.g., Letter of May 30, 2012 to SEC Chair Mary Schapiro
http://www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/2012-
5.30-Glass Lewis-letter-release.pdf.
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Additionally, proxy advisory firms have not taken steps to ensure
that their recommendations are developed based on clear, objective, and
empirically based analysis. With ISS companies often times may only be
given a few hours to respond to an ISS recommendation and, for example,
point out if ISS has made an error in developing the recommendation.
Even more troubling, Glass Lewis appears to have no clear process or
procedures for providing companies with ample time to respond to
recommendations.
H.R. 4015 would address many of these problems by building upon the
2014 SEC staff guidance by requiring proxy advisory firms to register
with the SEC and to become more transparent with the public about their
methodologies and conflicts of interest.
Under the legislation, proxy advisory firms would need to develop
clear procedures and methodologies for the development of voting
recommendations, which would allow for fair due process in the system.
Firms would also have to both disclose and manage any conflicts of
interest they have, including whether they engage in any ancillary
services (such as a consulting arm) that present a direct conflict to
their research work.
Proxy advisors would also have to demonstrate that they have the
capability and expertise to provide empirically based and objective
vote recommendations. ISS, for example, currently has only about 1,000
total employees covering 40,000 shareholder meetings in more than 100
countries. Glass Lewis has roughly 360 employees issuing approximately
20,000 research reports annually. Both firms have been prone to making
flaws in assumptions or outright factual errors in many of their
recommendations. H.R. 4015 would help promote a system of fact-based
proxy advice and improve the quality of information that investors
receive.
Additionally, H.R. 4015 directs the SEC to withdraw two no-action
letters issued in 2004 to Egan-Jones and ISS. As a practical matter,
these no-action letters had the effect of allowing a registered
investment advisor to rely on a proxy advisory firm's general policies
and procedures regarding conflicts of interest--as opposed to any
specific conflict that a proxy advisory firm may have in relation to a
voting recommendation. The Egan-Jones and ISS no-action letters have
therefore helped to further entrench the position of proxy advisory
firms, while doing little to mitigate actual conflicts of interest as
they relate to particular proxy recommendations.
H.R. 4015 is a logical next step in the wake of the 2014 SEC staff
guidance. The Chamber strongly supports this legislation and urges the
Committee to advance a companion Senate bill as swiftly as possible.
S. 536, the Cybersecurity Disclosure Act.
There is no question that cybersecurity has become a critical issue
for both businesses and Government. Illicit activity on the part of
cybercriminals and other threat actors represents a grave danger to the
economy and capital markets. While we are generally supportive of
efforts to enhance cybersecurity, we believe that the Cybersecurity
Disclosure Act misses the mark.
Regulators have worked aggressively to deal with cyber threats. The
SEC has become very aggressive in its regulatory efforts, and we
generally support these activities intentioned to keep our capital
markets safe. The SEC's Division of Enforcement recently formed a
dedicated Cyber Unit, and has been actively pursuing cases involving
cybersecurity and data security. Even before the formation of the Cyber
Unit, the SEC began to bring a series of cases against broker-dealers,
investment advisers, and other market intermediaries for violations of
SEC rules regarding safeguarding of customer data involving hacks and
other cybersecurity shortcomings.\8\ To its credit, FINRA (the
Financial Industry Regulatory Authority), which also regulates the
conduct of securities broker-dealers, has likewise been highly engaged
on the issue.\9\
---------------------------------------------------------------------------
\8\ A lengthy list of SEC cybersecurity enforcement cases appears
at https://www.sec.gov/spotlight/cybersecurity-enforcement-actions.
\9\ See FINRA's web page describing these efforts at http://
www.finra.org/industry/cybersecurity.
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The SEC also recently issued Commission-level guidance (the
``Guidance'') that clearly lays out the disclosure expectations for
public companies on this important topic.\10\ Central to the Guidance
is the concept that material cybersecurity risks must be disclosed to
investors. The Guidance also encourages public companies to adopt
comprehensive policies and procedures related to cybersecurity and to
assess their compliance regularly, including the sufficiency of their
disclosure controls and procedures as they relate to cybersecurity
disclosure. To that end, the SEC urges companies to assess whether they
have sufficient disclosure controls and procedures in place to ensure
that relevant information about cybersecurity risks and incidents is
processed and reported to the appropriate personnel, including up the
corporate ladder, to enable senior management to make disclosure
decisions and certifications. Additionally, the Guidance recommends
that public companies adopt policies and procedures designed to
prohibit directors, officers, and other corporate insiders from trading
on the basis of material nonpublic information about cybersecurity
risks and incidents.
---------------------------------------------------------------------------
\10\ The complete text of the Commission Statement and Guidance on
Public Company Cybersecurity Disclosures is available at https://
www.federalregister.gov/documents/2018/02/26/2018-03858/commission-
statement-and-guidance-on-public-company-cybersecurity-disclosures.
---------------------------------------------------------------------------
Of particular relevance to today's hearing, existing SEC
regulations already require a public company to disclose the extent of
its board's role in the risk oversight of the company.\11\ To the
extent cybersecurity risks are material to a company's business, the
Guidance makes clear that this disclosure should include the nature of
the board's role in overseeing the management of that risk.
Additionally, the Guidance reiterates the SEC's view that disclosures
regarding a company's cybersecurity risk management program and how the
board of directors engages with management on cybersecurity issues will
allow investors to assess how a board of directors is discharging its
risk oversight responsibility.
---------------------------------------------------------------------------
\11\ For example, see Item 407(h) of Regulation S-K and Item 7 of
Schedule 14A.
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Investors have also begun to express concerns to public company
boards and management over cybersecurity risks and disclosures.
According to Pricewater-
houseCooper's most recent Global Investor Survey,\12\ cyber threats
were the most common concern of investors when asked to rank potential
business, economic, policy, social, and environmental threats to a
company's growth prospects. Not surprisingly, cybersecurity
preparedness has become a common topic of discussion among public
companies and their investors during shareholder engagement sessions.
---------------------------------------------------------------------------
\12\ https://www.pwc.com/gx/en/ceo-survey/2018/deep-dives/pwc-
global-investor-survey-2018.pdf.
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We believe existing SEC regulations and market practices already
provide the kinds of disclosure that the Cybersecurity Disclosure Act
seeks to address. We believe that policymakers must focus on
strengthening public-private cooperation to proactively protect against
cyberattacks as opposed to taking a ``blame the victim'' approach.
Moreover, companies are sometimes subjected to competing directives
from different Government agencies regarding cyberattacks. For example,
a company may be advised by a law enforcement or national security body
to not disclose an ongoing cyber breach so that the source of the
attack may be discovered. Such guidance could find itself in conflict
with a company's obligation to inform its investors that it has been
hacked. Agencies should coordinate with one another to ensure that a
company complying with one agency's directive does not find itself out
of compliance with another agency.
Companies take cybersecurity very seriously and are generally
proactive in taking steps to mitigate or respond to threats.
Effectively requiring companies to have a board member with cyber
expertise will not make companies any more or less responsive to cyber
threats.
S. 1744, the Brokaw Act
We do not believe it is wise for Congress to consider S. 1744 at
this point.
In its current form, the Brokaw Act would direct the SEC to amend
the Section 13(d) reporting rules in a number of notable ways. First,
the Brokaw Act would reduce the 10-day filing deadline for an initial
Schedule 13D filing to four business days. Second, it would require the
disclosure of short positions over 5 percent on Schedule 13D. Third, it
would expand the definition of beneficial ownership to include a direct
or indirect pecuniary interest, in addition to voting or dispositive
power. As a practical matter, in making this determination, investors
would therefore have to include shares held in swaps and other cash-
settled derivatives, not merely equity securities or securities
convertible into equity securities. Finally, the Brokaw Act would
specifically require the disclosure of activity by hedge funds and
groups of hedge funds under Section 13(d). The explicit inclusion of
``hedge fund'' in the definition of ``persons'' is a clear signal that
the SEC is directed to pay close attention to activist investors and to
concerted activity among them.
There remains a vigorous debate among market participants about the
propriety of the Brokaw Act. On one side of the issue, its supporters
contend that the Act would bring an additional layer of transparency to
capital markets, particularly as it concerns public disclosure of short
positions.
On the other hand, we have heard from many institutional investors
that the Brokaw Act's accelerated Schedule 13D reporting requirements
and new short position disclosures would have a chilling effect on
proprietary investment strategies.
Many investors contend that they would change their market behavior
as a result, which over the longer term could impede liquidity and
price discovery.
The Chamber has long called on the SEC to address abusive practices
related to short sales, including our call to put an end to ``naked
short selling.'' We also have very serious concerns regarding ``short-
and-distort'' schemes, which involve spreading false or misleading
information about a company in order to drive its stock price down and
return a profit for the short seller. However, we are sympathetic to
concerns that adoption of a broad short sale disclosure regime could
hamper a legitimate market activity that increases liquidity and price
discovery.
Even if the SEC were to determine that a new short-sale disclosure
regime is in the public interest, the Chamber has doubts as to whether
modeling such a regime on Schedule 13D reporting would prove optimal.
The current legislation makes no distinction between a short seller who
has taken a net short position in a company because they believe the
stock will decline in value, and a short seller who may short the
company as a hedge against an existing long position. Making such a
distinction would require Congress or the SEC to determine the
motivation and investment strategy of market participants--a difficult,
if not impossible, task that speaks to the complexities of adopting a
short sale disclosure regime.
We support continued study of issues related to short selling, and
urge the SEC to take the lead in assessing whether future modifications
to its rules on these issues are necessary or prudent.
S.__, the 8-K Trading Gap Act of 2018
The Chamber believes it is important to root out bad actors from
capital markets. However, we do not believe the 8-K Trading Gap Act
will prevent future insider trading activity.
First, it is already unlawful to trade on the basis of material,
nonpublic information (MNPI) in violation of a fiduciary duty.
Corporate insiders may not trade or make tips on the basis of MNPI
learned during the course of employment. A bad actor who has determined
to violate the Federal securities laws by engaging in conduct as
serious as insider trading is not likely to be deterred by a second,
redundant prohibition against the same misconduct that is found in an
employer's internal policies, procedures, and controls.
Second, the Act assumes that all Form 8-K events are certain on Day
1 of what is often a four-business-day reporting cycle, but decisions
may take several days and consultations with counsel. In many cases, a
public company will not determine to file until closer to the reporting
deadline of Day 4.
If this timing problem raises several questions and the company is
unsure of the reporting status on Days 1, 2, and 3, how is it going to
develop policies and procedures to bar insiders from trading? And how
would insiders even know they are blacked out if their employer has not
provided notice to them? What if the company unintentionally misses a
filing deadline and the company makes a late filing months later? What
are the consequences then? How do policies, procedures, and controls
address these kinds of hypotheticals in any realistic, enforceable way?
S. 2756, the Fair Investment Opportunities for Professional Experts Act
The Chamber supports the Fair Investment Opportunities for
Professional Experts Act, which is an innovative way to expand
accredited investor definitions in a limited manner to bring more
sophisticated investors into the marketplace.
It is appropriate to put in place requirements and tests that
correctly define persons who have the sophistication to invest in
complex vehicles and have the ability to withstand loss. Asset and
income tests are objective standards that have served well in
determining who should be allowed the designation of accredited
investors.
Still, one may not meet these objective tests but could still fit
the criteria of a sophisticated investor. Such a person, in limited
circumstances, could be considered an accredited investor. If that
issue is addressed appropriately, more investors can access markets and
the potential for capital formation for businesses can be expanded.
However, other factors should be allowed to be considered.
Presumably an individual who has met the educational and licensing
requirements to sell securities and investments could be deemed to be
of such a level of sophistication that they should be considered to be
an accredited investor. This is also an objective test that could be
easily codified. Accordingly, we support the Act's provisions that
would lead to this result.
We also support the idea that SEC should, through notice and
comment rulemaking, consider other ways to expand the accredited
investor definition.
S. 2499, Compensation for Cheated Investors Act
Arbitration is an important means for customers to resolve
disputes, and it provides significant benefits to consumers, investors,
and businesses. Arbitration forums can provide investors or other
injured parties with accessible and fair procedures for obtaining
redress for claims that cannot be vindicated in court. Current FINRA
rules do not mandate that arbitration be the sole forum for investors
to resolve disputes with brokerages, however FINRA does require that
arbitration be used if it has been requested by an investor.
According to FINRA statistics, in 2016, 2,457 arbitration cases
involved customer disputes, but only 16 percent of these cases resulted
in the customer being awarded compensation. Seventy-one percent settled
prior to the award, while another 9 percent were withdrawn.\13\ This
distribution of arbitration outcomes has remained fairly consistent
over the years, and a relatively low number of cases each year end up
as unpaid customer arbitration awards. For example, there were 44 such
cases in 2016.\14\ Furthermore, 13 of the 44 unpaid arbitration award
cases in 2016 involved a pre-award settlement between the customer and
a brokerage firm.\15\ Other cases of unpaid arbitration awards may
include situations involving brokerage firms that are inactive or no
longer active or registered with FINRA, meaning that FINRA no longer
has jurisdiction over the firm.
---------------------------------------------------------------------------
\13\ Discussion Paper--FINRA Perspectives on Customer Recovery
available at http://www.finra.org/sites/default/files/
finra_perspectives_on_customer_recovery.pdf.
\14\ Id. at 6.
\15\ Id. at 9.
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FINRA's Customer Code states that unless a brokerage firm has a
bona fide reason for nonpayment of an arbitration award, the firm must
pay the award within 30 days. Firms that do not pay within 30 days risk
being penalized or suspended by FINRA. The Chamber fully supports such
regulatory mechanisms that ensure customers or investors receive the
full amount of arbitration awards granted to them.
However, we are concerned that S. 2499, the Compensation for
Cheated Investors Act would do more harm than good for investors. The
legislation creates an open-ended ``FINRA Relief Fund'' that is to be
funded in part by ``sources determined by FINRA.'' The Relief Fund
would ostensibly be created in order to compensate customers that have
not received arbitration awards they are entitled to.
The legislation could effectively allow FINRA to assess firms that
have done nothing wrong in order to pay out arbitration awards that
have been awarded due to the activities of bad actors. It would also
establish what amounts to an insurance fund that has no actuarial basis
whatsoever for the amounts that should be assessed on FINRA members in
order to properly fund it, which will likely lead to the fund becoming
insolvent in the future.
More troubling, the legislation would empower bad actors by
ensuring them there is a backstop in place--paid for by somebody else--
to compensate investors they have cheated. S. 2499 also does not
contemplate or take into account the existing Securities Investor
Protection Corporation (SIPC) regime that was created to compensate
investors in the event of a broker liquidation. We believe that these
issues make S. 2499 inherently flawed, and would urge the Committee to
reject the legislation.
S. 2953, the Expanding Access to Capital for Rural Job Creators Act
The Chamber supports this legislation, which would expand the focus
of the Office of the Advocate for Small Business Capital Formation at
the SEC to include ways to increase capital access for rural-area small
businesses.
A 2016 report from the Economic Innovation group found that half of
all post-recession business creation in the United States occurred
across only 20 counties, and that many rural areas missed out on
economic growth following the financial
crisis.\16\ S. 2953 is an incremental but important step that will help
focus the SEC on the needs of businesses in rural communities.
---------------------------------------------------------------------------
\16\ https://eig.org/wp-content/uploads/2016/05/
recoverygrowthreport.pdf.
---------------------------------------------------------------------------
Conclusion
The Chamber appreciates the opportunity to provide perspective on
these important issues on behalf of our member companies, and we
commend the Senate Banking Committee for holding this important
hearing. I would be happy to answer any questions you may have.
______
PREPARED STATEMENT OF DARLA C. STUCKEY
President and CEO, Society for Corporate Governance
June 28, 2018
Chairman Crapo, Ranking Member Brown, and Members of the Committee,
my name is Darla Stuckey, and I am the President and CEO of the Society
for Corporate Governance. The Society appreciates the opportunity to
present its views on corporate governance legislation before the
Committee.
Founded in 1946, the Society is a professional membership
association of more than 3,600 corporate secretaries, in-house counsel,
and other governance professionals and service providers to the
industry who serve approximately 1,200 entities, including about 1,000
public companies of almost every size and industry across the United
States.
Society members are responsible for supporting the work of
corporate boards of directors, their committees, and the executive
managements of their companies on corporate governance and disclosure.
Our members generally are responsible for their companies' compliance
with the securities laws and regulations, corporate law, and stock
exchange listing requirements.
The Decline of Public Company Ownership
A fundamental mission of the Society is to advocate for legislative
and regulatory changes that will relieve some of the burdens that
discourage companies from becoming and remaining public companies.
There are a wide range of forces that discourage investors and the
companies they own from going and remaining public. In 1997, there were
approximately 7,100 public companies in the United States. Now there
are fewer than 3,600.
The decline in public ownership should concern every American.
Growing wealth inequality has many drivers, but fewer public companies
means fewer investment opportunities for average American investors.
This is particularly troubling when one considers that a significant
amount of wealth is generated by a company shortly after that company
goes public. Think of the opportunities that ordinary American savers
have missed out in just the last few years. In fact, companies are
staying private longer. In a study published on August 8, 2017, by Jay
R. Ritter, Cordell Professor of Finance at the University of Florida, a
company's median age for an IPO in 1999-2000 was 5 years, while from
2001-2016 it was 11 years.\1\ In 2016, 74 companies became public at a
median age of 10 years.\2\
---------------------------------------------------------------------------
\1\ Jay R. Ritter, ``Initial Public Offerings: Updated
Statistics,'' University of Florida, at 11, August 8, 2017, available
at https://site.warrington.ufl.edu/ritter/files/2017/08/IPOs2016
Statistics.pdf.
\2\ Id. This was the lowest number of IPOs since 2009.
---------------------------------------------------------------------------
As I said, there are a range of factors discouraging public
ownership of companies. But the Committee has before it two bills that
can directly and concretely improve the climate for public ownership,
H.R. 4015, the Corporate Governance Reform and Transparency Act; and S.
1744, the Brokaw Act. I will discuss each individually.
H.R. 4015, ``Corporate Governance Reform and Transparency Act''
H.R. 4015, which has passed the U.S. House of Representatives,
addresses the role and activities of the private firms providing proxy
advisory services to institutional investors. These entities--called
proxy advisory firms--operate with very little regulation or oversight.
H.R. 4015 would provide badly needed improvements to the accuracy and
processes of these firms.
Background on Proxy Advisory Firms
The proxy advisory market is dominated by two firms--Institutional
Shareholder Services, or ISS, and Glass Lewis. For the uninitiated,
proxy advisory firms play an important role in the capital markets by
advising investors how they should vote their proxies. This involves
preparing recommendations to institutional investors who hold shares in
companies--sometimes very large amounts--whether they should (or should
not) vote for a particular director, approve the CEO's compensation,
and/or how the investor should vote on shareholder proposals. These
shareholder proposals can range from an amendment to a company's by-
laws to a new climate change policy.
While simply recommending how an investor should vote may sound
somewhat unimportant, the reality is far different. ISS and Glass Lewis
recommendations are the single most influential pronouncement on the
composition of a public company's board, its executive compensation
policies, and an increasingly diverse range of shareholder proposals.
In fact, anecdotal evidence from some of our member companies
consistently shows that as much as 30 percent of the total shareholder
votes are cast within 24 hours of the ISS and Glass Lewis
recommendations being released to their clients.
In our view, proxy advisory firms exert outsized influence in the
proxy voting process. These firms own and control the software
platforms that send investor votes to the tabulator for a shareholder
meeting, so they can be counted. The combination of generating proxy
voting recommendations and controlling the physical infrastructure
through which the votes are cast (sometimes with voting decisions made
by the institutional investors and sometimes by default if no client
voting decisions are made) are what give proxy advisory firms their
importance and give rise to the imperative that these firms ``get it
right.''
Accuracy and Accountability Problems with Proxy Advisory Firms
Proxy advisory firms make proxy recommendations on literally every
public company in the United States and thousands of public companies
in Europe and Asia. This is a large and labor-intensive task. The scale
and complexity of making proxy voting recommendations for thousands and
thousands of companies during ``proxy season'' effectively requires
proxy advisors to do all their analysis from February to June. With
almost all of the recommendations coming out in a 6-8 week period.
Reading and accurately digesting thousands of proxy statements,
annual reports, and--increasingly--corporate social responsibility
statements in a condensed period makes errors inevitable. Compounding
this problem is the fact that many companies are not able to see the
proxy advisors' reports about themselves until after each report has
been issued. For any company not in the S&P 500, the only way it can
see the report is to subscribe to the proxy advisor's service.\3\
---------------------------------------------------------------------------
\3\ ISS permits companies in the S&P 500 to have 24-48 hours to
review their reports before they are issued, with no subscription
required. Smaller companies must pay to receive them. Glass Lewis uses
a factual database that companies can access, but does not provide
draft reports to any company of any size for review before issuance.
---------------------------------------------------------------------------
It is true that ISS and Glass Lewis will send the underlying data
for their reports to some companies for their review. But the analysis
and final recommendations are not known, and errors occur during this
process. S&P 500 companies are given their reports in advance by ISS,
but companies only have 1 or 2 days (frequently over a weekend) to
review before the recommendations are released publicly. There is often
not enough time for companies to review what is arguably the most
important corporate governance recommendation about that company each
year.
One Small Cap Company's Multi-Year Battle with Factual Errors
An inability to review draft reports from proxy advisory firms
means that companies who want factual errors corrected are often unable
to get a response from proxy advisory firms until it is too late, i.e.,
after investors have voted on the basis of a recommendation relying on
inaccurate information.
A very real example of this problem comes from a Society member
that works for a small-cap company in the transportation industry. The
company's story highlights a multitude of problems that the provisions
of H.R. 4015 would fix:
In May 2016, we received an ISS report with an `against'
recommendation regarding say-on-pay that was based on a
material factual error. The ISS personnel incorrectly concluded
that under our annual bonus plan, we set the financial metric
goal for the 2015 fiscal year lower than the actual
results we had obtained in 2014. This was simply untrue--this
was not a matter of methodology or interpretation, but a clear
mathematical mistake.
As a small-cap company, unlike larger companies, we are not
given a `preview' of our report from ISS, so we received this
report just 2 weeks prior to our May 2016 annual meeting. We
quickly utilized all of the methods available to us to try to
get the error corrected and the recommendation
reversed. Although ISS acknowledged the error, they declined to
issue either a correction or a revised report.
We engaged in robust shareholder outreach as we have for many
years, and while the shareholders who were able to speak with
us quickly understood the mistake and supported our say-on-pay
[proposal], we were not able to have meetings with all the
shareholders we reached out to due to the extremely busy proxy
`in-season' and a large portion of our shareholders being
quantitative or passive firms who outsource their voting to
proxy advisory firms. The result was that our 2016 say-on-pay
[proposal] narrowly failed with a 49.8 percent favorable vote
outcome.
We engaged in extensive `offseason' shareholder outreach during
the fall of 2016, reaching out to shareholders representing
over 75 percent of our outstanding shares, and, while
shareholders offered small governance-related suggestions such
as proxy access, none expressed any wish to see specific
changes in our executive pay program; some instructed us to
`fix' our ISS recommendation and then they would be sure to
vote in support. We promptly added proxy access, and disclosed
our outreach efforts and feedback in our April 2017 proxy
statement fully and accurately.
In May 2017, ISS issued their report, again recommending
against our say-on-pay, alleging that due to our prior year's
low vote outcome, our shareholders must have demanded extensive
pay program changes that our compensation committee ignored.
This was simply factually untrue.
Due to ISS' programmatic rules, a second consecutive year meant
ISS not only recommended against say-on-pay but against the re-
election of our four-member compensation committee, including a
new committee member who was not even on the board at the time
compensation decisions were being made. This meant that four
members of our 10-member board who had been key drivers of an
extraordinary 2016 business year that saw a transformative
transaction with a global e-commerce company and a 26 percent
shareholder return were at risk of nonre-election due to proxy
advisory errors and formulaic inflexibility. Moreover, the
board members being recommended against included at the time
the sole female member of our board and one of our two racially
diverse board members.
Thanks to above-and-beyond shareholder outreach efforts we were
able to get the compensation committee members re-elected but
received only 32 percent in favor of our say-on-pay vote in May
2017.
Through a combination of extensive pro-active compensation
program changes and at-length engagement with ISS and Glass
Lewis in the fall of 2017, this May we received `for'
recommendations from both firms in reports which were
fortunately finally absent material factual errors (ISS' report
still has an error regarding our perquisite program which we
are attempting to fix). This recommendation resulted in a 94
percent favorable say-on-pay vote this year, demonstrating the
outsize influence of proxy advisory firms and the crucial need
for regulation that ensures shareholders who rely on proxy
firms' recommendations are relying on accurate data. (emphasis
added).
Other Problems with Proxy Advisory Firm Practices
In addition to the problems discussed above, proxy advisory firms
use a ``one-size-fits-all'' approach that imposes the same standards on
all public companies, instead of evaluating the specific facts and
circumstances of each company they evaluate. This has the effect of
homogenizing corporate governance practices for the benefit of the
proxy advisory firms themselves and not for other stakeholders in the
proxy process. In fact, one proxy advisory firm, ISS, told a large-cap
Society member its proxy access bylaw that was the subject of a
shareholder proposal did not comport with ``best practices'' and that
it would recommend against management, even though over 90 percent of
such bylaws have the same provisions as the one on the ballot. When
pressed about how ISS could not identify this bylaw amendment as a best
practice, the ISS corporate sales team member said that ``for ISS best
practice is the preferred practice by ISS.'' In short, ISS sets the
standard.
Proxy advisory firms also operate without providing adequate
transparency into their internal standards, procedures, and
methodologies. These firms are basically ``black boxes,'' operating
with little accountability or input into their internal processes.
Conflicts of interest within these firms also need to be addressed.
One of the firms--ISS--provides corporate governance and executive
compensation consulting services to public companies, in addition to
providing voting recommendations to its institutional clients on the
same companies. A common practice is for a company to get a call from
the ISS corporate consulting sales force with a pitch that--for a
price--they can miraculously fix any problems that company has had with
a previous vote. Indeed, for an even higher price, a company can get
even more service, including language explaining elements of an annual
bonus plan in a company's Compensation Discussion and Analysis section.
And, even more recently, ISS now has an environmental scorecard it
pitches to companies showing negative results, and, when asked what
forms the basis of the score, companies are told they can learn about
it if they pay $35,000 to ISS.
Another conflict that exists is proxy advisory firms providing
voting recommendations on shareholder proposals submitted to companies
by their institutional investor clients. These conflicts need to be
specifically and prominently disclosed to
clients of proxy advisory firms so that they may evaluate this
information in the context of the firms' voting recommendations. Not
only do the firms recommend on their own clients' proposals, one of the
firms, ISS, has a service for investors to help them craft proposals
that will pass muster under SEC rules.
The Fiduciary Responsibilities of Institutional Investors
One of the reasons that proxy advisory firms have become so
powerful is the belief that every vote is an asset and that asset
managers must vote every item on a ballot in order to satisfy their
fiduciary duty to their clients, and their clients' beneficiaries. SEC
and Department of Labor rules and guidance confirm that a proxy vote is
an asset and that institutional investors owe fiduciary duties to their
clients, investors, and beneficiaries with respect to the voting
process.
While some have interpreted these rules and guidance to mean they
must vote each and every item on a proxy card, this is not the case.
Rather, institutions should weigh the cost of voting certain items
against the benefits of voting on those items. Clearly, not every item
on a ballot must be voted if the manager in his or her judgment
believes it costs more to understand and vote on an item that the vote
is worth.
Practically speaking, however, no investment manager will say to
his or her clients that they didn't exercise their right to vote. So
they hire proxy advisory firms at the lowest cost possible and then
report that they voted each of their positions (although not the number
of shares)--even if they have little interest or expertise in executive
compensation or environmental issues, for example. This would be the
case typically with smaller passive investors, or quantitative fund
managers, or those who simply own one stock as a hedge against another
position.
Again, the outsize influence of proxy advisory firms is due to the
many institutional investors and their third-party managers who choose
to reduce costs by not having in-house proxy staffs to analyze and vote
at shareholder meetings.
This is not the group of asset managers that public companies
typically engage with and it is not the group of asset managers and
owners who lobby and advocate against legislative proposals like H.R.
4015. That group--consisting of large asset managers like BlackRock,
Vanguard, T. Rowe Price, State Street Global Advisors, TIAA-CREF, BNY
Mellon, Capital Group, and other household names--manage their voting
process by using proxy advisory firms as one of many data points,
typically as a screen or filter, and they conduct a deeper analysis on
particular companies that fall outside parameters that they have set.
These firms also have ``custom guidelines'' that they instruct the
proxy advisory firms to use when voting their shares. In addition,
these institutions engage with companies directly and make their own
voting policies transparent and available to issuers.
However, there are smaller institutional investors and managers
that do typically ``outsource'' their voting decisions to proxy
advisory firms that provide automated voting services. This is a way to
fulfill what they believe to be their compliance obligations with
respect to proxy voting at the lowest cost. Together, these small
managers add up.
A number of these small managers adopt ISS and Glass Lewis
``default'' voting guidelines and policies and then let the proxy firms
apply these policies by generating electronic ballots that reflect
these default positions for each shareholder meeting. As a technical
matter, the client has the right to override a particular ISS or Glass
Lewis voting recommendation. However, most of these ballots are left
untouched and submitted automatically without any client input or
decision. This ``robo-voting'' process results in as much as 20 percent
of votes that are cast automatically within 24-48 hours of the issuance
of ISS and Glass Lewis reports on a company in advance of a shareholder
meeting.
In all these cases, the result is an outsourcing of voting
responsibilities to a nonfiduciary.
SEC Actions to Address Proxy Advisory Firm Issues
The SEC has taken a few steps to address the role and activities of
proxy advisory firms. The agency evaluated the proxy system in 2009 and
issued a wide-ranging Concept Release in 2010. In December 2013, the
SEC held a Roundtable on Proxy Advisory Services to discuss many of
these issues. The Society testified at that Roundtable.
The SEC followed up its Roundtable by issuing Staff Legal Bulletin
20 in June 2014, which provided guidance to institutional investors
about their obligations under the Investment Advisers Act and
established several standards for proxy advisory firms to adhere to,
under the Securities Exchange Act of 1934. Institutions can and do use
proxy advisory firms, so long as they insure the voting is done in
accordance with their own fiduciary duties.
While these were excellent first steps in addressing these
problems, more needs to be done.
The Need for Legislation to Establish a Regulatory Framework Applicable
to Proxy Advisory Firms
Proxy advisory firms exist because of well-intentioned regulatory
action that nevertheless has resulted in many different unintended
consequences. One consequence is that the proxy advisory industry is
subject to an incomplete and harmful regulatory framework. As an
example, the largest proxy firm, ISS has chosen to register under the
Investment Advisers Act of 1940. However, the SEC's rules for
investment advisors do not reflect the unique role that proxy advisory
firms perform in the proxy voting process. Proxy advisory firms do not
select securities for their clients or provide investment advice in the
way a typical asset manager does. Instead, these firms recommend how to
vote at shareholder meetings and, as described above, automate the
voting process for their clients.
The second biggest proxy advisory firm, Glass Lewis, is not
registered as an investment advisor (or under any other securities
statute). As a nonregistered entity, Glass Lewis is not subject to the
provisions of the Investment Advisers Act, or any other SEC regulation.
Additionally, the SEC has created an exemption from its proxy rules
for proxy advisory firms, so they are not required to abide by
solicitation and disclosure rules that apply to other proxy
participants. Thus, their recommendation reports, in contrast to
company proxy materials, are not always available to issuers unless
they pay for them, and they are not subject to any outside review or
oversight, even after annual meetings.
This unworkable regulatory system should not be permitted to
continue, and these firms should be subject to more robust oversight by
the SEC and the institutional investors that rely on them. This can be
accomplished by developing a targeted regulatory framework that
reflects the unique role that proxy advisory firms perform in the proxy
voting process.
Along with considering greater regulatory oversight of proxy
advisory firms, the SEC and Department of Labor should review the
existing framework applicable to the use of proxy advisory firms by
institutional investors. This review should include the Egan Jones and
ISS no-action letters that were issued by the SEC staff in 2004.\4\ The
SEC and Department of Labor should ensure that institutional investors
are exercising sufficient oversight over their use of proxy advisory
services, in a manner consistent with their fiduciary duties.
---------------------------------------------------------------------------
\4\ See Egan Jones Proxy Services, May 27, 2004; and Institutional
Shareholder Services, Inc., September 15, 2004.
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H.R. 4015 addresses many of the concerns raised by public companies
and other participants in the U.S. proxy system. It requires the proxy
advisory firms to register with the SEC. It requires these firms to be
more transparent about their internal standards, procedures, and
methodologies. It provides companies with a mechanism to review draft
reports before they are issued. It also provides companies with a
process to correct mistakes. And, finally, the bill authorizes the SEC
to regulate and/or prohibit the conflicts of interest that exist in
proxy advisory firms.
For these reasons, the Society strongly supports H.R. 4015 and
urges its passage through the Committee on Banking, Housing, and Urban
Affairs.
We do understand that several institutional investors and the proxy
advisory firms themselves have opposed H.R. 4015 because of concerns
about the increased costs that the requirements of the bill may impose
on these firms and their institutional clients. The Society understands
the need that institutional investors and their proxy voters have for
summaries and analyses of proxy materials, particularly those who hold
every U.S. equity and are required to vote thousands of meetings each
year. The Society is mindful of these concerns and is more than willing
to work with the Committee to improve the legislation in a manner that
accomplishes its goals, while also reducing its compliance costs.
H.R. 1744, ``Brokaw Act''
Another disincentive to public ownership of companies is the burden
of being subject to attacks by activist investors, a number of whom
have short-term agendas.
There is no doubt that some activists create longer-term
shareholder value and the Society is not seeking to stifle activist
investing. The Society does not believe, however, that there is a level
playing field between activists and companies. Companies are required
by securities laws to publicly disclose material information within 4
days. Activist investors, on the other hand, have 10 days to file a
Schedule 13D, disclosing the material fact that they have acquired 5
percent of a particular company's stock.
This 10-day window has been the subject of criticism for allowing
too much time for activist investors to accumulate large positions in
public companies--sometimes through undisclosed derivative positions--
before being required to disclose anything publicly. As an example,
former SEC Chair Mary Schapiro noted in 2011 that many feel that the
10-day reporting deadline ``[r]esults in secret accumulation of
securities; [r]esults in material information being reported to the
marketplace in an untimely fashion; and [a]llows 13D filers to trade
ahead of market-moving information and maximize profit, perhaps at the
expense of uninformed security holders and derivative
counterparties.''\5\
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\5\ Chairman Mary L. Schapiro, ``Remarks at the Transatlantic
Corporate Governance Dialogue, U.S. Securities and Exchange Commission,
December 15, 2011, available at https://www.sec.gov/news/speech/2011/
spch121511mls.htm.
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S. 1744 would equalize these reporting timeframes and make other
necessary modernizations.
The SEC has not updated its 13D disclosure requirements in several
decades and, in fact, this year is the 50th anniversary of the
enactment of the Williams Act, which established this regulatory
framework. S. 1744 would update these SEC requirements by closing
certain loopholes and ensuring that securities positions taken by
activist investors are more transparent to companies and to the capital
markets.
The Brokaw Act--named for a village in Wisconsin that went bankrupt
in part due to the actions of a group of hedge funds that pressured the
Wausau Paper Company in 2011--would make three changes to the SEC's
13(d) disclosure rules. First, it would direct the SEC to shorten the
deadline for disclosing an ownership interest from 10 days to 4 days,
which is the current deadline for companies filing an 8-K report. The
original 10-day deadline was developed when snail mail was the primary
form of written communication, and this deadline has been eclipsed by
the rise of electronic communication and the rapid speed in which
securities are currently traded.
Some have argued that the 10 days was a careful balance drawn at
the time to give investors an advantage over potentially entrenched
management. A lot has changed on that front in 50 years and the
argument that the legislative history of the Williams Act requires the
10 days for activists to have an advantage is longer relevant.
Shareholder rights and shareholder engagement have come of age. In
fact, so much so that we see a decrease in the number of private
companies willing to take advantage of the public markets, and we see
those who do go public institute stock classes to alleviate the burdens
of activism and other shareholder empowerment mechanisms.
Second, the bill would require disclosure of any short or
derivative positions that cross the 5 percent threshold, something that
does not occur today. This closes a significant loophole that otherwise
permits investors to accumulate large short and/or derivative positions
in a security without any public disclosure.
And third, the bill would expand the 13(d) reporting requirement to
include hedge funds and other activist investors that are coordinating
activities for the purpose of seeking control or influence over a
public company.
The Society has been working with the original sponsor of the
Brokaw Act, Senator Tammy Baldwin of Wisconsin. This Act is now co-
sponsored by Senator Perdue of Georgia and it represents good public
policy for both public companies and their investors. We urge the
Committee to pass this legislation to update and modernize the 13(d)
disclosure regime.
Let me now turn to two bills before the Committee that could
further discourage companies from going or remaining public, and that
the Society opposes in their current form, S. 536, the Cybersecurity
Disclosure Act, and the 8-K Trading Gap Act.
S. 536, ``Cybersecurity Disclosure Act''
S. 536 requires public companies to disclose if they have a board
member with expertise or experience in cybersecurity and to describe in
detail the nature of that expertise or experience. If there isn't a
cybersecurity expert on a board, a company will have to disclose ``what
other cybersecurity steps taken by the reporting company were taken
into account by such persons responsible for identifying and evaluating
nominees'' for such board positions.
The Society generally believes that having special interest
directors is not a good practice. First, there are not enough cyber
``experts'' around to serve on every board. Even if there were, it is
unlikely they would agree to serve as an expert because a board member
is only an overseer and not in control of all corporate affairs. He or
she can only determine if management has organized and spent the
resources to protect the company from cyber breaches given the type of
data it has, the costs required to be expended, and the likelihood of
success.
In addition, this bill is not necessary because director
qualifications in the proxy already describe a person's experience and
background. Anyone reading a proxy would be able to tell if a board has
someone with cyber expertise as a member. A bill like this could lead
to requirements that boards appoint other special interest directors.
This bill also creates a false presumption that a cyber expert
director is required to effect appropriate board oversight. Concerns
expressed by a Society member about encouraging a single-issue director
are illustrative:
Of course, we want our public companies' boards to have the
requisite skills to deal with all sorts of issues. However,
specifying the types of skills that a company's board must have
strikes me as the ultimate one-size-fits-all approach and has
no logical limits.
Should every public company have an expert on revenue
recognition? Related-party transactions? Has anyone thought
through the consequences of having a board comprised of one-
issue experts who may not have any other applicable skill sets?
And would a cyber-expert want to be on a board, given that he
or she would likely be blamed (and possibly sued) if the
company had a breach or other cyber problem?\6\
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\6\ Robert B. Lamm, ``Beware when the legislature is in session,''
The Securities Edge, March 19, 2017, available at https://
www.thesecuritiesedge.com/2017/03/beware-when-the-legislature-is-in-
session/.
Further, in its 2016 guidance for investors to assess the adequacy of
their portfolio company boards' cybersecurity oversight, even the
Council of Institutional Investors doesn't subscribe to the view that
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all boards need a resident cyber expert:
Cybersecurity is an integral component of a board's role in
risk oversight. Directors have the authority, capacity and
responsibility to make pivotal contributions in this area by
ensuring adequate resources and management expertise are
allocated to robust cyber risk management policies and
practices, and ensuring disclosure fairly and accurately
portrays material cyber risks and incidents.
To achieve these objectives, directors need not develop
advanced technical expertise. Nor do directors need to support
unrestrained capital spending on any project with a `cyber'
prefix.\7\ (emphasis added)
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\7\ Council of Institutional Investors, ``Prioritizing
Cybersecurity,'' at 1, April 2016, available at https://www.cii.org/
files/publications/misc/4-27-16%20Prioritizing%20Cybersecurity.pdf.
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S.__, ``8-K Trading Gap Act''
The 8-K Trading Gap Act requires the SEC to issue new rules
prohibiting insider trading during a ``covered period.'' The term
``covered period'' is defined as the period between: (1) the date when
material nonpublic information is known to officers and directors of a
company; and (2) the date when the information is disclosed to the
public through an 8-K or other SEC filing.
The Society believes this bill is unnecessary and could lead to
unintended consequences. It is already illegal to trade on material
nonpublic information, and
recent SEC guidance has confirmed existing law for circumstances
involving cybersecurity. In addition, public companies uniformly have
insider trading policies that require pre-clearance and strictly
regulate trading in a company's securities by
employees, including executive officers and directors of a company.
These are conservative risk management policies that apply broadly, and
they typically have two levels of protection: (1) a trading window that
is closed (a.k.a. ``blackout period'') when the company is in
possession of material nonpublic information; and (2) a pre-clearance
procedure for more senior executives whereby no trading is allowed
unless cleared by the senior legal officer of the company.
In order to determine whether the company has material nonpublic
information, companies have internal processes for information to be
communicated up the chain of command so that appropriate decisions can
be made. This reporting up the chain is a common practice in public
companies and it runs through several internal mechanisms within
companies, including preparation of SEC reports, financial statements,
etc.
A practical difficulty with this bill is how best to make the
judgment call about whether a particular piece of cybersecurity
information (or a situation) involves material nonpublic information,
especially in an evolving situation where a company is trying to
determine the difference between an intrusion and a breach.
First, a company must determine if the information is nonpublic.
This sounds easier than it is, as the information must be analyzed in
light of the company's current public disclosures (e.g., its risk
factors and MD&A).
Second, a judgment must be made as to whether the information is
material. This is typically the most difficult judgment to be made; in
these situations, an expected value analysis needs to be conducted,
i.e., would the event be material if it occurred and what is the
likelihood that the event will occur? This analysis is made more
difficult when, as in the case of a cyber-attack, it is often not clear
for some time what the event itself is. It could be a meaningless
intrusion, or a significant one.
For example, is the event when an issuer's computer system detects
an intrusion; is it when the first employee learns about the
intrusions; is it when the company makes a determination that the
intrusion could be material; or is it when the company makes a
determination that the intrusion is actually material?
These difficult judgment calls also apply to other evolving
circumstances, such as an internal investigation, a negotiation over
the continued employment of a senior executive, or a merger and
acquisition transaction.
Trying to fix the problem of trading when there is the potential
for material nonpublic information within a company would be fixing the
problem by killing an ant with a bazooka. Companies are in a difficult
position here as there is always potential material nonpublic
information inside a company. In the case of cyber intrusions, a
company would have to keep the trading window closed permanently. The
net effect could be, at worst, that insiders could never sell their
stock, or, at best, they would be severely limited in doing so. This
would be a strong disincentive for those making a decision to take a
company public, or to remain public. Moreover, because many companies
compensate their employees with some form of equity, to align their
interests with those of all shareholders, a reduction in the ability
for employees to sell their company equity would be problematic and
could lead to a de-equitization of America's workforce.
For all these reasons, the Society believes that current laws and
conservative risk management policies by companies are adequately
preventing executive insider trading between the time that material
nonpublic information is determined and the time when a public filing
is made.
Conclusion
Thank you for the opportunity to present the views of the Society
on these important legislative proposals affecting corporate
governance. I am happy to answer any questions you may have about these
proposals.
______
PREPARED STATEMENT OF JOHN C. COATES IV
John F. Cogan, Jr. Professor of Law and Economics, Harvard Law School
June 28, 2018
Chairman Crapo, Ranking Member Brown, and Members of the Committee,
I thank you for inviting me to testify. Effective corporate governance
is a crucial foundation for economic growth, and by providing
accountability and legitimacy to large-scale businesses, it is a core
part of America's success story. I am honored to have been asked to
participate. The Committee asked for comment on the role that law plays
in corporate and shareholder disclosures and governance, and how they
could be improved. After answering those questions, I comment on five
of the seven bills that are the focus of today's hearing, although I am
happy to take questions about any of the bills.
Background and Credentials
By way of background, prior to joining Harvard, I was a partner
practicing securities and corporate law at one of the Nation's most
prestigious law firms, Wachtell Lipton Rosen & Katz. I drafted proxy
statements, annual reports, and prospectuses, worked with SEC staff,
managed shareholder meetings, and advised on most of the governance
topics before the Committee. As an advisor, I had to assist boards
respond to shareholder pressures in the absence of good information. In
short, I have lived the experience of coping with disclosure
obligations, as well as their absence.
At Harvard, I teach, research and write about corporate law and
governance in both the law school and the business school, as well as
in executive education sessions with directors, CEOs, and general
counsels. I co-authored a foundational ``core reading'' on corporate
governance designed for all MBAs.\1\ I am on the SEC's Investor
Advisory Committee, and I am also serving as a monitor for the DOJ and
a compliance consultant to the SEC.
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\1\ John C. Coates and Suraj Srinivasan, Corporate Governance, Core
Reading, Harvard Business Publishing (2018 forthcoming).
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General Remarks on Corporate Governance
Law--and the subset of law known as regulation--has always played
an important role in corporate governance, and it continues to do so.
Corporations are creatures of law; without an act of Government, no
corporation would exist. Initially, corporate charters included
Government-imposed terms that some would now label regulation,
including terms about who is authorized to act for a company, how
disputes among corporate officials are to be resolved, and the relative
powers of investors, boards, officers, and other agents, including
rights of access to information. The features of limited liability,
legal personality (including the right to sue), and indefinite lifespan
represent, in essence, economic subsidies--they facilitate capital
formation and economic activity that would not occur without corporate
law.
Today, reflecting a traditional embrace of separation of powers,
those terms are set out in an array of locations. They include:
Federal statutes such as
the Foreign Corrupt Practices Act,
the Williams Act, and
the Investment Company Act of 1940,
SEC, DOL, and IRS regulations,
State corporate statutes,
court decisions interpreting purposefully vague standards
of conduct,
stock exchange listing standards (which function as
regulation),
corporate charters and bylaws,
corporate governance principles and codes of ethics (which,
once adopted, function like regulation in many respects),
academic treatises (relied up on by courts on occasion),
and
increasingly, codes of best practices, stewardship codes,
voting policies and governance positions taken by large index
funds, other mutual funds, pension funds and proxy advisors
(which reflect and reinforce governance norms).
As this list suggests, law pervades corporate governance.
Most of these laws allow ample room for variation and
experimentation. The United States has never imposed ``one size fits
all'' regulation in corporate governance. The most contentious part of
the Sarbanes-Oxley Act (section 404), for example, permits companies to
comply or disclose.\2\ Companies are not required to do what audit
firms think is necessary for an effective control system, if companies
are prepared to disclose the disagreement and live with the market
consequences, which a substantial number of companies choose to do.
Still, the law provides the basic framework within which governance is
negotiated.
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\2\ John C. Coates, The Goals and Promise of the Sarbanes-Oxley
Act, 21 J. Econ. Persp. 91 (Winter 2007); John C. Coates and Suraj
Srinivasan, SOX After Ten Years: A Multidisciplinary Review, 28:3
Accounting Horizons 627 (2014).
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The core part of that framework--although not the only one--
consists of disclosure obligations. Disclosure has many virtues.
Disclosure enhances legitimacy. It assures the public generally that
State-created and State-subsidized corporations such as Apple, AT&T,
and Facebook, with their enormous power and resources, are also working
in the public interest. Disclosure is necessary for accountability. It
allows investors and enforcement officials to hold corporate agents
responsible for theft, fraud, or violations of other laws. Disclosure
provides a basis for lawmakers to evaluate whether current laws are
doing what they are intended to do. These lawmakers include Congress,
the SEC, and ultimately, in a democracy, the public. Is existing law,
for example, minimizing the production of ``externalities''--harms on
third parties not in a position to protect themselves? Disclosure
provides a foundation for improving law over time.
As an economic matter, disclosure enhances the best allocation of
resources for sustained growth. Basic theorems of economics that
undergird our Nation's preference for free trade commonly assume among
other things those trading are on the same informational playing field
(no ``asymmetric information''). Disclosure helps move toward that
ideal. While voluntary disclosure is common and valuable, well-designed
disclosure laws also add value. They create standards, ensure
comparability across companies, add enforcement tools, and greatly
improve the credibility and reliability of the disclosures.
Disclosure laws are also among the least intrusive and costly forms
of regulation. They are not a panacea. They have costs, although those
costs are often overestimated. Generally, those costs fall--often
dramatically--over time.\3\ But disclosure is a mild and often clearly
socially efficient means to address specific problems. This is
especially true when disclosure is compared to mandatory conduct rules,
structural laws such as activity bans (even if coupled with
exemptions), State ownership, or political governance. The public has a
tendency to demand legal change in response to crises, market crashes
or corporate scandals. Those responses can be prescriptive, especially
if the behavior involved took place in the dark. Disclosure reduces
paranoia, and moderates reactions.
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\3\ See Coates and Srinivasan, supra note 2; see also John C.
Coates, Toward Better Cost-Benefit Analysis: An Essay on Regulatory
Management, 78 Law and Contemporary Problems 1 (2015); John C. Coates,
Cost-Benefit Analysis of Financial Regulation: Case Studies and
Implications, 124 Yale Law Journal 882 (2014-2015).
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Even if information disclosed is not readily understood by the
public, or even by most investors, the role of sunlight in deterring
misconduct is too well known to elaborate. Disclosures can be processed
by analysts, who can then provide summaries and recommendations to
others. For example, as I have written about with Glenn Hubbard--who
served as Chairman for President George W. Bush's Council of Economic
Advisors and who currently Co-Chairs the Committee on Capital Markets
Regulation--the Investment Company Act is one of the most successful
disclosure laws of all time.\4\ It requires disclosure of much
information that few investors ever learn about directly. But the
disclosures are consumed, analyzed and simplified by financial advisors
and intermediaries such as Morningstar. The United States has the most
successful fund industry in the world, thanks in significant part to
mandatory disclosure laws.
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\4\ John C. Coates and R. Glenn Hubbard, Competition in the Mutual
Fund Industry: Evidence and Implications for Policy, 33 J. Corp. L. 151
(2008); see also John C. Coates, Reforming the Taxation and Regulation
of Mutual Funds: A Comparative Legal and Economic Analysis, 1 J. Legal
Anal. 591 (Summer 2009).
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Five Specific Bills
I turn now to five of the bills before the Committee.
Cybersecurity Disclosure Act (S. 536)
I support the Cybersecurity Disclosure Act (S. 536). On the basic
issue of cyber-risk, I will not detail here what I expect the Committee
already knows: cyber-attacks are more frequent and consequential each
year; they are producing more and more harms to the public and
investors; and, as SEC Chair Jay Clayton testified, they are not well
understood by American investors.\5\
---------------------------------------------------------------------------
\5\ John McCrank, SEC Chief Says Cyber-Crime Risks are Substantial,
Systemic, Reuters, September 5, 2017, http://www.reuters.com/article/
us-sec-enforcement/sec-chief-says-cyber-crime-risks-are-substantial-
systemic-idUSKCN1BH094.
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What I will emphasize is that cyber-risk is, among the many kinds
of risks that companies face, nearly unique. Cyber-risk is intense,
ever-changing and growing. But unlike other kinds of risks, cyber-risk
is general to all companies. Only basic financial risks affect more
companies. In fact, while there are some sectors (retail, financial
services, and telecom) where cyber-risk is most acute, it is hard to
identify any major public companies that are not faced with significant
cyber-risks. This is why cyber-risk warrants special public policy
attention, and why a modest disclosure law aimed at cyber-risk is not a
slippery slope to overly burdensome disclosures about all kinds of
risks.
S. 536 is well designed. It does not attempt to second-guess SEC
guidance and rules regarding disclosures generally, or even as to
cyber-risk overall. The bill
simply asks publicly traded companies to disclose whether a
cybersecurity expert is on the board of directors, and if not, why one
is not necessary. To be clear, the bill does not require every publicly
traded company to have a cybersecurity expert on its board. Publicly
traded companies will still decide for themselves how to tailor their
resources to their cybersecurity needs and disclose what they have
decided. Some companies may choose to hire outside cyber consultants.
Some may choose to boost cybersecurity expertise on staff. And some may
decide to have a cybersecurity expert on the board of directors.
The disclosure required would typically amount to a sentence or
two. The disclosure would be contained in a particular type of
document--annual proxy statements--that are among the documents that I
know from experience are regularly and carefully read by boards of
directors. Proxy statements are how directors are re-elected each year.
They describe the directors themselves, what committees they are on,
and how they function as a board. Being human, directors tend to read
things about themselves more carefully than other disclosures. Given
this, the bill would gently remind boards to take direct responsibility
for cybersecurity, by focusing them on board-level resources regarding
cyber-risk, and through that reminder, on cyber-resources more
generally.
In short, no board would have to change its composition in
response, and it preserves flexibility for companies to respond to
cyber threats in a tailored and cost-effective way. It would not
require disclosure of sensitive or proprietary information, and so
would not increase the risk of cyber-attacks. It would be extremely low
cost--the board is already required under SEC rules and guidance to
disclose its role in risk oversight, including oversight of material
cyber-risks. The bill would simply flip the switch on whether the topic
needs to be explicitly addressed in proxy statements, so boards could
not fail to engage the issue, as, unfortunately, many still do, despite
SEC guidance and numerous high-profile examples of cyber-attacks.
8-K Trading Gap Act
I also favor the 8-K Trading Gap Act, with one suggested
modification. Current rules permit insiders to game disclosure rules
and reap unwarranted windfalls by trading in company stock in the
window between the moment a material ``current event'' requiring
disclosure occurs, and the moment that the disclosure is actually made.
Such trading may already violate SEC Rule 10b-5. But enforcement of
Rule 10b-5--an intentionally broad anti-fraud standard--is restrained
by available SEC resources and the magnitude of expected recoveries in
private litigation. The proposed bill would enact a bright-line ban on
such trading. It would have relatively modest effects on nonfraudulent
trading, as the trading could occur after a company makes required
disclosure, the timing of which is within the company's control. It
also exempts trades under pre-committed 10b-5-1 trading plans, further
allowing insiders to achieve liquidity and diversification on a fair
basis that does not disadvantage other investors.
The one suggestion I would make is to lengthen the ``covered
period'' as defined in the bill by one trading day. Information takes
some time to be reflected in market prices. Forms 8-K can be filed late
in a day. The market and public investors generally should have one
full trading day to digest the information in a Form 8-K before having
to worry that insiders are on the other side of the trade. While I
would still favor the bill without this modification, this modest
change would more effectively accomplish its purposes, without imposing
unnecessary costs on insiders or companies.
Proxy Advisor Regulation Act (H.R. 4015)
The third bill on which I offer comment is formally titled the
``Corporate Governance Reform and Transparency Act of 2017,'' but in
the spirit of fair disclosure, it should be renamed the ``Proxy Advisor
Regulation Act,'' because that is in fact what it is--a bill to
regulate proxy advisors--and its current title provides no useful
information as to its contents. Proxy advisors are indeed the sole
target of the bill. In general, as a background fact, no one is
required by law or regulation to consult a proxy advisor. To my
knowledge, there are no regulatory or legal barriers to entry for new
entrants to compete with the existing advisors. Of course, there is the
usual requirement in a market economy that someone offer better
services at a lower cost.
As a result, on the substance of the bill, I find myself puzzled.
The bill states that its goals are to ``to improve the quality of proxy
advisory firms,'' and to ``foster accountability, transparency,
responsiveness, and competition in the proxy advisory firm industry.''
Those are worthy goals.
The puzzle is why these goals are important as a target of
regulation in the proxy advisory industry, and how the bill is meant to
accomplish those goals. I am unaware of a clamor from investors for
regulation of proxy advisors. Usually evidence of market failure is a
pre-requisite for regulation--here, that would presumably consist of
evidence of the inability of investor-clients of advisory firms to
obtain information by directly asking for it. Alternatively, disclosure
laws may be needed for comparability or enforcement purposes. There are
so few proxy advisors, and their recommendations are under such
constant scrutiny, that it seems unclear at best how those goals would
be advanced by new regulations enforced by the SEC.
It is also a puzzle how its provisions could possibly pass a cost/
benefit test to accomplish those goals, even if one thought the bill
could accomplish those goals. Some parts of the bill--e.g., the
requirement to have an ombudsman and a compliance officer--seem worthy
in the abstract, but have the distinct characteristic of ``one size
fits all.'' That is usually not a phrase of praise in the corporate
governance arena.\6\ Would a new entrant in the proxy advisory services
market need a full time ombudsman or compliance officer? If not, then
that requirement would deter rather than enhance competition.
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\6\ Cf. Society for Corporate Governance, Inc., Statement on
Corporate Governance (``the Society is skeptical of one-size-fits-all
governance prescriptions'').
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A ban on modifying recommendations based on whether companies buy
other services from the advisor also seems like a worthy specific goal.
Is it best addressed in a Federal statute? The conduct so prohibited on
its face sounds like garden-variety fraud or deceptive sales practices,
something the States are long used to regulating in a variety of areas.
Are the pension funds and other clients of proxy advisors not capable
of enlisting State attorneys general or other enforcement allies if
they suspect systematic deception of that kind? They seem able to
protect their own interests from fraud or quasi-fraud with existing
laws in other areas of their business.
And the final puzzle is why its sponsors and supporters believe
that a Federal statute and mandatory regulation would do more to
accomplish these goals as applied to proxy advisory firms than they
would as applied to public company boards of directors, who routinely
face conflicts of interest, or index fund advisors, who routinely make
voting decisions on behalf of others without publishing their
methodologies.
To be clear, I am open minded about what well-designed regulation
can accomplish. Indeed, as outlined above, well-designed disclosure
laws can achieve a great deal, including accountability, transparency,
responsiveness, and (in some contexts) competition. But this bill is
not limited to disclosure, and it is not clear that the disclosures it
requires are well-suited to its goals, or are the least costly means of
accomplishing the same objectives. Substantially more evidence should
be in hand before mandating new regulations of this kind. I am unaware
of any reliable economic evidence that would suggest that the net
benefits of the bill would exceed its costs, which would be
substantial.
Take, for example, the requirement that a proxy advisory firm be
required to register with the SEC for simply providing proxy advice.
Registration requirements are not to be mandated lightly. They impose
more burdens on new entrants than on incumbents. They therefore also
risk reducing competition, not increasing it.
One element of the registration form that the SEC would not have
authority to drop under the bill is a requirement that the proxy firm
disclose ``the procedures and methodologies that the applicant uses in
developing proxy voting recommendations,'' and the SEC would be
required to make that information publicly available. Since procedures
and methodologies are essentially trade secrets, the bill would destroy
existing or new proxy firms' ability to protect their intellectual
property. New competitors will have no way to recover investments in
research and development of better procedures or methods. How would
such a requirement make the industry more competitive?
I would not want to reject out of hand the idea that some
regulation of proxy advisors might be warranted--particularly
concerning conflicts of interests. I could imagine that some light
touch disclosure rules, informational barrier requirements, or back-up
enforcement might help alleviate concerns that the concentrated market
for proxy advice was susceptive of abuse through that channel. If the
SEC believes it lacks resources or authority to hold hearings and
ultimately develop such a regulatory approach, there might be a clear
need for Federal legislation. Absent that, I would recommend--in the
language of academic publishing--a ``revise and resubmit'' decision on
this bill.
Fair Investment Opportunities for Professional Experts Act (S. 2756)
This bill does three things. First, it substantially removes
discretion from the SEC to alter the definition of ``accredited
investor'' based on net worth and income, by moving the current
definition into a statute and out of a rule. Second, it inflation-
adjusts the current definition. Third, it directs the SEC to consider
education, job, or professional experience (among other things) in
potentially expanding the definition.
On the overall topic of how to define ``accredited investor'' and
why it matters, I commend to this Committee the advice of the SEC's
Investor Advisory Committee.\7\ That advice was developed before I
joined that Committee, but it is good advice, it was carefully
considered, and it is advice that I endorse. I also commend to this
Committee the research conducted by the SEC's Division of Economic and
Risk Analysis, which lays out many consequences of different policy
choices available here.\8\ I note, finally, that the SEC is required to
review the definition of accredited investor every 4 years under the
Dodd-Frank Act.\9\
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\7\ See https://www.sec.gov/spotlight/investor-advisory-committee-
2012/investment-advisor-accredited-definition.pdf.
\8\ See https://www.sec.gov/corpfin/reportspubs/special-studies/
review-definition-of-accredited-investor-12-18-2015.pdf.
\9\ Dodd-Frank Act, section 413(b)(2).
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Based on that information, I conclude that the second and third
effects are good ideas. The first is not. The current net worth and
income thresholds have been eroded by inflation for 30 years. They are,
as a result, too low.\10\ To lock them into the statute now would
durably expose a large number of financially vulnerable Americans to
the heightened fraud risk that unregistered offerings create.
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\10\ John Coates and Robert Pozen, Bill to Help Businesses Raise
Capital Goes Too Far, Wash. Post (Mar. 12, 2012).
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While inflation-adjusting the thresholds is a good idea, doing so
would be a good idea to do so in a statute only if the current levels
were a reasonable proxy for financial resilience, literacy, and
sophistication. It is a good idea to add the financially educated and
financial professionals to the pool of potential private-placement
investors. Net worth and income have always been imperfect proxies for
sophistication. It is also a good idea to delegate to the SEC, as the
bill does, the precise way in which education and experience should
play into a broadened definition. Some consideration should be given to
ways that the definition could assure that even educated or experienced
investors have financial resources to absorb losses that routinely
accompany investment.
Expanding Access to Capital for Rural Job Creators Act (S. 2953)
I favor having the SEC receive advice about the interests of small
businesses based in rural areas. In an era of increasing distrust and
distance between rural and urban parts of this country, fostering more
communication and understanding across an array of policy areas is
increasingly important. Small businesses in rural areas are less likely
to be able to raise capital in conventional ways than other businesses.
Although rural area population is declining, relative to cities and
suburbs, rural areas remain home to 60 million Americans, and a greater
share of rural workers have jobs in small businesses than other areas.
______
PREPARED STATEMENT OF DAMON A. SILVERS
Director of Policy and Special Counsel, AFL-CIO
June 28, 2018
Good morning, Chairman Crapo, Ranking Member Brown, and Members of
the Committee. My name is Damon Silvers, and I am the Policy Director
and Special Counsel for the AFL-CIO, America's labor federation
representing 55 national and international labor unions and more than
12 million working people.
The AFL-CIO has since its founding seen ensuring the retirement
security of working people as a central mission of the labor movement--
both through our advocacy for Social Security and Medicare and through
collective bargaining with employers. Today collectively bargained
retirement plans account for more than $7 trillion of invested capital
in this country. While the ownership of stocks and bonds remains
predominantly in the hands of the wealthiest Americans, working people
are major investors through our benefit funds, and our retirement
security is bound up with the health of the financial system. Our
members are major investors and their retirement security is bound up
with the health of the financial system. For these reasons the labor
movement has been actively engaged for decades in promoting effective,
commonsense regulation of our capital markets.
Following the financial crisis that began in 2007, it was clear
that our system of financial regulation had been dangerously weakened
by laws that exempted large parts of the financial system from
effective regulation, and in other cases created opportunities for
regulatory arbitrage. While the Dodd-Frank Act addressed many of these
weaknesses, at the time of the passage of the Act investor advocates
recognized there was much left to be done. Among the key issues that
remained were----
1) How to effectively protect investors from the threat of self-
dealing by the experts they hire to help them manage their
money.
2) How to ensure a level playing field for all investors in capital
markets where information moves instantaneously and where big
data means big power and big money.
3) How to prevent the reoccurrence of the dynamic that led to the
financial crisis of large parts of the financial system
becoming unregulated and/or opaque?
Each of the bills under consideration in this hearing fits within these
three questions. Some of these bills would productively address these
challenges, others would make these challenges worse for investors.
The remainder of my testimony will address each of the bills under
consideration in turn.
H.R. 4015--Corporate Governance Reform and Transparency Act of 2017
The Corporate Governance Reform and Transparency Act would create a
special regulatory regime for firms that advise investors on how to
exercise their voting rights as stockholders. The bill claims to foster
``accountability, transparency, responsiveness, and competition in the
proxy advisory firm industry,'' while in reality it will interfere with
shareholders' access to impartial analysis and undermine shareholders'
ability to hold corporate management accountable. This bill would
create conflicts of interest where none now exist, and treat proxy
advisory firms differently than other asset managers. Having the right
to vote and exercise other corporate governance rights is at the heart
of what it means to be a shareholder. Pension funds in particular have
a legal duty under ERISA, the Internal Revenue Code, and State law to
obtain expert, independent advice in the management of all their plan
assets, including voting rights. Pension funds and other institutional
investors rely on proxy advisory firms to sort through the thousands of
pages of complex financial reporting that issuers send to shareholders
every proxy season. Limited time and resources makes the kind of
intensive analysis performed by proxy advisory firms prohibitively
difficult and costly for many institutional investors to review the
massive amounts of information involved in voting proxies for large,
diversified investors.
The United States Department of Treasury (Treasury) 2017 report to
the President on ``A Financial System that Creates Economic
Opportunities, Capital Markets'' found that ``institutional investors,
who pay for proxy advice and are responsible for voting decisions, find
the services valuable, especially in sorting through the lengthy and
significant disclosures contained in proxy statements.'' After
extensive review of the industry, Treasury did not recommend any
legislative changes governing proxy advisory firms.
Despite these findings, H.R. 4015 effectively gives corporations'
CEO's and boards the ability to control the people who are supposed to
be holding them accountable. The bill would do this by enabling
companies to delay vote recommendations. Corporate executives would
then be able to object to any proxy voting recommendation that is
contrary to their own preferences, including votes on their own
executive compensation packages.
Institutional investors and associations, including the National
Association of State Treasurers and the Council of Institutional
Investors oppose this bill. It would increase costs for investors,
compromise the quality and reliability of information, and reduce board
accountability to investors.
The AFL-CIO does believe that proxy advisors should be regulated
like other investment advisors, and would not oppose a requirement that
they register as such. However we strongly oppose H.R. 4015 because
this bill appears to punish proxy advisors for doing their job and
seeks to impose upon them a regulatory scheme designed to make them
disloyal to their clients, among which are our members' pension funds.
S. 2756--Fair Investment Opportunities for Professional Experts Act
This legislation would codify the current Securities and Exchange
Commission (SEC) definition of ``accredited investor'' The bill defines
accredited investors to include individuals or couples with a net worth
of $1 million excluding their primary residence, individuals with an
income above $200,000 in each of the last 2 years, or couples with a
joint income above $300,000 in each of the last 2 years. This
effectively makes many Main Street retirement savers, particularly in
high income areas, ``accredited investors''.
This issue is a critical component of the way our securities laws
defines public markets versus private markets. We are concerned
generally that private markets have increasingly been defined in law
and regulation in ways that make them
essentially the same as public markets in terms of the scale of the
markets and in terms of who is actually exposed to risk, but without
the transparency and investor protection systems that have been built
up in the public markets. S. 2756 would accelerate this trend.
This is because the definition of ``accredited investor'' is
crucial in securities laws to determine whether a transaction qualifies
for the private offering exemption from investor protection
requirements. The Supreme Court limits this exemption ``to those who
are shown to be able to fend for themselves.''\1\ In other words,
accredited investors are those individuals who do not need the
registration and disclosure protections afforded by the Securities Act
of 1933, because they would be able to evaluate potentially risky and
illiquid private offerings without the investor protections provided in
a public offering.
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\1\ See: Securities and Exchange Commission v. Ralston-Purina Co.
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The SEC's Investor Advisory Committee (IAC) has found that the
current accredited investor definition based on financial thresholds is
inadequate to protect mom and pop investors, and has opposed codifying
this definition in law, instead advocating for a new rulemaking that
would improve the definition to permit more sophisticated investors to
access private offerings while better protecting less sophisticated
retirees.\2\ The State securities administrators (North American
Securities Administrators Association, or NASAA) also oppose codifying
this low net-worth threshold.\3\
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\2\ See: Recommendation of the Investor Advisory Committee:
Accredited Investor Definition (October 9, 2014). Available at http://
bit.ly/22HoUHw.
\3\ North American Securities Administrators Association, ``Letter
from NASAA President and Alabama Securities Director Joseph P. Borg to
the HFSC Chair and Ranking Member regarding markup of H.R. 3758, H.R.
477, H.R. 3857, H.R. 2201, and H.R. 1585,'' October 11, 2017. Available
at http://bit.ly/2xK1Lag.
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The $1 million asset threshold was originally set by rule in 1982
and has not been updated since then. Even with the inflation
adjustments the bill requires every 3 years, the definition would make
Main Street retirement savers ``accredited investors'' simply because
they have saved for retirement. While we support indexing the net-worth
threshold, the current baseline is far too low to act as a starting
point. These individuals are often dependent on their retirement
savings to survive and cannot easily recoup large investment losses.
The Fair Investment Opportunities for Professional Experts Act
codifies a weakness in current investor protections and would require
average retirees to be able to evaluate the risk of financial
instruments as well as trained, experienced investment professionals.
For the above stated reasons, we urge you to oppose this bill.
S. 1744--Brokaw Act
In 1968, Congress passed the Williams Act to require investors to
publicly disclose when they accrue a large ownership stake in a public
company. The purpose of the Act was to end corporate raiders' ability
to make cash tender offers to shareholders without any need to disclose
their identities, intentions or report anything to the SEC. The
Williams Act amended the Securities Exchange Act of 1934 to require
that investors file public disclosures with the SEC within 10 days of
acquiring a 5 percent or more stake in a public company. In the 50
years since the Williams Act was passed, there have been substantial
changes in trading activities and technology. The Brokaw Act is a
necessary and timely update to the disclosures required in Section
13(d) of the Exchange Act that accounts for trading behaviors that have
emerged in recent decades and market expectations related to the speed
of information access.
Currently, there is a 10-day window between when an investor
crosses the 5 percent ownership threshold of a company and when that
beneficial ownership position must be disclosed with a 13D filing.
Since the Williams Act passed in 1968, evolution in information
technology has created an appropriate expectation among investors that
they will have access to information much more quickly. SEC disclosure
forms are now filed electronically, which makes disclosure faster and
easier for issuers. As a result, we believe the shorter filing window
proposed in the Brokaw Act for 13D filings is necessary and
appropriate.
Empirical evidence shows an abnormally high level of trading inside
of that 10-day window, which is best explained as the action of traders
with knowledge of the hedge funds' positions. This trading activity is
likely to be attributable to groups of sophisticated hedge fund
investors, known as ``wolf packs,'' that communicate in the period
between which they begin accumulating their position and the 13D filing
is made. These groups take positions in the company with the
expectation that the stock price will jump once the 13D is filed. These
``wolf packs'' can currently exceed the 5 percent ownership threshold
collectively without triggering any disclosure requirements at all.
Finally, activist investors can manipulate the process by secretly
taking net short positions. In other words, they use their long
(public) position to boost the stock price in the near term while
investing far more in a short (nonpublic) position. Thus their net
position is actually a bet against the company but their public
position looks favorable. Activist investors often engage in public
campaigns to influence stock prices. Additional transparency in this
area would help investors by providing insight into the incentives of
the hedge funds and the messages they are promoting about a company's
prospects.
The Brokaw Act addresses three major gaps in the current legal
framework related to the requirements that investors disclose when they
accrue large ownership positions in a public company. First, it
shortens the 10-day window between crossing the 5 percent ownership
threshold and the required 13D filing--the period when trading activity
spikes--down to 2 days. Second, it reforms the definition of ``groups''
under section 13(d) so that so-called wolf packs, groups of short-term
investors seeking cash payouts, can trigger the collective ownership
threshold collectively. Finally, the bill extends section 13(d) to
require disclosure of ``net short'' positions, that is, investors would
have to disclose their full position, preventing them from profiting
off a large hidden short position while taking a public long position
to boost the stock price.
The reforms proposed in the Brokaw Act are commonsense changes to
address each of these problems. They adapt the existing securities laws
to cover current practices and are essential for the strength of our
markets and capital formation.
S. 2499--Compensation for Cheated Investors Act
One of the central flaws in our current system of securities
regulation is the weak and inconsistent nature of the regulation of
individuals and firms that provide investment advice. As an economic
matter, broker-dealers, insurance agents, and investment advisors all
provide investment advice. There should be a single standard of
fiduciary duty that blocks self-interested behavior by all three types
of advisors, and this duty should be heightened when retirement assets
or other ERISA assets are at stake. But in our current system, there
are significant differences in how these three types of advice
providers are regulated, and how the regulations are enforced.
One particularly egregious problem that has resulted from this
system is that when duties to investors are enforced by regulators,
defendants are able to avoid paying damage awards, and are able to move
among the three types of advice provider without consequence. Consumer
protections mean nothing if regulators are unable to guarantee that
defrauded consumers are made whole.
In the case of broker-dealer misconduct, a disturbing number of
damage awards to investors by regulators and the courts never reach the
harmed investors. The Financial Industry Regulatory Authority's (FINRA)
Dispute Resolution Task Force found that in 2013 more than $62 million
in arbitration awards to consumers went unpaid, with a large number of
unpaid awards assessed against broker-dealers who had become inactive
since the complaint was issued.\4\ Between 2012 and 2016 unpaid FINRA
arbitration awards totaled nearly $200 million.\5\
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\4\ FINRA Dispute Resolution Task Force, Final Report and
Recommendations of the FINRA Dispute Resolution Task Force, 50 (2015),
available at https://www.finra.org/sites/default/files/Final-DR-task-
force-report.pdf.
\5\ FINRA, Discussion Paper--FINRA Perspectives on Customer
Recovery, 7 (Feb. 8, 2018), available at file:///C:/Users/slewis/
Downloads/finra_perspectives_on_customer_recov-
ery.pdf.
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The compensation for Cheated Investors Act would make sure
investors defrauded by brokers are able to collect the full amount of
the award owed them while increasing accountability and public trust in
the financial system and broker-dealers.
This bill would require FINRA to establish a compensation fund for
defrauded investors who have not been able to collect from brokers even
after winning arbitration or court judgment. The fund would be
supported by fines and penalties charged to FINRA-regulated broker-
dealers. Greater transparency for consumers is also incorporated into
the bill in the form of an annual report to be published by FINRA
detailing the number and value of arbitrations, awards, and unpaid
claims. FINRA already collects this data and shares it with other
regulators. Sharing it with the public will help improve confidence in
the financial system without significant costs to regulators, broker-
dealers, or investors.
FINRA has acknowledged the problem of unpaid awards and a recent
discussion paper from FINRA staff included such an approach in their
list of potential measures to address unpaid claims.\6\ This bill gives
FINRA substantial latitude in administering its basic mandate, and we
believe FINRA should work with the bill's sponsors to ensure that if
the bill passed that its implementation was maximally effective both
from the perspective of seeing to it that awards were paid and from the
perspective of FINRA's effectiveness as a self-regulatory body.
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\6\ FINRA, Discussion Paper--FINRA Perspectives on Customer
Recovery (Feb. 8, 2018), available at https://www.finra.org/sites/
default/files/finra_perspectives_on_customer_recov-
ery.pdf.
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Ensuring that awards are actually paid is a basic test of FINRA as
a self-regulatory body. This bill is the consequence of FINRA failing
to pass that test. But in reality what S. 2499 really does is give
FINRA another chance to get it right, while at the same time making
clear that FINRA cannot continue to ignore the problem. Passing S. 2499
is in the interests of investors and in the interest of maintaining and
improving the integrity of our securities laws.
S. 536--Cybersecurity Disclosure Act of 2017
The need for the board and upper management responsibility for
corporate cybersecurity is, by now, an accepted part of running a
business. Data breaches have cost consumers and investors millions in
recent years.
This bill directs the SEC to mandate issuer disclosure of whether
any board members have expertise or experience in cybersecurity and to
detail that expertise/experience; if no board member has cyber
expertise, the company must disclose how cybersecurity factors were
taken into account in selecting board members.
At a time when cybersecurity compromises can cause significant
financial and reputational damage to businesses, investors have a
reasonable expectation that publicly traded companies invest in
protecting employees' and consumers' data as well as proprietary
business information and internal communications. But as matters stand
today investors have no real way to be sure companies are actually
doing any of these things. This bill requires the SEC to promulgate
rules that require companies to be transparent about what they are
doing, and to do so within the context of the securities laws where
misrepresenting what they are doing would subject officers and
directors to liability.
Again, like the issue of FINRA not ensuring awards are paid, this
is an issue that the Commission should long ago have addressed through
rulemaking. But in the absence of Commission action around the issue of
cybersecurity at the board level, S. 536 creates a workable framework
for ensuring investors are properly informed about the seriousness with
which their companies are taking these risks.
S. 2953--Expanding Access to Capital for Rural Job Creators Act
S. 2953 amends the list of entities the SEC Advocate for Small
Business Capital Formation considers in its duties. The first change
mandates the Advocate ``identify problems that small businesses have
with securing access to capital, including any unique challenges to
minority-owned small businesses, women-owned small businesses, and
small businesses affected by hurricanes or other natural disasters.''
The second change requires the Advocate report annually ``a summary of
the most serious issues encountered by small businesses and small
business investors, including any unique issues encountered by
minority-owned small businesses, women-owned small businesses, and
small businesses affected by hurricanes or other natural disasters and
their investors, during the reporting period.''
These changes are sensible ones in light of the challenges faced by
minority, women-owned and rural small businesses, and the extraordinary
challenges faced by small business owners in many parts of this country
as a result of natural disasters and the growing costs of climate
change.
We note however that for this mandate to actually be helpful to
small business requires that the SEC Advocate effectively distinguish
between the interests of actual small businesses and the interests of
large firms, which are increasingly dominant in the U.S. economy and in
the U.S. capital markets. This is an area that deserves more thoughtful
and sustained oversight by this Committee.
With that important reservation we support S. 2953.
8-K Trading Gap Act of 2018 (Van Hollen)
This bill addresses another problem involving inside information.
Similar to the gaps in securities laws addressed by the Brokaw Act,
this bill seeks to expand the language of current legislation to cover
actions clearly prohibited by the spirit and intent of the legislation.
In this case, there is a 4-day gap between when an issuer
determines that it is in possession of material nonpublic information
and when it must file Form 8-K making that information public. This gap
provides opportunities for insiders to trade on that information--
evading the clear intent of the law.
This practice was confirmed by a research report published by a
group of Harvard and Columbia professors in 2015 that coined the term,
the ``8-K Trading Gap.'' It looked at a dataset of over 15,000 Form 8-
Ks and tracked insiders' trading transactions within the window before
the disclosure was filed. Unsurprisingly, it found that insiders could
almost always anticipate the direction of any price movement following
an 8-K announcement. Additionally, they found ``systematic abnormal
returns of 42 basis points on average, per trade, from trades by
insiders during the 8-K gap.'' And further, if insiders engaged in an
open-market purchase of their own company's stock, they earned even
larger abnormal returns of 163 basis points, which is of course far
higher on an annualized basis.\7\
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\7\ Cohen, Alma and Jackson, Robert J. and Mitts, Joshua, The 8-K
Trading Gap (September 7, 2015). Columbia Law and Economics Working
Paper No. 524. Available at SSRN: https://ssrn.com/abstract=2657877 or
http://dx.doi.org/10.2139/ssrn.2657877.
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This bill directs the SEC to issue rules to restrict officers and
directors from profiting by trading on inside information during the 8-
K trading gap. Again, this is a commonsense reform that merely extends
the current legal framework to cover current abuses.
Conclusion
The AFL-CIO commends the Committee for holding this hearing that in
every respect addresses serious issues in capital markets regulation.
Investors will benefit if loopholes can be closed that encourage self-
dealing and insider trading. Investors will also benefit from
legislation that encourages regulatory bodies as diverse as FINRA and
the Office of the Small Business Advocate at the SEC to be more
effective in doing their jobs. However, we strongly oppose the two
bills in front of you, H.R. 4015 and S. 2756, that propose to weaken
investor protections and the ability of our corporate governance system
to perform its function of encouraging the managements of public
companies to act in the long-term best interest of the corporations and
their shareholders that they serve.
Thank you again for the opportunity to testify today, and I welcome
your questions.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN FROM THOMAS
QUAADMAN
Q.1.a. Your written testimony discussing the Fair Investment
Opportunities for Professional Experts Act, S. 2756, states,
``[a]sset and income tests are objective standards that have
served well in determining who should be allowed the
designation of accredited investors.'' The current asset and
income tests were established in the original adoption of
Regulation D in 1982, with limited changes since then.
Without adjustment for the passage of time or the impact of
inflation, the income and net worth thresholds now capture a
greater portion of investors than in 1982.
Please estimate the percentage of investors that would have
qualified as accredited investors (i) in 1982 and (ii) as of
the most recent practicable year-end using each of (a) the
income test (for an individual) and (b) the net worth test.
Please explain any assumptions made in estimating the number of
investors or determining time periods, etc.
A.1.a. Section 413(b)(2)(A) of the Dodd-Frank Wall Street
Reform and Consumer Protection Act (the ``Dodd-Frank Act'')
directs the SEC to review the accredited investor definition as
it relates to natural persons every 4 years. The SEC determines
whether it should modify or adjust the definition for the
protection of investors, in the public interest and in light of
the economy. Section 413(b)(2)(A) specifies that this review
shall be conducted no earlier than 4 years after enactment of
the Dodd-Frank Act and every 4 years after that. The SEC staff
issued the first report under Section 413 on December 18, 2015,
entitled Report on the Review of the Definition of ``Accredited
Investor'' (the ``Report'').\1\
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\1\ https://www.sec.gov/files/review-definition-of-accredited-
investor-12-18-2015.pdf. While the Chamber does not necessarily agree
with all the policy recommendations contained in the Report, it
provides a wealth of qualitative and quantitative analysis concerning
the accredited investor definition.
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Section X of the Report considers how revising the
standards for qualifying as an accredited investor would alter
the size and composition of the pool of accredited investors
that are natural persons. The Federal Reserve Board's (``FRB'')
Survey of Consumer Finances (the ``SCF'') for 1983 and 2013
provided the underlying household data for this analysis. FRB
conducts the SCF every 3 years, and it provides insights into
household income and net worth.\2\ According to the Report the
population in 1983 included approximately 83.9 million
households and in 2013 included approximately 122.5 million
households.
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\2\ https://www.federalreserve.gov/econres/scfindex.htm. The 2016
SCF is the most recent survey conducted; the Report relies on 2013
data.
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In 1983, an estimated 440,000 U.S. households (0.5 percent
of all households) met the $200,000 individual income
threshold. In 2013, 8.07 million U.S. households (6.6 percent
of all households) met the $200,000 individual income
threshold.
Similarly, the SEC staff estimated in 1983 that 1.42
million U.S. households (1.7 percent of all households) met the
$1,000,000 net worth threshold. In 2013, 9.22 million U.S.
households (7.5 percent of all households) met the $1,000,000
net worth threshold.
As the Report notes, Section 413(a) of the Dodd-Frank Act
excluded the value of a person's primary residence from the
$1,000,000 net worth calculation and directed the SEC to adjust
similarly any accredited investor net worth standard in its
rules. In 2011, the SEC revised Rules 215 and 501 to exclude
any positive equity individuals have in their primary
residences. The SCF statistics described in the preceding two
paragraphs do not give effect to this change in methodology for
determining net worth. Because some investors reached the
$1,000,000 threshold only by including the value of their
primary residence, the impact of the rule change was to reduce
the total pool of eligible investors who relied on the net
worth test.
Q.1.b. In addition, please provide inflation-adjusted estimates
of the $200,000 annual income test and $1,000,000 net worth
test, beginning from 1982 to year-end 2017. Please explain the
inflation measure used and any other assumptions.
A.1.b. Using the Bureau of Labor Statistics' online Consumer
Price Index (CPI) Inflation Calculator,\3\ we calculated the
amounts as follows measuring from the month of December in each
year:
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\3\ https://data.bls.gov/cgi-bin/cpicalc.pl.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The inflation adjustments in the preceding chart do not
account for the SEC's 2011 change in methodology for
determining net worth (excluding positive equity in a primary
residence). Amounts rely on a base number of $1,000,000 without
regard to what assets constitute that amount.
The Bureau of Economic Analysis in the Department of
Commerce also maintains a Personal Consumption Expenditures
(PCE) Price Index that, when used for inflation adjustment,
usually produces lower results than the CPI calculation.
Q.2. You were asked about the Small Business Audit Correction
Act, S. 3004, which would allow certain brokers or dealers
defined under the bill to use auditors that are exempt from
Public Company Accounting Oversight Board registration and
supervision.
How many brokers or dealers do you believe would be covered
by the definition in the bill?
A.2. The Small Business Audit Correction Act (S. 3004) would
narrowly exempt privately held, noncustodial broker-dealers
from a requirement that a firm registered with the Public
Company Accounting Oversight Board (PCAOB) audits those
privately held dealers. The 2010 Dodd-Frank Act expanded the
mission of the PCAOB by granting it the authority to oversee
and examine the audits of SEC-registered broker-dealers.
However, this provision of the Dodd-Frank Act failed to
recognize the unique business models and corporate structures
of certain broker-dealers different from the types of systemic
threats to the financial system that Congress intended Dodd-
Frank to address. Specifically, broker-dealers that are not
carrying brokers, i.e., do not hold client funds in custody,
and which do not issue stock to the public, have a very
different risk profile than large and interconnected brokers.
S. 3004 would not exempt a noncustodial, privately held
broker from audits--it simply provides that such brokers need
not use a PCAOB-registered firm to conduct an annual audit.
Audit standards that apply to PCAOB registered firms are
designed for large, publicly traded businesses and are not
appropriate for small and closely held entities. Furthermore,
the exemption afforded certain broker-dealers under S. 3004 is
entirely optional--if the shareholders and customers of such
entities continued to demand PCAOB-registered auditors, nothing
in this legislation precludes from doing so. Responsiveness to
the needs and concerns of market participants is preferential
to top-down mandates that fail to account for the diverse
makeup of regulated entities.
To the best of our knowledge, current publicly available
data does not provide for a specific number of broker-dealers
that would meet the definition under S. 3004. We expect that
the types of entities who would be eligible for this exemption
would be small broker-dealers that operate in a diverse set of
communities across the country. Data from the Financial
Industry Regulatory Authority (FINRA) demonstrates that the
vast majority of registered broker-dealers are considered
``small'' (less than 150 registered representatives), and we
expect that firms that would benefit from S. 3004 would fall
into that category.\4\ Additionally, the overall
number of broker-dealers in the United States has steadily
declined--from 3,969 in 2008 to 3,132 in 2017. Rising
regulatory costs may have led to this decline and to increased
industry consolidation. We believe S. 3004 would help address
some of those concerns.
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\4\ 2018 FINRA Industry Snapshot.
Q.3. Does the definition in the bill capture brokers or dealers
in one or more of the following categories: active high-
frequency trading or principal trading firms, sophisticated
market-maker firms, private placement brokers, dealers in the
to-be-announced (TBA) for mortgage-backed securities market,
and alternative trading system routing brokers, in addition to
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retail customer-facing brokers or dealers?
A.3. The legislation provides the PCAOB need not oversee
auditors of privately held, noncustodial brokers in good
standing, and that those auditors do not need to abide by PCAOB
standards when auditing such brokers. It does not exempt
brokers that meet this definition from any or all audits.
Because the definition included in S. 3004 does not contemplate
certain lines of business that a broker may engage in, publicly
available data does not provide a definitive answer as to
specific included or excluded lines of business.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SASSE FROM THOMAS
QUAADMAN
Q.1. As policymakers how should we strike the right balance
between encouraging firms to go public and improving the
private capital markets?
A.1. In one of the more troubling recent developments in the
IPO market, not only are fewer companies willing to go public,
but those that do tend to go public much later in their
lifecycle. Instead of young, fast growing companies that need
the public markets to grow, many IPOs in recent years have been
of relatively large and established companies, and the IPO
process is largely a liquidity event for company founders. This
has two main effects: 1) It has become clear that the public
markets are more inhospitable for small companies than in the
past; 2) ``Main Street'' investors now invest in later stage
companies after institutional or accredited investors have
earned many of the early stage gains. As a result, households
have fewer opportunities to create sustainable wealth over the
long term.
We believe there are many actions policymakers can take to
help improve the public company model, particularly for smaller
companies. Earlier this year the Chamber, along with seven
other organizations, released a report with 22 recommendations
for how to help more companies go and stay public.\1\ We
believe that this is a multifaceted regulatory issue that
covers overall reporting burdens and costs for public
companies, market structure concerns, as well as financial
reporting issues that policymakers need to be address.
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\1\ https://www.centerforcapitalmarkets.com/wp-content/uploads/
2018/04/IPO-Report_EX-
PANDING-THE-ON-RAMP.pdf.
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In terms of private capital markets, the strength and depth
of these markets has certainly increased in recent years. Many
contributing factors are outside the realm of Congress or the
SEC, such as low interest rates and the growth of sovereign
wealth and private equity funds. These factors--low interest
rates in particular--have fueled an M&A boom in the private
markets that have made a buyout a more attractive option than
going public for many growing companies.
However, we believe that policymakers should not always
count on the private markets being this robust. While companies
should not go public before they are ready, we believe that
many artificial regulatory barriers make staying private a more
attractive option. We believe that removing some of these
barriers would give companies more financing options, which
should be the ultimate goal of policymakers.
Q.2. Are the private capital markets currently high-
functioning? If not, where are the biggest potential areas for
improvement?
A.2. We believe that the private capital markets are very high
functioning for many companies, particularly for those in the
midmarket or for larger companies that seek to acquire other
businesses. However, we believe policymakers can make several
improvements to help small and startup businesses acquire the
capital they need to grow. Several such improvements are
included in the JOBS and Investor Confidence Act, which
recently passed the House of Representatives.
That legislation includes provisions that would clarify
some of the general solicitation rules stemming from the 2012
Jumpstart our Business Startups (JOBS) Act, and would expand
the definition of an ``accredited investor.'' We believe that
these provisions and others would help young, early stage
companies raise capital from a broad pool of investors and
would ultimately lead to greater economic growth and job
creation.
Q.3. I'm concerned about the increasingly uneven geographic
distribution of growth. As the Economic Innovation Group has
found, economic growth is largely clustered in the most
prosperous areas, instead of evenly distributed across areas
like the Great Plains and the Midwest. Would increasing access
to equity and crowdfunded debt improve the geographic
distribution of new firms?
A.3. We agree with your concerns. The Economic Innovation
Group's 2016 study \2\ found that roughly 50 percent of new
business startups in the post-recession period occurred in only
20 counties in the United States. Business formation has
largely occurred only in coastal areas, leaving behind broad
swaths of the country. Additionally, many post-crisis rules
have hindered bank lending, particularly to small businesses.
The Federal Reserve's 2016 survey of small businesses found
that 60 percent of applicants received less than the amount for
which they applied, while 24 percent were unable to obtain any
financing at all.\3\ New, innovative ideas such as crowdfunding
can help businesses raise capital from their communities and
from investors around the country.
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\2\ https://eig.org/wp-content/uploads/2016/05/
recoverygrowthreport.pdf.
\3\ Federal Reserve Banks, 2016 Small Business Credit Survey:
Report on Employer Firms (Apr. 2017), available at https://
www.newyorkfed.org/medialibrary/media/smallbusiness/2016/SBCS-Report-
EmployerFirms-2016.pdf.
Q.4. When do new and smaller firms tend to rely upon access to
equity or crowdfunded debt instead of a traditional bank loan?
For example, some have suggested that technology-based firms
rely more upon equity while main street companies like
restaurants more rely upon bank loans. What are the biggest
hurdles new and smaller firms have--regulatorily or otherwise--
---------------------------------------------------------------------------
in accessing equity and crowdfunded debt?
A.4. Companies seeking a high level of growth but that need an
infusion of capital to meet customer demands or to invest in
production tend to favor equity financing, which is typically
significantly more expensive than debt financing. In the
securities space, regulatory hurdles make it difficult for
businesses to access equity financing. One such hurdle is the
limited pool of ``accredited'' investors who are eligible to
invest in certain private offerings.
Current SEC rules deem only those that meet certain asset
or net income thresholds as ``accredited.'' Expanding that
definition to include those that can demonstrate a certain
level of financial sophistication would expand the pool of
investors and capital available to growing businesses. Allowing
special purpose vehicles (SPVs) to pool investors in a
crowdfunding offering (significantly reducing recordkeeping and
other costs) is another potential solution. The House-passed
JOBS and Investor Confidence Act includes such a solution.
Q.5. Is there currently sufficient clarity about the conditions
under which an offering by a small business issuer would
qualify as a ``transactions by an issuer not involving any
public offering'' under Section 4(a)(2) of the Securities Act?
Are small businesses able to acquire such clarity without
paying a meaningful amount in legal fees?
A.5. Attorneys who practice securities law believe there is
sufficient clarity on these issues. The seminal case on Section
4(a)(2) is the Supreme Court's 1953 decision in SEC v. Ralston
Purina Co.\4\ In that case, the Court laid out a series of
factors that regulators must balance to make the critical
inquiry of whether a private offering exists. Numerous
subsequent lower court opinions over the past six decades have
further fleshed out these criteria.
---------------------------------------------------------------------------
\4\ 346 US 119 (1953).
---------------------------------------------------------------------------
However, the test is necessarily a subjective one and,
unlike a private offering under the SEC's Regulation D, an
offering conducted under the statutory exemption in Section
4(a)(2) does not receive the benefit of blue sky (State
securities law) preemption under the National Securities
Markets Improvements Act of 1996. An issuer relying on Section
4(a)(2) must also find an exemption from registration in each
State in which it makes an offering, or qualify the offering
with the applicable State securities regulator. This can be an
expensive and time-consuming process. For these reasons, most
securities lawyers prefer to rely on the Regulation D safe
harbor instead of the statutory exemption when conducting a
private offering on behalf of an early stage or smaller
business.
While securities lawyers understand these parameters fairly
well, the criteria are not necessarily intuitive and the
average small business owner is not likely to be knowledgeable
of their intricacies. It is a daunting task to research the
criteria on one's own without the aid of an attorney,
particularly as it concerns State securities law requirements.
Many of the lower-cost attorneys who focus on smaller
businesses are not knowledgeable about securities law, or
choose not to practice it due to hefty insurance premiums that
errors and omissions (E&O) insurance carriers assess against
lawyers who practice securities law. Accordingly, many small
business owners are not able to retain low-cost, competent
securities counsel.
We understand that the SEC frequently receives inquiries
from small business owners seeking to understand the securities
laws as they apply to their businesses. Because the SEC cannot
provide legal advice to the public, its ability to respond to
these inquiries is somewhat limited. However, the SEC has
informed us that these inquiries commonly involve small
business owners seeking to complete a ``friends and family''
fundraising for seed or growth capital. Congress could provide
relief by expanding the Securities Act of 1933 to exempt
offerings for close friends and family members of small
business owners, insofar as such offerings do not always meet
the criteria of Section 4(a)(2) as the courts or the SEC's
Regulation D safe harbor have laid out.
Although we are sensitive to the fact that State securities
law preemption is a delicate issue, preempting the registration
and qualification provisions of State securities law (but not
the antifraud authority of blue sky regulators) would also
simplify the offering process for small business owners.
Q.6. Representative Emmer's bill, H.R. 2201, the Micro Offering
Safe Harbor Act would ``exempt certain micro-offerings from:
(1) State regulation of securities offerings, and (2) Federal
prohibitions related to interstate solicitation.''\5\ Such
offerings could be worth up to $500,000, have 35 participants,
and involve an instance where the ``purchaser has a substantive
pre-existing relationship with the issuer . . . ''\6\ How would
you evaluate this legislation? If you have concerns with this
legislation, how would you ideally address them?
---------------------------------------------------------------------------
\5\ https://www.congress.gov/bill/115th-congress/house-bill/2201.
\6\ https://www.congress.gov/bill/115th-congress/house-bill/2201.
A.6. The Chamber strongly supports this legislation, which
would provide a regulatory regime for a tailored and narrow
type of securities offering. Attorney, accounting, and other
costs for such small offerings can be daunting enough to small
businesses that they often refrain from raising the capital
they need to expand. We believe that H.R. 2201 properly
balances both capital formation and investor protection
concerns and we urge Congress to pass it as swiftly as
---------------------------------------------------------------------------
possible.
Q.7.a. How viable is conducting an offering under the SEC's
Regulation Crowdfunding, particularly for new and smaller
businesses? What about for businesses that are not located in
the top five largest cities? What about for smaller offering
sizes? If smaller offering sizes tend to be less viable, how
large must an offering be to be viable?
Q.7.b.Would there be merit to increasing the offering limit for
Regulation Crowdfunding issuers, from $1 million? Why or why
not? If so, what should the limit be? For example, the 2017 SEC
Government-Business Forum on Small Business Capital Formation
recommended raising the limit to $5 million.
A.7.a.-b. As the SEC's Division of Economic Risk and Analysis
reported, as of February 2017, 75 percent of completed
crowdfunding offerings have occurred across only four States
(CA, TX, MA, and DE).\7\ During the period covered in this
report (5/16/2016-12/31/2016), there were 163 unique
crowdfunding offerings, with a median amount raised of
$171,000. These statistics indicate that the total impact of
Title III of the JOBS Act remains somewhat muted, given the
relatively low number of crowdfunding offerings initiated and
amounts raised.
---------------------------------------------------------------------------
\7\ U.S. securities-based crowdfunding under Title III of the JOBS
Act, SEC Division of Economic and Risk Analysis. February 28, 2017, at
18. Covers period from May 16, 2016-December 31, 2016.
---------------------------------------------------------------------------
We do believe that the arbitrary cap on the amount that
businesses can raise during a 12-month period ($1 million)
ultimately serves as a disincentive to commence a crowdfunding
offering. In many cases, businesses must seek the advice of
outside counsel in order to ensure compliance with all
crowdfunding rules and may be required to obtain audited
financial statements for an offering over $500,000. Legal and
audit costs can be significant, and when compared with the
relatively low amount companies are able to raise via
crowdfunding, costs associated with an offering can become a
disincentive to use Regulation CF.
We believe that increasing the $1 million limit could
ultimately make crowdfunding a more attractive means of
obtaining financing. We also support changes included in the
House-passed JOBS And Investor Confidence Act that would allow
special purpose vehicles (SPVs) to pool individuals together to
invest in crowdfunding offerings.
We also believe that since the SEC adopted its crowdfunding
rules in 2015 and that equity crowdfunding is a new capital
formation concept, it will take time for market participants to
learn how to use Regulation CF for their benefit. This, coupled
with the changes included in the JOBS and Investor Confidence
Act and a potential increase in the offering amount allowed,
would ultimately help Title III of the JOBS Act reach its full
potential.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORTEZ MASTO FROM
THOMAS QUAADMAN
S. 2756, Fair Investment Opportunities for Professional Experts Act
(Accredited Investor Bill)
Q.1. In recent months, we read about how millionaires like
Rupert Murdoch, the Waltons, and the DeVos's each lost a
hundred million dollars or more when they invested in Theranos.
One of many red flags was the absence of an audited financial
statement which one would think a sophisticated investor would
demand before shelling over $125 million dollars.
The bill requires the SEC develop a test for financial
sophistication for accredited investors who do not meet the
income or wealth threshold.
Q.1.a. Is a test a reasonable requirement to help investors
better protect themselves?
A.1.a. The SEC's current rules for defining an ``accredited
investor'' only allow the SEC to deem individuals accredited
based on certain asset and income levels. An accredited
individual must have at least $200,000 in annual income
($300,000 for couples), or must have a net worth of $1 million
(excluding the value of an individual's primary residence).
This definition may be both under- and over-inclusive: It
excludes individuals that have income and assets that fall
below the thresholds, but who may be financially savvy and
fully capable of understanding the risks and awards associated
with private placements. However, it could include individuals
that may be extremely wealthy but who do not have any
understanding of basic financial or investment concepts. Put
simply, we do not believe that an individual's financial status
presents a complete picture as to their ability to invest
wisely and in a manner that will not expose them to serious
financial risk.
Furthermore, as former SEC Commissioner Michael Piwowar has
noted, allowing a household to invest in both private and
public
offerings could ultimately have the effect of reducing that
household's overall portfolio risk, as long as their assets
have a low correlation with one another.\1\ We agree with
Commissioner Piwowar's sentiments and believe that opening up
the private markets to greater investment will ultimately
benefit not just issuers but also households that will have
more opportunities to create wealth.
---------------------------------------------------------------------------
\1\ Acting Chairman Michael S. Piwowar, Remarks at the ``SEC
Speaks'' Conference 2017: Remembering the Forgotten Investor. February
24, 2017.
---------------------------------------------------------------------------
We believe that some type of test or other mechanism to
determine the investment understanding of an individual--as
envisioned by S. 2756--is an appropriate requirement that will
help protect investors and ensure that the SEC will only
accredit those who are able to demonstrate investment
knowledge. It should be noted that the Financial Industry
Regulatory Authority (FINRA) administers several exams in order
to license professionals to, for example, sell securities or
oversee those who do. Individuals that take these exams must be
able to demonstrate a strong understanding of financial markets
and investment concepts. An exam designed to do the same for
individuals looking to invest in private offerings could be an
effective means of responsibly expanding the number of
accredited investors in the United States.
Q.1.b. If so, what do you think should be in such a test?
A.1.b. S. 2756 envisions that potential accredited investors
should be able to demonstrate a ``reasonable level of relevant
financial expertise'' that includes an ability to understand
voting rights, economic rights, and disclosure obligations of a
private issuer, the basic components of a financial statement,
and the investment risk associated with a private investment.
Furthermore, the courts over the years have ascribed a
number of factors to help define a ``reasonable investor.'' For
example, courts have indicated that reasonable investors should
be:
1. LAble to complete basic mathematical calculations.
2. LFamiliar with the basic operation of a securities margin
account.
3. LAble to understand the time value of money and basic
principles of diversification.
4. LAware of what free cash and securities may be used to
earn interest
5. LAble to read and understand risk factors and other
disclosures plainly presented in a prospectus.
6. LAble to ``grasp the probabilistic significance'' of
merger negotiations.
7. LGenerally aware of macroeconomic conditions.\2\
---------------------------------------------------------------------------
\2\ See, e.g., In re Merck & Co., Inc. Securities Litigation, 432
F.3d 261, 270 (3d Cir. 2005); Levitin v. PaineWebber, Inc., 159 F.3d
698, 702 (2d Cir. 1997); In re Donald J. Trump Casino Securities
Litigation, 7 F.3d 357, 371-77 (3d Cir. 1993); Dodds v. Cigna
Securities, Inc., 12 F.3d 346, 351 (2d Cir. 1993); Flamm v. Eberstadt,
814 F.2d 1169, 1175 (7th Cir. 1987); Zerman v. Ball, 735 F.2d 15, 21
(2d Cir. 1984); Ash v. LFE Corp., 525 F.2d 215, 219 (3d Cir. 1975).
We believe that many of these concepts--in addition to the
factors already included in S. 2756--would be appropriate to
---------------------------------------------------------------------------
consider in such a test.
Q.1.c. How should the test ensure that biases do not arise?
A.1.c. We believe that the focus should be on determining one's
financial sophistication based upon objective investment
topics, whatever entity will develop and administer such a
test. The provisions included in S. 2756--coupled with court-
articulated factors that define a ``reasonable investor'' would
be an appropriate starting point.
Q.1.d. Do you think the SEC should permit other firms to
develop, teach and administer tests? If so, what would be the
benefits and concerns of a third-party testing system?
A.1.d. The SEC currently delegates certain examination
authority to self-regulatory organizations. For example, FINRA
develops and administers dozens of examinations for individuals
employed in the securities industry.
A third-party testing system could be a cost-effective and
efficient way to administer examinations. Such a third party
must be independent and must be able to demonstrate that it has
the ability and expertise to administer examinations in a fair
and objective manner. Under such an arrangement, the SEC may
choose to retain some authority. For example, the SEC could
assist with the development of exam questions (and update
questions and topics as necessary), then assign the third party
to administer the test, record results, and furnish the results
to the SEC. We believe that S. 2756 as currently written
provides the SEC with sufficient flexibility to determine the
best manner in which to utilize third parties.
Q.2. As you know, my State of Nevada is one of the leading
States for retiree in-migration. Many of these retirees, and
many working Nevada residents, are counting on their pensions
from State, teacher or labor union pension funds. Several of
these large pension fund managers, including the SEIU which has
about 18,000 members in Nevada, have publicly opposed H.R.
4015. They have raised concerns that it will interfere with the
independent advice that they rely on from proxy advisors.
Why should the Congress undermine the fiduciary
responsibility and interfere with the contractual relationship
of proxy advisors to their clients by requiring these proxy
advisors to show their data and recommendations to the
companies under review, even before their clients get to see
them?
A.2. Under existing law and SEC regulation, proxy advisory
firms do not owe any underlying fiduciary duty to any party.
Institutional Shareholder Services (ISS) claims that its status
as a registered investment advisor (RIA) requires it to act as
a fiduciary to its investor clients, but not its corporate
clients. However, Glass Lewis is not registered in any capacity
with the SEC. Put simply, no existing law or regulation
requires a proxy advisory firm to owe a fiduciary duty to
anyone.
In the context of proxy advice and proxy voting, the actual
fiduciary duty lies with institutional investment managers who
are
required to vote proxies in the best interests of their
shareholders. Past SEC actions have effectively allowed
investment managers to outsource this responsibility to third
parties such as proxy advisory firms. Two no-action letters the
SEC issued in 2004 to Egan-Jones and to ISS allowed investment
managers to ``cleanse'' any conflict of interest related to a
particular proxy issue by relying on a proxy advisor firm for a
vote recommendation. The no-action letters also allowed an
investment manager to rely solely on a proxy advisory firm's
general policies and procedures pertaining to conflicts of
interest, as opposed to any specific conflicts around a
specific company or issue.
This has enabled rampant conflicts of interest in the proxy
advisory firm industry. For example, ISS runs a consulting
business for corporate clients in addition to its voting
recommendation business, which is an inherent conflict of
interest. An activist Canadian pension plan owns Glass Lewis
that has taken positions on proxy issues at U.S. companies.
Since proxy advisory firms have no underlying duty or
applicable regulatory regime, they face little or no
consequences for poor business practices. Public companies
often tell us that they are granted an insufficient amount of
time to respond to a draft voting recommendation, even in cases
where the recommendation includes factual errors or flaws in
methodology. For example, a survey the U.S. Chamber and Nasdaq
conducted in 2017 found that a majority of public companies
surveyed were only given 1 or 2 days to review and respond to a
proxy advisory firm recommendation.\3\ Small and mid-size
companies usually have no chance to respond to a recommendation
from either Glass Lewis or ISS.
---------------------------------------------------------------------------
\3\ http://www.centerforcapitalmarkets.com/wp-content/uploads/2017/
07/FINAL-CCMC-Survey.docx.pdf?x48633.
---------------------------------------------------------------------------
This opaque system--which has resulted in multiple errors
and mistakes in recommendations--is ultimately harmful to
investors as it leads to bad information in the marketplace. We
believe that the modest requirement in H.R. 4015 to grant at
least 3 days for companies to respond to a recommendation is an
entirely reasonable expectation, and there is nothing in the
legislation that would require a proxy advisory firm to
incorporate the feedback it received from a company into its
recommendation.
Proxy advisory firms also do not have the proper resources
to analyze appropriately the tens of thousands of director
elections and shareholder proposals they issue reports on. The
combination of a lack of resources, faulty reports, failure to
fix errors, and conflicts of interest adversely affects the
useful information available to investors. This can lead to a
faulty decisionmaking process that can generate lower returns
for the retirees mentioned in the question, and the entities
that help them attain a secure retirement.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN FROM DARLA C.
STUCKEY
Q.1. You stated, ``[i]f you are talking about Mr. and Mrs.
401(k) as long-term retail shareholders, they are represented
by investment managers who largely vote with ISS and Glass
Lewis,'' and ``[p]ublic, State, and private pension
beneficiaries as well have no individual voice.''
Does any pension fund check with their beneficial owners
before they vote how they should vote on a particular
shareholder proposal, say climate-related?
A.1. I am not aware that this happens. Please see study from
Spectrem Group [attached] for further information on pensioners
and their views on how their assets are managed.
Q.2. Putting aside proposals related to corporate social
responsibility, do investment managers regularly consult
individual 401(k) investors, or pension plan participants, on
voting decisions relating to the securities held in their funds
or plans for corporate actions such as mergers? Please describe
any such mechanisms or voting processes and identify the funds
or plans that have consulted ultimate beneficial owners on
corporate actions or shareholder votes.
A.2. I am not aware that this happens.
Q.3. In what ways to do companies seek out the views of
ultimate beneficial owners (e.g., individual 401(k) investors
or pension plan participants) on corporate actions or
shareholder votes? Please provide relevant examples, if any.
A.3. Companies know their own 401(k) beneficiaries and
communicate with them generally as employees or former
employees. I am not aware that they seek out the views of those
individuals on shareholder votes. However, they do have a
fiduciary duty to vote in accordance with what they think is
best for all shareholders including 401(k) plan beneficiaries.
With respect to companies seeking out the views of the
beneficial owners of their stock held in other company-
sponsored 401(k) plans or pensions, those individuals are not
known to the company because typically shares are held through
indexes or mutual funds whose managers vote the shares.
EX. If I own a Mutual Fund ``A'' large cap growth fund in
my personal Society 401(k) which owns Google stock, Google
would never know me or be able to solicit my input on voting.
Rather, the Mutual Fund A would vote those Google shares.
Q.4. Your testimony discussed a transportation company's
interaction with ISS over a recommendation on a say-on-pay
vote.
Q.4.a. Generally, what is the result of a failed say-on-pay
vote? What were the consequences for the company you mentioned?
Did the company benefit from its shareholder outreach?
Q.4.b. Would the representatives of that company be willing to
provide the Banking Committee detailed information regarding
the error and the facts of its case?
A.4.a.-b. A shareholder vote on executive compensation is
required by section 951 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act, which added section 14A to the
Securities Exchange Act of 1934. Pursuant to section 14A(c),
the shareholder vote is not binding on the issuer or the board
of directors. Nonetheless, the reputational effects of a failed
vote on executive compensation can be significant. As described
in my testimony, the effect on this company primarily related
to potential implications for shareholder approval of board
members and damage to the company's shareholder relations,
which required extensive outreach efforts. Although the
shareholder outreach was beneficial, ISS's factual error forced
the company to devote efforts to informing shareholders of
ISS's error, which risked crowding out other important
corporate matters.
The company provided the example to the Society for
Corporate Governance on the condition that the company not be
identified. My written testimony contains additional detailed
information regarding the error and the facts of this case.
------
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORTEZ MASTO FROM
DARLA C. STUCKEY
S. 2756, Fair Investment Opportunities for Professional Experts Act
(Accredited Investor Bill)
Q.1. In recent months, we read about how millionaires like
Rupert Murdoch, the Waltons, and the DeVos's each lost a
hundred million dollars or more when they invested in Theranos.
One of many red flags was the absence of an audited financial
statement which one would think a sophisticated investor would
demand before shelling over $125 million dollars.
Q.1.a. The bill requires that the SEC develop a test for
financial sophistication for accredited investors who do not
meet the income or wealth threshold. Is a test a reasonable
requirement to help investors better protect themselves?
Q.1.b. If so, what do you think should be in such a test?
Q.1.c. How should the test ensure that biases do not arise?
Q.1.d. Do you think the SEC should permit other firms to
develop, teach and administer tests? If so, what would be the
benefits and concerns of a third-party testing system?
A.1.a.-d. The Society does not have a position on this bill.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN FROM JOHN C.
COATES IV
Q.1. The Small Business Audit Correction Act, S. 3004, would
allow certain brokers or dealers defined under the bill to use
auditors that are exempt from Public Company Accounting
Oversight Board registration and supervision.
How many brokers or dealers do you believe would be covered
by the definition in the bill?
A.1. The great majority of broker-dealer firms would be
covered. The primary restrictions are that the firms have fewer
than 150 registered representatives, are noncustody firms, and
clear through another firm. Roughly 3,400 of FINRA's roughly
3,700 member firms have fewer than 150 registered reps. The
vast majority of broker-dealers, and an even larger percentage
of small broker-dealers, do not maintain custody of client
securities and are not self-clearing. While I am not aware of a
public dataset that could answer this question precisely, it
would be reasonable to believe that more than 3000 broker-
dealers would be covered by the definition in the bill.
Q.2. Does that definition in the bill capture brokers or
dealers in one or more of the following categories: active
high-frequency trading or principal trading firms,
sophisticated market-maker firms, private placement brokers,
dealers in the to-be-announced (TBA) for mortgage-backed
securities market, and alternative trading system routing
brokers, in addition to retail customer facing brokers or
dealers?
A.2. Yes. Many of the kinds of firms listed in the question
would be covered by the definition in the bill.
Q.3. At the hearing, proxy advisors were identified as
contributing to the decline in the number of public companies.
Do you know of any evidence or studies that support this
claim?
A.3. No. The best studies of the decline of the number of U.S.
public companies focus on large-scale economic shifts, such as
an increase in economies of scale in many industries, and the
relative increase in the availability of capital in the private
equity markets. The single best recent study is that Xiaohui
Gao, Jay R. Ritter, and Zhongyan Zhu, entitled ``Where Have all
the IPOs Gone?,'' 48 J. Fin. Quant. Anal. 1663-1692 (2013),
available at https://tinyurl.com/yba6sw9j. It concludes:
Regulatory changes aimed at increasing the number of IPOs are
likely to have minor effects, since the decline in IPOs is not
due to a broken IPO market, but because small independent
companies are not necessarily the profit-maximizing form of
organization.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR VAN HOLLEN FROM JOHN
C. COATES IV
Q.1. In your testimony you say that H.R. 4015, Corporate
Governance Reform and Transparency Act of 2017, would create
conflicts of interest for firms that use proxy advisory
services. Please elaborate on this. What is the problem that
H.R. 4015 is trying to solve?
A.1. Proxy advisory firms face potential conflicts of interest
if they have other lines of business (as with ISS) or owners
(as with Glass Lewis). Basic disclosure and information-barrier
regulation can address conflicts of interest, as in many other
settings. Well-designed, light touch regulation of conflicts
would seem to me a possibly admirable goal for a statute
addressing proxy advisory firms. However, as I testified, I do
not believe that H.R. 4105 as currently drafted does that. It
would impose unnecessary costs without adequately demonstrated
benefits.
Q.2. Some have tried to pinpoint the root causes of decreases
in IPOs. Please discuss what factors have been at play with
regard to the decrease in IPOs.
A.2. The best studies of the decline of the number of U.S.
public companies focus on large-scale economic shifts, such as
an increase in economies of scale in many industries, and the
relative increase in the availability of capital in the private
equity markets. The single best recent study is that Xiaohui
Gao, Jay R. Ritter, and Zhongyan Zhu, entitled ``Where Have all
the IPOs Gone?,'' 48 J. Fin. Quant. Anal. 1663-1692 (2013),
available at https://tinyurl.com/yba6sw9j. It concludes:
Regulatory changes aimed at increasing the number of IPOs are
likely to have minor effects, since the decline in IPOs is not
due to a broken IPO market, but because small independent
companies are not necessarily the profit-maximizing form of
organization.
I am aware of no reliable research to suggest proxy
advisory firms have played a meaningful role in the decline in
IPOs. It is hard to see how proxy advisory firms could have
done so. It should be noted that firms can elect dual-class
structures at the time of an IPO, which would make the prospect
of shareholder voting--whether or not informed by proxy
advisory firms--unimportant. Dual-class IPOs have been
increasing in recent years, but not enough to offset the
overall decline, which is driven by economic and not regulatory
or governance factors.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORTEZ MASTO FROM
JOHN C. COATES IV
S. 2756, Fair Investment Opportunities for Professional Experts Act
(Accredited Investor Bill)
Q.1. In recent months, we read about how millionaires like
Rupert Murdoch, the Waltons, and the DeVos's each lost a
hundred million dollars or more when they invested in Theranos.
One of many red flags was the absence of an audited financial
statement which one would think a sophisticated investor would
demand before shelling over $125 million dollars.
Q.1.a. The bill requires the SEC to develop a test for
financial sophistication for accredited investors who do not
meet the income or wealth threshold. Is a test a reasonable
requirement to help investors better protect themselves?
A.1.a. I would not view such a test as a way for investors to
better protect themselves. Rather, such a test would be a way
to evaluate whether some investors are already able to protect
themselves. If well-designed, such a test would be more likely
to distinguish such investors from others than the current
asset/income thresholds, which even if at a reasonable level
would be a crude measure, and are out of date.
Q.1.b. If so, what do you think should be in such a test?
A.1.b. Sophisticated investors able to protect themselves are
at least knowledgeable about finance, accounting, financial
statement analysis, and the institutions and regulations of the
financial industry. Designing a test of such topics would be a
challenging and somewhat time-consuming task, as it would
require balancing the need to fairly test relevant knowledge
(both theoretical and as applied to typical investment
decisions) against the need to not have the test be so lengthy
or detailed as to deter sophisticated investors from attempting
to take it. But could be done. While it would not need to be as
comprehensive as existing regulatory examinations for
individuals to become ``registered reps'' (the ``Series 7''
exam) or certified financial planners or analysts, it could
draw on those exams and tests for material and topics.
Q.1.c. How should the test ensure that biases do not arise?
A.1.c. To some extent, cognitive biases--such as over-optimism
or unjustified self-confidence, or attribution of luck in the
financial markets to skill--are inevitable. Even the most
sophisticated investors are subject to them. Standard tests of
financial knowledge are not generally viewed as creating or
worsening biases. If a concern is that third parties would
``teach to the test'' and through that process increase or
worsen biases, then that could be addressed by varying or
randomizing elements of the test--as with SATs--
so that no one could design a curriculum that would both
adequately prepare someone for the test and simultaneously
increase or worsen biases in the process. In any event, whether
a test (or the teaching to prepare for it) worsens biases is
itself capable of being tested, and the results could be used
to refine the test over time.
Q.1.d. Do you think the SEC should permit other firms to
develop, teach and administer tests? If so, what would be the
benefits and concerns of a third-party testing system?
A.1.d. I would prefer a dedicated unit with an adequately
funded SEC oversee the design, testing, and administration of
any such test. While for-profit private actors may be likely to
work more quickly and competition provides good incentives in
many contexts, the world of education is dominated by public
institutions and nonprofits for reasons that would carry over
to this area. I would worry that for-profit private test
designers (and trade associations and many other organizations
that are formally nonprofits as well) might have conflicts of
interest in designing the tests. (I would expect third parties
to then provide curricula to prepare investors to take such a
test, but they should not be privy to the actual contents of
the test.) If the SEC chose, it could seek to rely on third
parties--appropriately screened through customary RFP process
that would include consideration of potential conflicts of
interest. But I would leave that to the SEC to choose, rather
than directing that in a statute.
Additional Material Supplied for the Record
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