ESG takes centre stage
The increased focus on environmental, social and governance (ESG) initiatives ushered in by the changing of the US Administration in 2021 continued into 2022 and 2023, with the US
Securities and Exchange Commission (SEC) taking centre stage. The SEC is aiming to release 23 regulations currently in the proposal stage and 29 in the final rulemaking phase.1
The SEC’s proposed rules on climate-related disclosure are, after some delays, expected to be finalised in April 2023. Proposed in March 2022, the rules will significantly expand the climate-related disclosures required of US public companies and foreign private issuers (FPIs) in SEC reports and registration statements, including in audited financials. Modelled in part after the Financial Stability Board’s Task Force on
Climate-Related Financial Disclosures (TCFD) framework, the proposed rules would mandate detailed disclosures of:
- the nature of oversight and governance of climate-related risks by board and management, in particular their climate change expertise;
- the material impact, both likely and actual, of climate-related risks on strategy, business and outlook over set time horizons;
- their climate-related risks, including in some cases the zip code locations impacted;
- the impact of climate-related events and transition activities on consolidated financial statement line-items, subject to audit and internal controls attestations and a 1% (!) materiality threshold;
- scope 1 and 2 greenhouse gas (GHG) emissions with accompanying independent attestation reports and, if material, Scope 3 GHG emissions; and
- climate-related targets and goals, including defined baselines and consistent data reporting over time.
This proposal marks a significant departure from the SEC’s traditional principles- and materiality- based reporting framework and will increase the complexity, cost and effort of public reporting.
The comment period concluded in November 2022 with over 11,000 comments received. Chief among the concerns shared were questions regarding the feasibility of the Scope 3 emissions disclosures, which would include all upstream and downstream GHG emissions (ie those associated with consumers’ use of a company’s products).
There are also significant concerns regarding the proposed financial statement disclosures and the 1% materiality threshold. Once finalised, application of the new rules will be phased in based on registrant size and filing status.
In May 2022, the SEC proposed additional rules to enhance and standardise ESG disclosures by funds and advisers and to expand the regulation of the naming of funds with an ESG focus. The proposed rules would: (i) require specific disclosures on ESG strategies in fund prospectuses, annual reports, and adviser brochures; (ii) introduce a standardised disclosure table for ESG funds, allowing investors to compare funds more efficiently; and (iii) require disclosure of GHG emissions of portfolio investments for certain environmentally-focused funds. While most of the proposed rules would not directly affect private funds, except for proposed revisions requiring additional ESG disclosure on Form ADV, the SEC emphasised in its proposing release that all advisers should have compliance policies and procedures that address the accuracy of ESG disclosures and ESG-related investment objectives in portfolio management processes. The SEC also proposed amendments to Rule 35d-1 under the Investment Company Act of 1940, which currently requires registered funds with certain names to adopt a policy to invest 80% of their assets in investments that are aligned with the fund name. Under the proposed amendments, ESG- related fund names would be subject to the 80% requirement. A fund that considers ESG factors together with, but not more than, other non-ESG factors in its investment decisions would not be permitted to use “ESG” or similar terminology in the fund name.
Following the creation of the Enforcement Division’s Climate and ESG Task Force in 2021, there has been an increase in ESG-related enforcement in 2022 focused on increasing transparency and reducing greenwashing. The SEC’s enforcement division has brought actions related to misleading statements and misrepresentations concerning ESG- related disclosures. In April 2022, the SEC filed an enforcement action against a Brazilian mining company following the collapse of one of its dams, alleging that the company knew about the dam’s safety shortcomings but falsely continued to assure investors in presentations and sustainability reports that all of its dams were in stable condition. Director Grewal noted that investors rely on ESG disclosures to make informed investment decisions and that by allegedly manipulating those disclosures, the company undermined investors’ ability to evaluate the risks posed by its securities. In May 2022, the SEC charged an investment adviser for ESG-related material misstatements and omissions, alleging that the adviser represented or implied in various statements that all investments in its funds had undergone an ESG quality review, even though that was not always the case. The Co-Chief of the SEC Enforcement Division’s Asset Management Unit commented that the SEC “will hold investment advisers accountable when they do not accurately describe their incorporation of ESG factors into their investment selectionprocess.”
More generally, the US Supreme Court’s ruling in West Virginia v. EPA has potentially significant impacts on US federal regulatory authority with respect to ESG-related rulemaking, including the authority of the SEC. We expect, for example, that critics of the SEC’s proposed rules on climate-related disclosure may challenge the SEC’s statutory authority to enact the proposed rules under the “major questions doctrine”.
Outside the “E” in ESG, in October 2022, the SEC finalised rules requiring NYSE and Nasdaq listed companies, including FPIs, to adopt clawback policies mandating recovery of erroneously awarded incentive-based compensation to any current or former executive officers in the event of an accounting restatement. This coincides with a broader shift in SEC policy towards utilising the Section 304 clawback provision of the Sarbanes-Oxley Act of 2002 when pursuing enforcement actions. In February 2021, the SEC issued a cease-and-desist order settling charges against the former CEO and CFO of WageWorks Inc. stemming from the company’s restatement of financial results. The SEC alleged the executives made false and misleading statements to its accountants and auditor concerning revenue due under a client contract and charged that during the 12 months following the periods the company was required to restate, both executives received incentive- based bonuses and the CEO realised profits from the sale of company stock for which neither executive had reimbursed the company. As part of the settled charges, the CEO and CFO agreed to reimburse nearly US$2 million and US$257,590 in incentive compensation, respectively.
Finally, the SEC’s Fall 2022 Regulatory Flexibility Agenda highlighted corporate board diversity and human capital management as areas of the SEC’s rulemaking focus in 2023. The SEC’s Investment Advisory Committee noted in its September 2022 meeting that it was continuing to discuss human capital management and suggested that the most useful information for investors to evaluate risks and opportunities related to human capital management could include information on wages, hours worked, DEI statistics, turnover percentage and investment in training.
We believe 2023 will be a watershed year for ESG in the United States given the sheer volume of initiatives in the area. While we believe there is no longer a dominant debate as to whether ESG is a viable governance, investment, risk management and disclosure principle, this is not a universal view in the United States, and we expect the debate over ESG will be dominated to a large extent by the politics of ESG and the broader political environment, with a number of anti-ESG initiatives advancing at the federal (including Congressional) and state level. We believe these will intensify in the current election cycle and will have an impact on the potential challenges to, the emergence of competing initiatives to, the success of and the timing and content of the large volume of current rulemaking.
Cryptocurrencies – winter chill
The chaos in the cryptocurrency market climaxed with the implosion in November 2022 of cryptocurrency exchange FTX Trading Ltd., the ramifications of which are still ongoing. Following a report that suggested potential leverage and solvency concerns, the exchange faced a liquidity crisis and sought a bailout by rival Binance that quickly fell through. FTX filed for Chapter 11 bankruptcy in Delaware shortly thereafter, and its former CEO was later arrested and extradited to the US on numerous fraud and conspiracy charges. In a parallel action, the SEC brought civil securities fraud charges against the former CEO and other FTX executives. FTX does not have securities registered with the SEC but has raised numerous rounds of private financing that are governed by the anti-fraud laws. Just two weeks after the collapse of FTX, crypto lender BlockFi Lending LLC filed for Chapter 11 bankruptcy in New Jersey, indicating that it is burdened with billions of dollars of estimated liabilities and more than 100,000 creditors. In January 2023, crypto lender Genesis Global Holdco LLC and two affiliates similarly filed for Chapter 11 bankruptcy in the Southern District of New York, becoming the latest casualty of the FTX fallout.
The stark declaration of the new FTX CEO in the company’s initial Chapter 11 bankruptcy filing says much about the current state of the industry: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as has occurred here. From compromised systems integrity and faulty regulatory oversight abroad to the concentrations of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, the situation is unprecedented.”
In light of recent bankruptcies and financial distress among crypto asset market participants, SEC staff issued a “sample letter” in December 2022 making clear that US public companies will be required to disclose the direct or indirect impact that these events and any collateral consequences have or may have on their business, with a view towards providing investors with specific, tailored disclosure about market events and conditions, the company’s situation in relation to those events and conditions, and the potential impact on investors.
In May 2022, the SEC Division of Enforcement nearly doubled the size of its Crypto Assets and Cyber Unit, focusing on securities laws violations related to crypto asset offerings, exchanges, lending and staking products, decentralised finance platforms, non-fungible tokens, and stablecoins. According to Cornerstone, the number of cryptocurrency-related enforcement actions brought by the SEC has also increased in recent years, from 97 total in 2013-21, to 20 in 2021 alone.
Such actions have focused on unregistered securities offerings and fraudulent securities offerings or sales, and on market intermediaries, including exchanges and broker-dealers, rather than issuers or promoters of single tokens. Cases against the latter group generally appear to be pursued when there are allegations of fraud and substantial investor losses.
The SEC has also brought a number of high-profile enforcement actions against crypto influencers, including in August 2022 against crypto influencers who promoted Forsage, a US$300 million crypto Ponzi scheme. This trend continued in October 2022 when the SEC fined Kim Kardashian US$1.26 million for touting the EthereumMax token on social media without disclosing that she had received compensation, and the amount of that compensation, as required by the Securities Act of 1933, as amended (Securities Act). In December 2022, the SEC charged eight social media influencers who used Twitter and Discord to manipulate exchange-traded stocks.
Nevertheless, in his opening remarks at the annual “SEC Speaks” event in September 2022, Chair Gensler noted that “nothing about the crypto market is incompatible with securities laws,” concluding that the “vast majority” of crypto tokens in existence are securities that fall within the ambit of the federal securities laws and where crypto intermediaries function as exchanges, brokers, or dealers, they should assess their registration obligations.
The SEC has also shown interest in two relatively new areas of digital asset enforcement:
- Insider trading: In July 2022, the SEC announced insider trading charges against a former Coinbase product manager, his brother, and his friend for perpetrating a scheme to trade ahead of announcements regarding crypto assets to be made available for trading on the Coinbase platform, generating illicit profits totalling more than US$1.1 million. Director Grewal noted that the realities of the offering “affirm that a number of the crypto assets at issue were securities, and, as alleged, the defendants engaged in typical insider trading”, and affirmed that they will “continue to ensure a level playing field for investors, regardless of the label placed on the securities involved.”
- Registration violation: In August 2022, the SEC charged 11 individuals beyond the issuer of the securities with registration violations in creating and promoting Forsage, a fraudulent crypto pyramid scheme that raised more than US$300 million from retail investors worldwide, including the founders and certain promoters. The complaint alleged that each defendant was a necessary participant or substantial factor in the failure to register.
The number of securities litigations focusing on cryptocurrencies has also increased. At least 16 cryptocurrency-related class actions were filed in 2022 – more than in any single year since the first such filing was recorded in 2016, according to Stanford Law School’s Securities Class Action Clearinghouse. The question of extraterritoriality and the Howey test have been areas of focus that will continue to develop in 2023. In March 2022, a district judge in New York held that a cryptocurrency trading platform’s use of US-based servers was not enough to demonstrate that either it was a domestic exchange or the transactions themselves were otherwise domestic.2 In August 2022, another judge in the same district rejected the plaintiffs’ theory that the location of the token purchaser in the US was dispositive.3
The application of the Howey test also remains a developing area. That test sets out factors to determine what qualifies as a security: (1) whether there is an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits from the efforts of others. In June 2022, a district judge in Connecticut concluded that shares in a crypto mining operation, called Hashlets, were not securities under Howey, disagreeing with the SEC’s determinations regarding the same assets.4 As more cryptocurrency litigation is filed and decided, the application of the Howey test will continue to develop.
The market fallout from the FTX bankruptcy has had a chilling effect on a crypto and digital asset market that was already suffering from severe market volatility. In 2023, we would expect to see continued instability in the digital asset sector. We may see a trend towards market participants moving assets, exchanges and offerings offshore to mitigate the risk of US securities liability. Such developments will be closely watched by the SEC, though, and issuers and distributors of digital assets will need to be very careful about structuring transactions in a way that could be viewed as evading the registration and related provisions of the US securities laws. We also expect the market structure and disclosure practices in the private placement market to attract greater regulatory scrutiny given that the private placement market was so widely used to fund FTX. Finally, although the asset class was new the type of misfeasance alleged at FTX was not – we expect the industry to mature, including because of the imposition of more robust regulatory and control environments.
SPACs – the bloom is (almost) off the rose
Special purpose acquisition company (SPAC) sponsors have faced a challenging IPO and de-SPAC market in 2022, which we expect to continue into 2023. In 2022, there were 86 SPAC IPOs on US stock exchanges with total proceeds of US$13.43 billion,5 a significant decline from the 613 listings that raised US$162.50 billion in 2021.6 De-SPAC deals have also decreased, with 129 de-SPAC deals from January through September 2022, versus 234 in the same period a year ago.7 2022 also saw an increasing number of withdrawn SPAC IPOs and terminated de-SPAC transactions.
SPACs have also faced significantly higher redemption rates in 2022, with an average redemption rate of 80% within the first two months of 20228 and an average redemption rate of 97% in December 2022.9 In contrast, between January and July 2021, the average monthly redemption rate ranged from just 7% to 43%10 and from 43% to 67% between July and November 2021.11 A high redemption rate complicates the completion of business combinations as SPACs have less cash to satisfy any minimum cash conditions. High redemptions also result in decreased cash proceeds for the combined company’s future operations.
Potential private investment in public equity (PIPE) investors have been more cautious and selective given the number of SPACs still looking for a target and the post de-SPAC performance issues of many newly combined companies. This has exacerbated the issues noted above and has also led to a deviation from the traditional $10 per common share PIPE transaction structure, with some PIPE investors receiving warrants in addition to common stock, and SPACs issuing convertible debt and preferred stock to provide investors with more certain returns. There has also been a rise in instances of PIPE investors consisting solely of SPAC sponsors, target insiders and their respective friends and family, or investors with business or commercial relationships with the target.
On 30 March 2022, the SEC approved the issuance of proposed SPAC rules. These include (i) new disclosure and financial statement requirements in certain SEC filings, including with respect to financial projections and fairness determinations in de-SPAC transactions; (ii) new registration requirements under the Securities Act for de-SPAC transactions and the elimination of the safe harbour for forward-looking statements under the Private Securities Litigation Reform Act of 1995 for disclosure in those registration statements; (iii) Securities Act liability for underwriters (and other distribution participants who may be viewed as “statutory underwriters”) in de-SPAC transactions; (iv) a 20-calendar day minimum dissemination period for disclosure documents in a de-SPAC transaction; and (v) a safe harbour for SPACs under the Investment Company Act of 1940 that may effectively limit SPACs to an 18-month life. Though the proposed rules aren’t expected to be finalised until April 2023, they have already become embedded in market practice through the investment banks - viewed as “underwriters” or “gatekeepers” - facilitating de-SPACs and because many of the proposals have already been advanced through the SEC comment process. For example, parties in de-SPAC transactions have started undertaking enhanced diligence processes and requiring deliverables similar to those in traditional IPOs, including “Rule 10b-5” negative assurance letters and auditor comfort letters.
Plaintiff interest in SPAC and de-SPAC transactions remains robust and growing, with claims related to SPACs in 2022 on track to surpass 2021. While SPAC activity has declined, litigation is likely to persist due to the numbers of SPAC IPOs and de-SPAC transactions conducted in 2021 and early 2022.
Lawsuits continue to be common with respect to issuance of proxy and registration statements concerning de-SPAC transactions, generally alleging breaches of fiduciary duty or claims under Section 14(a) of the Securities Exchange Act of 1934, as amended (Exchange Act). Plaintiffs often attack alleged conflicts of interest and the structural features of these transactions in addition to disclosure deficiencies. More traditional securities fraud lawsuits have become common after de-SPAC transactions where the stock price falls or the combined company fails to meet projections. Section 10(b) material misstatement or omission claims are also filed against companies acquired by SPACs and begin reporting financial results that are not aligned with prior, more optimistic business projections.
A recent Delaware Chancery Court ruling in January 2023 highlights de-SPAC litigation risks under Delaware law. In Richard Delman v. GigAcquisitions3 LLC et al., the plaintiff alleged that defendants breached their fiduciary duties and were unjustly enriched in connection with the de-SPAC transaction by issuing a false and misleading proxy statement that did not accurately disclose the net cash per share to be invested in the target. The court denied the SPAC’s motion to dismiss and held that the de-SPAC transaction is subject to entire fairness review. In addition to holding that the proxy statement was materially false and misleading, the court also indicated that the de-SPAC transaction was not entirely fair to the SPAC’s public shareholders, as (i) the sponsor’s controller and spouse dominated the negotiations with the target; (ii) the SPAC’s financial advisors stood to gain significantly from the consummation of the de-SPAC transaction; and (iii) the board did not receive a fairness opinion.
These litigation trends, together with the SEC’s proposed rules, highlight the importance of vigorous disclosure controls and due diligence throughout the SPAC process.
The severe downturn in the SPAC market, embodied by high redemption rates from investors and a significant narrowing of the SPAC PIPE market, have made it increasingly difficult for many SPACs to identify and complete target acquisitions successfully. After the current wave of “de-SPAC” transactions ends in 2023, we expect the growth of new SPACs to continue to wane. Also, the SEC’s SPAC proposals (particularly in relation to statutory underwriter liability) have had a far-reaching impact on the diligence and disclosure practice of both US-listed and non-US listed SPACs (including those offered and sold to qualified institutional buyers under Rule 144A), but in 2022 these largely became embedded into market practice even though the rules remained at the proposals stage. The enhanced diligence and disclosure practices that have been applied under the proposal rules (in anticipation of their enactment) have narrowed the gaps between a de-SPAC and a traditional IPO such that we believe the de-SPAC route to the public markets will be perceived as less advantageous than a traditional IPO than has been the case in the past.
New interpretation of Rule 15c2-11 – extension to Rule 144A debt offerings
Rule 15c2-11 under the Exchange Act sets out certain requirements for US broker-dealers seeking to initiate (or resume) quotations for securities trading in the US over the counter (OTC) market, also known as the “pink sheets”. Historically the rule applied only to equity securities that trade in the pink sheets. In 2020, however, the SEC amended Rule 15c2-11 to require, among other things, that the documents and information that a broker-dealer reviews to provide or resume quotations generally must be current and publicly available. In the proposing release, the SEC implied (seemingly for the first time) that Rule 15c2-11 also applies to debt securities, including those issued under Rule 144A under the Securities Act. While Rule 144A already requires similar information about the issuer to be made available to investors upon request, not all issuers have made such information publicly available. The amended Rule 15c2-11 interpretation means that any failure by an affected issuer to make relevant information publicly available could lead broker-dealers to not provide quotations for affected 144A bonds, which could materially reduce the secondary market liquidity (and thus the trading price) for such bonds.
In December 2021, the SEC staff issued a no-action letter that affirmed the application of Rule 15c2-11 to debt securities but established a compliance regime over three phases to allow for an orderly and good faith transition to compliance. In response to continued concerns raised by market participants, the SEC staff issued another no-action letter in November 2022 delaying implementation of amended Rule 15c2-11 by two years. In the absence of any further action by the SEC, the new interpretation will apply to 144A bonds from 4 January 2025.
FPIs whose equity is exempt from registration under Rule 12g3-2(b) of the Exchange Act (ie certain non-US companies with equity securities listed on non-US exchanges who publish information distributed to their shareholders and via the exchanges in English on public websites) generally already publish information sufficient to satisfy the public information requirements of Rule 15c2-11. Any issuers who do not already satisfy the public information requirements of Rule 15c2-11 could establish compliance by making relevant information publicly available (eg by posting relevant information on a public website).
For issuances of 144A bonds, offering participants will want to consider the position of the issuer under Rule 15c2-11. For example, the issuer may be asked by underwriters or other agents in the subscription agreement or related documents to provide relevant representations (eg regarding compliance with Rule 12g3-2(b)/Rule 15c2-11 information requirements) and undertakings/covenants (eg to make relevant information publicly available during any period when the issuer no longer has a class of equity securities exempt from registration under Rule 12g3- 2(b)). In the event the issuer is not otherwise compliant with Rule 15c2-11 and is unwilling to make the required information publicly available, the offering participants will want to consider adding appropriate risk factor language to the offering document regarding potential adverse effects on secondary market liquidity. However, we would expect most issuers to take such steps that are required to facilitate the secondary market trading and would recommend that they do so.
Other notable SEC developments
Modernisation of beneficial ownership reporting
In February 2022, the SEC proposed amendments with respect to reporting beneficial ownership on Schedules 13D and 13G, which are aimed to reduce information asymmetries and promote transparency and address the timeliness of key filings. Specifically, the proposed amendments would, among other things: (i) accelerate the filing deadlines for Schedules 13D and 13G; (ii) clarify the circumstances under which two or more persons have formed a “group” for purposes of beneficial ownership reporting; and (iii) expand the definition of beneficial ownership to include certain cash-settled derivative securities. The finalised rules are anticipated to be adopted in April 2023.
Mandatory cybersecurity disclosure rules
In March 2022, the SEC proposed rules that would require public companies to make prescribed cybersecurity disclosures. The proposed rules would strengthen investors’ ability to evaluate public companies’ cybersecurity practices and incident reporting by requiring: (i) the reporting of material cybersecurity incidents within four business days; and (ii) ongoing disclosures about companies’ governance, risk management, and strategy with respect to cybersecurity risks, including board cybersecurity expertise and board oversight of cybersecurity risks.
The proposed rules would apply directly to US-reporting FPIs through Form 6-K and Form 20-F reporting requirements.
FPIs are required to furnish a Form 6-K to report to the SEC any material mandatory public disclosures or disclosures required by their local law, among other disclosure triggers (ie changes of control, significant acquisitions, bankruptcy filings). The proposed rules would add reference in Form 6-K instructions to cybersecurity incidents as a type of event that may trigger the need to furnish a current report on Form 6-K.
Similar disclosures would be required regarding cybersecurity risk management, oversight, governance and incidents in Form 20-F annual reports. The finalised rules are anticipated to be adopted in April 2023.
The SEC’s proposed amendments to its beneficial ownership rules have largely been viewed favourably by the market and consistent with the timing requirements for reporting in other jurisdictions, including Australia. The SEC’s cybersecurity disclosure rules, however, have generated more concern. For US domestic issuers, the requirements for having to report material cybersecurity incidents within four business days may place a significant amount of pressure on issuers to accelerate their materiality for such incidents. US-listed FPIs have the benefit of not having to report material cybersecurity incidents on a Form 6-K until it has been otherwise reported publicly or is required to be disclosed by foreign securities laws to which the issuer is subject. Nevertheless, the reporting rules that are likely to become applicable to domestic issuers will likely inform, at least in part, the market practice for FPIs as well.
- See Agency Rule List – Fall 2022, Securities and Exchange Commission, Office of Information and Regulatory Affairs, https://www.reginfo. gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST¤tPub=true&agencyCode=&showStage=active &agencyCd=3235&csrf_token=3B44E0FF19F8A07EFF228DE7155F7E062EAF175D233CCA0D724F4FBC7B2AA8C1A7E9722897EE598 2C223B2924DCED2621F24 (last visited 1 February 2023).
- Anderson et al. v Binance et al. (2022 WL 976824 (S.D.N.Y., 31 March 2022)).
- Williams et al. v. Block.One et al. (2022 WL 5294189 (S.D.N.Y., 13 August 2022)).
- Audet v. Fraser (2022 WL 1912866 (D.Conn., 3 June 2022)).
- See SPACInsider, SPAC Statistics, https://www.spacinsider.com/data/stats (last visited 25 January 2023).
- See Michael O’Connor, Annie Sabater and Darakhshan Nazier, SPAC offerings, deals fall to pre-surge levels, S&PGLOBAL (14 November 2022), https://www.spglobal.com/ marketintelligence/en/news-insights/latest-news-headlines/spac-offerings-deals-fall-to-pre-surge-levels-72960244.
- See CBInsights, What is a SPAC? (5 April 2022), https://www.cbinsights.com/research/report/what-is-a-spac/.
- See David Drapkin, SPAC Market Review – December 2022, BOARDROOMALPHA (3 January 2022), https://www.boardroomalpha.com/spac-market-review- december-2022/.
- See Roger E. Barton, High redemption rates see SPACs relying on alternative financing, REUTERS (14 January 2023), https://www.reuters.com/legal/transactional/ high-redemption-rates-see-spacs-relying-alternative-financing-2022-01-14/.