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From Securities Regulation Daily, October 6, 2017

Treasury capital markets report echoes much of CHOICE Act but with some nuances

By Mark S. Nelson, J.D.

The Treasury Department published its recommendations for capital markets oversight as part of its second report on the core principles for financial regulation outlined in an executive order issued earlier this year. Those principles focus on independent investor decision making, avoiding bailouts, promoting economic growth, promoting competition, promoting U.S. interests, tailoring regulations, and holding federal financial regulators accountable. The report (FAQ) contains many recommendations on a range of topics, including access to capital, securitization, and derivatives. Treasury issued its first report on the core principles in June.

Expanding access to capital. Many of the report’s goals for capital raising mirror those already proposed in the House-passed Financial CHOICE Act, although the report in some instances leaves its recommendations open-ended or provides nuance versus existing legislative proposals. With respect to access to capital, the report coalesces around the following:

  • Specialized disclosures—The report largely follows the CHOICE Act’s provisions that would repeal the Dodd-Frank Act’s authorities for the conflict minerals rule, the mine safety rule, the resource extraction issuers rule (the rule itself was disapproved by Congress), and the pay ratio rule. The report’s rationale is that these disclosures are not material to the workings of public companies. But the report also noted that with respect to pay ratio disclosures (now finalized with forthcoming disclosures for the first fiscal year beginning on or after January 1, 2017), the Jumpstart Our Business Startups (JOBS) Act had already exempted smaller reporting companies, and that the SEC should step in with broader exemptive relief if Congress does not enact related legislation. The SEC recently issued interpretive guidance on the pay ratio rule.
  • Regulation S-K—Regulation S-K has been the subject of an ongoing disclosure effectiveness review dating to former Chair Mary Jo White’s tenure. The report urges the Commission to move forward with a proposal to implement Regulation S-K changes under the Fixing America’s Surface Transportation (FAST) Act. The Commission had already scheduled an open meeting for October 11 to make that proposal before Treasury published its report.
  • Testing the waters—According to the report, the SEC’s recent expansion of its confidential submissions process for emerging growth company (EGC) registration statements to nearly all companies suggests a need to similarly expand which companies may test the waters ahead of an offering. The report recommends letting all companies, not just EGCs, test the waters with qualified institutional buyers and accredited investors. The report characterized the SEC’s broader use of confidential staff reviews of IPOs as a "positive step."
  • Proxy advisers—The relatively compact group of large proxy advisory firms has piqued some lawmakers’ attention in recent years as companies voiced concerns that such firms have potentially outsized influence on shareholder voting and potential conflicts of interest. The CHOICE Act includes proxy adviser registration requirements that were initially proposed by Rep. Sean Duffy (R-Wis). While the report cites a GAO study on the growing concerns about proxy advisers, the report does not take a set position and instead recommends further study.
  • Shareholder proposals—Reform of the SEC’s shareholder proposal process in Exchange Act Rule 14a-8 prompted Treasury to express concerns about the $2,000 holding amount and resubmission thresholds, but produced no specific recommendation. Currently the resubmission thresholds are fixed at 3-, 6-, and 10 percent; the CHOICE Act would re-set these thresholds at 6-, 15-, and 30 percent. The report recommends only that the thresholds be "substantially revised." Keith Higgins, chair of Ropes & Gray LLP's securities and governance practice and former Director of the SEC’s Division of Corporation Finance, recently blogged about freshening the resubmission thresholds, which he said are "too low." Higgins said that the proper threshold would be near to the CHOICE Act provision, which mirrors the SEC’s failed proposal from years ago (See also, Commissioner Wallman’s concurrence to the SEC proposal, noting that the proposed resubmission thresholds "…will rise to the very high level of 30% in the third year -- without any practical benefits being provided in return to a large percentage of the proponents"). The U.S. Chamber of Commerce also has called for shareholder proposal reforms.
  • Securities class actions—The report observed that securities class actions have increased in number during the past several years and that this may act as a drag on new IPOs. The report urged the SEC to mull ways to cut the costs of these suits, including by allowing arbitrated settlements.
  • Dual class stock—In recent years, a number of prominent companies adopted dual class share structures, ostensibly to ensure that their founders remain in control. Although the report concedes that state laws generally govern companies’ internal affairs, Treasury still recommended that the SEC use its staff comment letter filing review process to ask companies to make fulsome disclosures about dual share structures and how these structures impact investors.
  • Smaller reporting companies—Exchange Act Rule 12b-2 defines "smaller reporting company" to mean a company with under $75 million in public float (annual revenues under $50 million if its public float is zero). The report recommends increasing the public float threshold to $250 million.
  • Longer EGC on-ramp—According to the report, EGCs need a longer IPO on-ramp of up to ten years. The recommendation is similar to the Fostering Innovation Act of 2017 (H.R. 1645), sponsored by Rep. Kyrsten Sinema (D-Ariz), which is slated to be marked up by the House Financial Services Committee October 11.
  • Broker-dealers and analysts—Treasury noted lingering differences between broker-dealers subject to the Global Settlement and those subject to other SEC rules. The report recommends harmonizing the treatment of broker-dealers with respect to analysts. The report cited evidence that some smaller companies are unable to obtain sell-side research coverage, although it suggested several factors may be at work, including industry consolidation.
  • Regulation A+—Treasury expressed concern over the need to lower the cost of capital. To this end, the report urges the expansion of Regulation A to Exchange Act reporting companies. If enacted, H.R. 2864, another bill sponsored by Rep. Sinema, would achieve this by providing that compliance with the Exchange Act’s reporting requirements would satisfy Regulation A’s Rule 257; the bill passed the House in September by a vote of 403-3. The report also urges steps to promote a secondary market for Regulation A Tier 2 securities as exemplified by a recent study published by the SEC’s Division of Economic and Risk Analysis discussing primary market capital raises and secondary market liquidity. To this end, the report would have states exempt secondary trading in Tier 2 securities; otherwise, the report urges the SEC to preempt applicable state registration requirements. The report also recommends raising the Tier 2 limit from $50 million to $75 million.
  • Crowdfunding—The report made a number of recommendations to expand crowdfunding. For one, the SEC should revise Regulation Crowdfunding to adopt the "greater of" approach to investor limits. In a change from the proposal, the SEC’s final rules applied the investor limits across all crowdfunding offerings using the "lesser of" instead of the "greater of" approach. Second, the report recommends raising the amount of securities that can be offered in a 12-month period from $1 million to $5 million, as bills introduced in Congress have previously sought to do. Moreover, Treasury suggested that women entrepreneurs’ success at raising funds on non-equity-based crowdfunding platforms could be reproduced in the equity-based crowdfunding setting if Regulation Crowdfunding is expanded to a wider audience, but the report also observed that crowdfunding of any type is not a substitute for traditional venture funding.
  • Finders—The report recommended that the SEC, the Financial Industry Regulatory Authority, and state regulators develop a framework for dealing with finders. Finders occupy a legally fraught corner of the broker-dealer market because they engage in match-making activities which, if they are not careful, can result in them acting as unregistered broker-dealers. The American Bar Association’s Business Law Section Annual Meeting recently addressed the legal predicament of finders.

Securitization. Lax underwriting contributed to the Great Recession, so when Congress considered the Dodd-Frank Act, it included provisions requiring the SEC and other federal financial regulators to adopt rules imposing credit risk retention requirements (i.e., skin-in-the-game). While the Treasury report characterized these rules as "an imprecise mechanism" to achieve the desired link between sponsors and investors, the report shied away from recommending repeal of the Dodd-Frank Act provision.

Rather, the report called for a single lead regulator to handle future revisions to the existing risk rules. The report also recommended, among other things, that regulators adopt a qualified exemption from the rules for collateralized loan obligations and that banking regulators expand exemptions for a variety of asset classes through formal rulemaking.

Derivatives. The Dodd-Frank Act’s Title VII derivatives provisions required the SEC, the CFTC, and banking regulators to create a new regulatory regime for the diverse collection of financial instruments that are derivatives and swaps. The central theme of the Treasury report is harmonization of U.S. rules and cooperation by U.S. derivatives regulators with their overseas counterparts.

  • LIBOR replacement—The report commended the Alternative Reference Rates Committee’s effort to adopt the secured overnight financing rate as a substitute for LIBOR. The ARRC issued an FAQ with one of its interim reports in which it noted that the new rate could be expanded beyond the overnight rate.
  • SEC-CFTC harmonization—Overall, the report recommends that the SEC and the CFTC work to harmonize their respective derivatives rules and cut redundant provisions while also avoiding "distortive effects" on markets and "duplicative and inconsistent" compliance regimes. Treasury urged the SEC to finish its derivatives rules. The report also urged federal agencies to mull "alternative compliance regimes" such as interagency substituted compliance or mutual recognition.
  • CFTC guidance—According to the report, the CFTC’s extensive guidance on derivatives and swaps was necessary to establish its regulatory regime under the Dodd-Frank Act reforms, but the time has come for the CFTC to make portions of its guidance permanent through formal rulemaking. The report said this would have the added benefit of a fresh cost-benefit analysis. The report also noted that before the Dodd-Frank Act, the CFTC rarely used no-action letters and interpretive guidance, while also noting that these tools can be prone to regulatory capture, can diminish the quality of the agency’s rules, may impose new substantive requirements, and may lack certainty. The report recommends that the CFTC review its derivatives and swaps guidance to determine which provisions should be made permanent.
  • Margin for uncleared swaps—Here again, the report calls for both U.S. regulatory harmony and harmonization between U.S. and overseas regulators. U.S. regulators should "cooperate" with countries that follow the BCBS-IOSCO framework. U.S. banking regulators should consider an exemption from initial margin requirements for uncleared swaps for affiliate transactions. And the SEC should re-propose its rules in order to achieve harmony with the CFTC and bank regulators.
  • Position limits—Treasury also recommended that the CFTC finish its rules on position limits. According to the report, "[a]ppropriately tailored" rules can protect market participants from unscrupulous actors. But the CFTC also should establish a bona fide hedging exemption for end users; the agency also could explore a risk management exemption.
  • SD de minimis threshold—The swap dealer de minimis threshold currently rests at $8 billion, but that amount will fall to $3 billion in December 2018 when the current extension lapses. The report urges the CFTC to retain the $8 billion threshold and make further changes to it via formal rulemaking.

"Our team at the CFTC was actively engaged with Treasury in the preparation of this report, and we are pleased to see our perspective incorporated in the final product," said CFTC Chairman J. Christopher Giancarlo. The agency’s two newest commissioners also expressed a desire to work towards a better derivatives and swaps regime. Commissioner Rostin Behnam suggested "carefully targeted regulatory adjustments," while Commissioner Brian Quintenz urged fellow regulators to "get the oversight of these markets right."

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