April 26, 2018

House Financial Services Committee Capital Markets Subcommittee “Oversight of the SEC’s Division of Corporation Finance”

Key Topics & Takeaways

  • Capital Formation: There was substantial discussion throughout the hearing on ways the SEC broadly (and the Division of Corporation Finance specifically) could improve the capital formation landscape in the U.S. Hinman said that the Commission has explored numerous ways to improve capital formation, including by broadening the ability of firms to use confidential filing rules and by increasing the availability of SEC staff to would-be issuers. Hinman also expressed interest in scaling disclosure to encourage smaller issuers to go public, and in reviewing the disclosure requirements imposed on all public companies.
  • Initial Coin Offerings (ICOs): Hinman fielded several questions from members on whether ICOs should be registered and treated as traditional securities. Hinman said that ICOs that have the characteristics of securities should be registered but noted that some tokens may not truly be securities. Hinman said that regulators were working together to address the emerging ICO market and that the SEC did not want to preclude new forms of capital raising from developing.
  • Arbitration: Prior to the hearing, Financial Services Committee Democrats unanimously signed a letter to the SEC calling on the Commission to not award arbitration clauses to issuers in investor disputes. Ranking Member Carolyn Maloney (D-N.Y.) said that arbitration would effectively end private litigation as a way of enforcing and preventing securities fraud, and raised other legal issues that could preclude the SEC allowing arbitration agreements to govern investor-shareholder relations.

Witness

  • William Hinman, Director, Division of Corporation Finance, U.S. Securities and Exchange Commission

Opening Statements

Subcommittee Chairman Bill Huizenga (R-Mich.)

In his opening statement, Chairman Huizenga discussed the role of the SEC’s Division of Corporation Finance (“CorpFin”) in protecting investors and its mission of ensuring the accuracy of public company disclosures. Huizenga also talked about the ongoing decline in the total number of publicly listed companies and said that public markets are “less and less attractive” due to “one-size fits all” securities regulations and disclosure requirements. He called on the SEC to take steps to reverse the ongoing decline in public companies and in initial public offerings (IPOs).

Subcommittee Ranking Member Carolyn Maloney (D-N.Y.)

In her opening statement, Ranking Member Maloney discussed the importance of the current investor disclosure regime, due to the importance of disclosed information for investing decisions, and said the SEC should not make significant changes to the disclosure framework lightly. Maloney also discussed arbitration of shareholder disputes noting a letter to the SEC that all Financial Services Committee Democrats signed that was critical of efforts to push investors into arbitration. Maloney argued that arbitration would be the end of securities fraud lawsuits and allow companies to avoid complying with securities laws.

William Hinman, Director, Division of Corporate Finance, U.S. Securities and Exchange Commission (SEC)

In his testimony, Hinman discussed CorpFin’s mission and outlined its work reviewing filings related to public companies and offerings. Hinman noted the declining number of public companies and said that CorpFin is trying to make public markets more attractive, and that this is a “high priority” for his Division. Hinman outlined recent steps to encourage capital formation, including allowing all companies to file draft registration statements confidentially, which has had strong interest from would-be issuers and allows companies to better access public markets. Hinman also outlined recently published guidance and interpretations on the pay ratio rule, tax reform provisions, and cybersecurity disclosure. Hinman said the SEC was committed to taking a “balanced approach” towards initial coin offerings (ICOs) that would encourage capital formation and innovation while protecting investors. Hinman closed by discussing other ways that CorpFin could improve the attractiveness of public markets, including through changes to Regulation A, Regulation D, and crowdfunding rules, as well as ways to reduce the disclosure burden on public companies through changes to Regulation S-K and Regulation S-X. 

Question and Answer

Capital Formation

Huizenga led off the Q&A by asking Hinman how CorpFin and the SEC plan to encourage more companies to go and stay public. Hinman said that some measures would require rulemakings, but that the Commission has explored other ways to encourage capital formation, including through more industry dialogue with companies exploring IPOs and increasing the availability of SEC staff to would-be issuers.

Rep. Tom Emmer (R-Minn.) asked about venture exchanges, and if Hinman believed that concentrating liquidity could facilitate secondary trading of liquidity challenged securities. Hinman said that venture exchanges were the purview of the Division of Trading and Markets but noted that that Division is focused on the issue. In response to a related question from Emmer, Hinman also said that CorpFin is interested in scaling disclosure requirements for smaller companies.

Rep. Ted Budd (R-N.C.) spoke about H.R. 3903, the Encouraging Public Offerings Act, which would expand “testing the waters,” and asked if the SEC plans to extend this to all companies, as it currently only applies to emerging growth companies (EGCs). Hinman noted that “test the waters” exemptions have been available for EGCs and that it is on the SEC’s agenda to expand this usage to all companies, but that there is no current timeframe as to when that will happen. He added that such a change could potentially help level the playing field for EGCs and non-EGCs.

Initial Coin Offerings
Huizenga asked what role Congress has regarding initial coin offerings (ICOs) and if Hinman is concerned congressional regulatory intervention could “chill” the ICO market. Hinman replied that the Financial Stability Oversight Council (FSOC) is currently gathering views from the different FSOC regulators on know-your-customer and anti-money laundering concerns, to see if there are gaps in the overall regulatory approach. He continued that FSOC is trying to provide guidance to the marketplace but that it is still in development, adding that regulators are trying to coordinate with each other. Huizenga also asked if ICOs are a potential or partial replacement to IPOs as a capital formation mechanism. Hinman said that the SEC is working with ICO issuers on how to make those offerings compliant with existing securities laws, noting that the ’33 Act is “flexible.” Hinman also said that it is theoretically possible for tokens to not be securities.
Rep. Warren Davidson (R-Ohio) asked if the Howey test is appropriate for cryptocurrencies and whether it should be updated to better incorporate what a security is. Hinman replied that the Howey test has “solid principles” that are “pretty flexible and sound hallmarks” for judging whether an instrument is a security. Davidson then asked about the simple agreement for future token (SAFFT), to which Hinman replied that many people try to raise funds using SAFFT and that it is an “interesting idea.”

Arbitration

Maloney used her time to discuss the Democratic letter opposing arbitration in shareholder disputes and reiterated her belief that arbitration agreements would spell the end of securities fraud litigation. Maloney noted a Bloomberg article that claimed the SEC was exploring arbitration in certain cases, and asked if CorpFin or other SEC staff were encouraging issuers to apply for arbitration agreements. Hinman assured Maloney that CorpFin is “not actively looking at” the issue.

Shareholder Submissions

Maloney noted that H.R. 10, the Financial CHOICE Act, would have raised the threshold for shareholders to submit ballot measures at company annual meetings to one percent of outstanding stock for three years. Maloney noted that this would make it “impossible” for ordinary shareholders to submit proposals at large companies. Maloney asked if such a threshold would be unfairly restrictive. Hinman pivoted to say that the current shareholder submission rules are “somewhat aged” but that changes would require rulemaking. He declined to specify a desired submission threshold level of his own.

Rep. Randy Hultgren (R-Ill) asked if the Commission planned to revisit Rule 14a-8. Hinman said that changes to 14a-8 may emerge out of a broader request for comment on a wide range of proxy issues. Hinman noted that the initial submission and resubmission thresholds have not been examined for some time, and that the SEC wants public input on the current thresholds.

Cybersecurity Disclosure

Rep. Ann Wagner (R-Mo.) asked how the SEC’s newly-issued cybersecurity disclosure guidance expands on the previously issued 2011 guidance. Hinman noted that the new guidance is Commission-level guidance and carries more weight than the 2011 guidance. Hinman also said that the new guidance properly emphasized the need for companies to have internal controls regarding their cybersecurity risks as well as the trading of insiders on cybersecurity event information.

Rep. Stephen Lynch (D-Mass.) cited figures that showed only a small number (three percent) of companies that experienced major cybersecurity events filed an 8-K to inform their shareholders. Lynch asked Hinman how this figure could be improved. Hinman said that the SEC does indeed expect more from companies and that cybersecurity risks are an important disclosure issue.

Rep. Bruce Poliquin (R-Maine) asked if the SEC has the metrics in place so public companies know when to disclose information to investors, such as about hacks. Hinman replied that they have given “good guidance” in this area, but that they do not use bright lines because they can be over- or under-inclusive, and that the market should not be flooded with “noise.” He continued that instead, principle-based guidance is used to lead companies in disclosing information. 

Proxy Advisors

Republican Members spent considerable attention to proxy advisory firms at the hearing, with several members defending the House-passed bill H.R. 4015.  Hultgren asked when the Commission will address proxy advisory issues, including complaints about the two largest proxy advisor firms from the issuer community. He also asked if the Commission will reopen its comment file from the 2010 Proxy Concept Release. Hinman said that proxy advisors are “on the list” of things that CorpFin is looking at. Hinman also said that the proxy process has had more rigor since it began applying its 2014 legal bulletin on proxy advisors, which he said brought more rigor to the process.

Wagner also asked about proxy advisors, and specifically asked what steps the SEC will take to require more disclosure of conflicts of interest from proxy advisors. Hinman said that the 2014 legal bulletin addressed some of these concerns, noting that the SEC has seen better disclosure since the release of that guidance. Wagner also asked if the SEC is working to ensure that companies have sufficient time to respond to “errors or flaws” in proxy recommendations. Hinman said that the SEC has solicited feedback on this issue and encouraged the proxy advisory firms to listen more actively to these complaints.

Short Position Disclosure

Rep. Brad Sherman (D-Calif.) noted that the requirement to disclose long positions by investors is not mirrored by any similar requirement for investors with short positions. Sherman asked if Hinman would support requiring short position disclosure in a similar manner to long positions. Hinman noted that the SEC’s Division of Economic and Risk Analysis (DERA) conducted an examination of short disclosure and found there was not a compelling cost-benefit justification for such disclosure. Hinman said that DERA would need to examine any change to position disclosure rules.   

Share Class Structures
Rep. Greg Meeks (D-N.Y.) noted that dual class share structure companies are on the rise and asked what risks are associated with such structures. Hinman replied that the SEC’s Advisory Committee asked the Division of Corporation Finance to look at disclosures, but that the states have jurisdiction over this.

Board Diversity Disclosure
Meeks discussed the SEC’s board diversity disclosure proposal that would require companies to list the race, gender and ethnicity of board members, and asked Hinman if he will publicly recommend that the SEC adopt this proposal. Hinman replied that he will publicly recommend it, and that the proposal is on Clayton’s agenda, but that there are some sensitivities to the Board’s privacy that must be considered when developing the rules.

Finalizing Dodd-Frank Rules
Rep. Keith Ellison (D-Minn.) asked when the SEC will finalize rules on executive compensation, clawbacks, and incentive compensation guidelines, to which Hinman replied they will be part of the same package, but that they will probably not be done this fiscal year.

Definition of Accredited Investor
Rep. French Hill (R-Ark.) asked if the definition of accredited investor will be expanded to include adding expertise in a particular area. Hinman replied that they are looking at amending the definition to include investors that may be sophisticated but do not meet the financial tests.

XBRL

Hultgren asked Hinman to describe any efficiencies that CorpFin has realized using XBRL and machine-readable data formats. Hinman said the XBRL has allows the SEC to more quickly review financial statements with modern tools, and said that the SEC should be releasing an update on inline XBRL proposed rule in the next 12 months.

For more information on this hearing, please click here.