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Don’t Forget the G: After Years of “Environmental” and “Social” Regulations and Enforcement, the SEC’s Recent Priorities Demonstrate a Focus on “Governance”
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Don’t Forget the G: After Years of “Environmental” and “Social” Regulations and Enforcement, the SEC’s Recent Priorities Demonstrate a Focus on “Governance”

By Rebecca Fike, Jake Beach, and Jacob Mathew at Vinson & Elkins LLP

The SEC has been busy under the Biden administration. From rulemaking to enforcement, the agency is pushing boundaries and expanding its reach into new and active areas of the market. Here, we provide updates on the Commission’s activity in several high-priority areas, including ESG, insider trading, ephemeral messaging, and the clawback of executive incentive-based compensation.

ESG Regulation and Enforcement Using Preexisting Rules and Historical Causes of Action

SEC Chair Gary Gensler recently spoke about how various types of crypto technology, like “crypto token, stablecoin, or decentralized finance platform (DeFi) . . . are covered by [existing] securities laws.”1 Paraphrasing Aristotle, Gensler concluded, “[t]reat like cases alike.”2 Those observations mirrored earlier comments by Commissioner Hester M. Peirce on ESG regulation and enforcement:

We can bring, and already have brought, greenwashing cases using existing rules, so why is additional rulemaking necessary? Should our focus instead be on identifying where there may be gaps in Commission rules and tailor[ing] any new rulemaking accordingly, rather than producing a new rule that is arguably redundant?3

Such comments may reflect an institutional preference for amending preexisting rules and relying on historical causes of action rather than inventing new theories for ESG regulation and enforcement. This focus is evident in recent rulemaking, investigations, and enforcement actions — specifically, proposed amendments to the Names Rule, recent administrative proceedings against Bank of New York Mellon Investment Adviser, Inc. (“BNY Mellon”), and an ongoing investigation into Activision Blizzard, Inc. (“Activision Blizzard”).

  1. Proposed Amendments to the Names Rule

The Names Rule was adopted two decades ago to protect the public from “materially deceptive and misleading [fund] name[s].”4 Among other things, it forbids names “suggesting guarantee or approval by the United States government.”5 The rule also prohibits names which suggest that a fund focuses on “certain investments or industries,” “certain countries or geographic regions,” or has “[t]ax-exempt” status, unless the fund’s name accurately reflects “at least 80%” of the value of its assets.6 This is also known as the 80% rule.

The SEC recognizes when a fund’s name includes the term “ESG” or “similar terminology,”7 that “[i]nvestors may reasonably expect [such] funds . . . to invest in companies with policies, practices, or characteristics that are consistent with these standards.”8 The proposed amendments to the Names Rule would provide that “fund names with ESG and similar terminology . . . are subject to the rule’s 80% investment policy requirement.”9 The amendments would also “defin[e] certain uses of ESG terminology in fund names as materially deceptive and misleading.”10 The purpose of both amendments would be to stamp out “greenwashing.”11

Among the proposals the SEC is considering is whether the names of “integration funds” should be categorically deemed to be “materially deceptive or misleading” if those names indicate that a fund’s “investment decisions incorporate one or more ESG factors.”12 The SEC is also mulling over whether a fund’s investment policy “must address each element in the fund name that suggests an investment focus.”13 For instance, a fund named “XYZ Environmental, Social, and Governance Fund” may be required to “adopt an 80% investment policy to address all three of those elements.”14

On October 7, 2022, the SEC reopened the comment period for the proposed amendments to the Names Rule.15 So, it remains to be seen whether these amendments will emerge intact. For the time being, this serves as a useful reminder to embrace progress while keeping one foot firmly planted in the past, where much of the regulatory action still is.

  1. Settlement with Bank of New York Mellon Investment Adviser, Inc.

For companies concerned with ESG, the SEC has emphasized that “all three of those elements” matter.16 However, “G,” for governance, is sometimes overlooked.17 This may be a risky assumption, as seen in a recent settled administrative action against BNY Mellon, and a private lawsuit and ongoing SEC investigation into Activision Blizzard.

BNY Mellon recently found itself the subject of an administrative proceeding. At issue were alleged misstatements and omissions about how ESG principles informed the investment decisions of certain funds it advised.18 The decisional processes of two funds, the “Sustainable Funds” and the “Overlay Funds,” were scrutinized closely.19 Investment decisions for the Sustainable Funds always required adherence to a “proprietary ESG quality review.”20 To pass muster, securities had to “demonstrate attractive investment attributes and sustainable business practices,” and could not have any “material unresolvable environmental, social and governance (ESG) issues.”21 By contrast, investment decisions for the Overlay Funds were “not subject to that specific investment criteria.”22

But the SEC found that BNY Mellon misrepresented in board minutes and prospectuses the extent to which ESG quality reviews were part of the investment process of the Overlay Funds.23 The following statement was viewed as misleading:

Integrated into the investment process [is] a well-established approach to responsible investment. This process includes identifying and considering the [ESG] risks, opportunities and issues through the research process via . . . proprietary quality reviews, in an effort to ensure that any material ESG issues are considered.24

This was because “[a] reasonable investor . . . could mistakenly conclude that all portfolio holdings selected [for the Overlay Fund] were subject to an ESG quality review.”25 Also problematic was an RFP response which stated that, as part of the “due diligence process ahead of investing, each security being considered for investment . . . must have an ESG quality review conducted.”26

The SEC concluded BNY Mellon had willfully violated Sections 206(2) and 206(4) of the Investment Advisers Act, and Rules 206(4)-8 and 206(4)-7 promulgated thereunder, and had also violated Section 34(b) of the Investment Company Act, which prohibit fraud or deceit and untrue statements or omissions of material fact.27 Without admitting or denying any of the SEC’s findings, BNY Mellon agreed to an order requiring that it cease and desist from current and future violations, a censure, and a penalty payment of $1,500,000.28

  1. Investigation into Activision Blizzard, Inc.

Activision Blizzard has been the subject of an investigation for different governance reasons. It started when a federal class action lawsuit claimed that Activision Blizzard had violated federal securities law by misleading investors, in significant part, through its 2020 ESG Report:

Plaintiffs allege that [the ESG Report’s] provisions regarding no toleration of retaliation were materially false and misleading because during the Class Period retaliation against female employees of the Company who made sexual harassment and discrimination claims was rampant and tolerated by the Company.29

While the plaintiffs’ first two complaints were dismissed, they recently filed a third amended complaint, reasserting their claims that Activision Blizzard’s public commitment to ESG materially misled investors.30 Activision Blizzard has also announced that the SEC is investigating the company on “employment matters and related issues.”31

It is unclear whether any formal enforcement will materialize out of the Activision Blizzard investigation. Regardless, in light of administrative proceedings brought against BNY Mellon and other companies32 based upon their internal and external compliance efforts, this may indicate the form that future SEC enforcement may take against companies seeking to implement ESG protocols, especially in the area of governance.

Insider Trading Enforcement Based on Companies’ Own Insider Trading Language and Policies

In another trend, the language and provisions of several companies’ own insider trading policies have played a significant role in helping the Commission expand its insider trading litigation. While the SEC has made reference to companies’ insider trading policies in prior enforcement actions, those references have generally served to establish scienter.33 And when the SEC has tried to use the provisions of a company’s own insider trading policies to expand the definition of insider trading in the past, those efforts have often failed.34 In a recent line of cases, however, the specific language and provisions of companies’ own insider trading policies have been outcome determinative.

In SEC v. Jun, for example, particular provisions of Netflix’s insider trading policies were central to the SEC’s enforcement theory.35 Jun involved an insider trading ring that traded on tips about Netflix’s subscription information.36 That information was passed on at various times by three members of the circle, who were software and data engineers at Netflix.37 Of note, the SEC relied almost entirely upon Netflix’s “company policies, including its insider trading policy,” to establish that Netflix’s “periodic subscriber numbers” were material and confidential information.38

Similarly, in SEC v. Panuwat, the specific language of Medivation’s insider trading policy was critical. Panuwat, an employee of Medivation, Inc., traded in short-term call options in a peer company, Incyte Corp., after learning that Pfizer was about to acquire Medivation.39 Panuwat challenged the SEC’s complaint for failing to show he had breached any duty owed to Medivation through his trading in Incyte. The SEC responded by citing to Medivation’s own insider trading policy, which broadly prohibited the use of nonpublic information to trade in “the securities of another publicly traded company.”40 In particular, the SEC seized upon the fact that Medivation’s policy used the expansive word “including” to provide a non-exclusive list of types of publicly traded companies.41

Finally, in SEC v. Cavco Indus., Inc., Cavco’s investment and insider trading policies were used to support an action ancillary to a classic § 10(b) violation.42 Cavco’s corporate investment policy required it “to maintain surplus cash in a ‘low-risk, high credit quality portfolio’ such as money market accounts and Treasury bonds.”43 Before any investments could be made outside those guidelines, they needed to be approved “by both the CEO and CFO and reported to the Board of Directors.”44 The SEC sued the defendants for securities fraud in violation of § 10(b) and insufficient accounting controls in violation of § 13(b)(2)(B).45 In doing so, it relied on a step-by-step analysis of the company’s own investment and internal trading policies, describing how the trades were an improper use of “surplus cash,” and emphasizing how the trades were not disclosed to Cavco’s CEO, CFO, and board.46

It is too soon to tell whether this trend is here to stay or what it forebodes. For now, market participants would be advised to work with inside and outside counsel to scrutinize their insider trading and investment policies to ensure they are not creating unintended liability and that their internal procedures around insider trading police the full scope of liability created by their policies.

Ephemeral Messaging

Ephemeral messaging refers to the use of applications like WhatsApp, Signal, and Telegram to send “‘self-destructing’ messages that are deleted automatically after they are viewed or some set amount of time after they are sent.”47

On October 13, 2021, the Director of the SEC’s Division of Enforcement, Gurbir S. Grewal, opined on the need for a shift in SEC priorities, because “trust in our institutions is faltering.”48 Among other enforcement priorities, he advocated for the “robust enforcement of laws and rules concerning . . . violation[s] of record-keeping obligations.”49 Grewal specifically criticized the deliberate use of “ephemeral technology that allows messages to disappear.”50

Less than a year later, the Commission responded to Grewal’s call.51 On September 27, 2022, the SEC announced sanctions against several firms for violating record-keeping rules. Those firms included Barclays, Citigroup, Bank of America, Merrill Lynch, Goldman Sachs, Morgan Stanley, and several others.52 In addition to being ordered to establish comprehensive compliance regimes within the year, each firm was required to pay civil penalties between $10 million and $125 million. All told, the eleven firms paid fines totaling $1.16 billion.53

The infringing conduct constituted using personal text messaging services and other “off-channel” communication platforms like WhatsApp for communications “related to the business of the broker dealer,” and failing to “maintain or preserve” those communications.54 The Commission relied principally on Rules 17a-4 and 17a-4(b)(4) under the Exchange Act. Both rules were promulgated pursuant to the power granted under Section 17(a)(1) to issue record-keeping rules governing broker-dealers.55The SEC noted violations not just by junior employees, but managing directors and senior supervisors as well.56

The SEC explained further that “recordkeeping requirements are an integral part of the investor protection function of the Commission and other securities regulators, in that the preserved records are the primary means of monitoring compliance with applicable securities laws, including antifraud provisions and financial responsibility standards.”57 And so, it expressed concern that during the relevant time periods that the firms were using ephemeral messaging technology, they were also receiving and responding to subpoenas in other unrelated investigations. The SEC emphasized that the firms’ failure to maintain or preserve records “likely impacted the Commission’s ability to carry out its regulatory functions and investigate violations of the federal securities laws across [those other] investigations.”58

It is uncertain whether the SEC has reserved the right to bring further enforcement based upon the impact of the firms’ record-keeping failures on other unrelated investigations. For now, this is a space to watch closely. Furthermore, as accounting practices, corporate transparency, and record-keeping generally fall under the umbrella of governance within an ESG framework, this further underscores the importance of paying attention to “all three of those elements.”59

Clawback Rules for Executive Incentive-Based Compensation

On October 26, 2022, the SEC announced that it had adopted a final rule requiring exchanges and issuers to develop and implement policies pertaining to the mandatory recovery of executive incentive-based compensation (“EIBC”) overpaid due to an issuer’s noncompliance with financial reporting requirements, as well as disclosure policies regarding the same — the so-called Clawback Rule. The Rule was proposed in 2015 to implement, for the first time, Section 10D of the Securities Exchange Act, an amendment added by the Dodd-Frank Wall Street Reform and Consumer Protection Act.60 The proposal went dormant under Chairman Clayton, appointed under the Trump administration, until the comment period was reopened in October 2021. Commissioner Caroline A. Crenshaw described the Rule as being rooted in equitable concerns: “it is unfair to shareholders for corporations to allow executives to retain compensation that they were awarded erroneously.”61

Section 10D(b) of the Exchange Act authorizes the Commission: (1) to make rules requiring companies to develop and implement mandatory recovery policies for clawing back excessive EIBC overpaid due to an issuer’s “material noncompliance” with “any financial reporting requirement” during the “3-year period” preceding the date on which the company is required to prepare an “accounting restatement”; and (2) to make rules requiring companies to develop and implement disclosure policiespertaining to the same.62

Disclosure Policies. The Commission’s new disclosure rules require companies, among other things, to: (i) indicate on the cover of Forms 10-K, 20-F, and 40-F if an accounting restatement is published during the relevant reporting period;63 (ii) file their internal mandatory recovery policies as exhibits to annual reports on Forms 10-K, 20-F or 40-F, or for registered management investment companies, on Form N-CSR;64 (iii) disclose how recovery policies have been applied by a company during a given reporting period under Item 402;65 and (iv) disclose various additional information in Inline eXtensible Business Reporting Language (“XBRL”), “a structured (i.e. machine-readable) data language.”66

Mandatory Recovery Policies. In Section 10D(b), Congress provided that the mandatory duty to recover erroneously awarded EIBC should be triggered only when an erroneous award is the result of a company’s “material noncompliance” with financial reporting rules. Although the Rule incorporates a materiality standard,67 Commissioners Peirce and Mark. T. Uyeda have criticized the Commission for defining the term “material” to include both “Big R” and “little r” accounting restatements, which may “require [the] clawback of de minimis amounts.”68 While the Commission has certainly shown an increasing preference for a broad treatment of “materiality” in different settings, it has generally assured market participants that the term will be construed in a manner “consistent with applicable case law.”69 Critics contend, however, that the Clawback Rule strains the meaning of materiality to its limits, in “conflict with the statutory directive.”70

This seems to be by design, as the Commission aims to capture any and all erroneously awarded EIBC. In the Commission’s view, the Rule requires the recovery of “any incentive-based compensation that may be impacted by financial reporting.”71 The Rule was thus drafted “with the view that discretion to implement and execute [clawback] policies . . . should be limited.”72 At the same time, it was drafted with an understanding that these “policies were intended to apply broadly.”73 This dual heuristic has had two consequences.

First, the Commission has stripped boards of directors of the discretion to determine whether an error is “material” — that is to say, whether it requires “Big R” or “little r” accounting restatements.74 “Big R” restatements involve corrections to “historical financial statements” of “errors that were material to those previously issued financial statements.”75 By contrast, “little r” restatements typically “deal with immaterial misstatements, or adjustments made in the normal course of business” and are “not generally viewed as a sign of poor reporting.”76 But, as mentioned previously, the Clawback Rule’s definition of “material error[] . . . include[s] both.”77 The Commission has also explained that “[w]hile an initial error amount may not have been material to previously issued financial statements, it may become material due to its cumulative effect over multiple reporting periods.”78

Second, the Commission has adopted an “intentionally broad definition of executive officer.”79 The Senate Banking Committee understood Section 10D(b) to authorize rulemaking requiring mandatory recovery from only “a very limited number of employees.”80 But the Clawback Rule defines “executive officer” to include, among others, “any other officer who performs a policy-making function.”81 The scope of mandatory recovery is also not limited to just “those officers who may be ‘at fault’ for accounting errors . . . nor to those who are directly responsible for the preparation of the financial statements.”82

The Rule thus requires the implementation of clawback and disclosure policies pertaining to the incentive-based compensation awarded to any officer who performs a policy-making function. Furthermore, it triggers the duty of mandatory recovery when an erroneous award is the result of a company’s noncompliance with any financial rule, as defined by an exceedingly broad (and potentially illusory) standard of materiality.

The “Impracticability” Exception. The Rule contains at least one safeguard for companies — referred to as the “impracticability” exception — wherein recovery may not be required if: (i) “[t]he direct expense paid to a third party to assist in enforcing the policy would exceed the amount recovered”; (ii) “[r]ecovery would violate home country law where that law was adopted prior to [the Rule’s publication in the Federal Register]”; or (iii) “[r]ecovery would likely cause an otherwise tax-qualified retirement plan . . . to fail to meet the requirements of [26 U.S.C. § 401(a)(13) or 411(a)] and any regulations thereunder.”83 Even so, Commissioner Peirce, dissenting from the rule, described the exception “itself [as] impracticable,” since it imposes significant costs on any company seeking to take advantage of it.84 This is because, before the exception applies, a company must first make “a reasonable attempt to recover such erroneously awarded compensation” and document and report the same, or first “obtain an opinion of home country counsel, acceptable to the applicable national securities exchange or association.”85

The time for compliance is short. Each exchange is required to file “proposed listing standards” no later than 90 days following the Rule’s publication in the Federal Register.86 Those standards must be effective within “one year” after the Rule’s publication.87 Once that occurs, issuers will have only 60 days to adopt and implement their own mandatory recovery policies.88 In these circumstances, market participants are advised to begin working with counsel immediately to discuss the drafting and implementation of mandatory recovery and disclosure policies, and to seek advice on structuring executive compensation and benefits — and insider trading policies, internal controls around ESG disclosures, and more — to reflect this new landscape of risk.

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