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The year in review
Debt and equity markets in the United States had a strong run in 2020 and 2021, despite the covid-19 pandemic.3 Markets turned in 2022 and were more volatile. The S&P 500, an equity index of the largest companies listed on US exchanges, fell more than 31 per cent from January to mid-June, before recovering more than 17 per cent from that low point and then falling back more than 16 per cent by the end of September.4 Weaker equity markets have led to fewer initial public offerings (IPOs). From 1 January to 30 September 2022, 156 IPOs raised US$20.4 billion of proceeds5 compared to 470 IPOs in 2020 raising US$156.9 billion of proceeds6 and 1,025 IPOs in 2021 raising US$351.7 billion of proceeds.7 In 2019, prior to the pandemic, there were 220 IPOs raising US$62.8 billion of proceeds.8 IPO activity was especially strong in 2020 and 2021 because of a surge in IPOs of special purpose acquisition companies (SPACs) from a couple of dozen each year to 248 in 2020 and 613 in 2021.9 The SPAC market cooled in 2022. There were 77 SPAC IPOs from 1 January to 30 September 2022, 44 of which had initially filed before the start of the year.10
After treating increasing inflation as transitory during 2021, the Federal Reserve reversed course in early 2022 and aggressively increased interest rates. Debt capital markets have been more muted in this higher interest rate and volatile environment, with US$1,142 billion raised in new issuances of corporate debt securities from 1 January to 30 September 2022, compared to US$1,580.6 billion for the corresponding period in 2021.11
During 2022, the SEC and other regulators continued to pursue their regulatory agendas, reflecting the priorities of the Biden administration.
Two of the SEC’s five commissioners changed in 2022. Republican commissioner Elad Roisman resigned as of 30 January 2022. Mark Uyeda, a Republican who has served on the SEC staff since 2006, was sworn in on 30 June 2022 as a commissioner with a term expiring in June 2023. Democratic commissioner Allison Herren Lee’s term expired in June 2022. She announced in March 2022 that she would step down from the Commission upon confirmation of her successor. Jaime Lizárraga, a Democrat and most recently senior adviser to the Speaker of the House of Representatives, was sworn in as a commissioner on 18 July 2022. The SEC continues to be composed of three Democratic and two Republican commissioners, as required by a rule specifying that no more than three commissioners may belong to the same political party.
Chair Gensler continued to advance his regulatory agenda with a flurry of rule-making proposals. Many of these proposals will likely be brought before the SEC for finalisation over the remaining two years of President Biden’s term, indicating a period of significant regulatory change.12 The SEC released notice of its regulatory agenda in June 2022, which includes:
An emerging theme in Chair Gensler’s rule-making is a movement from existing disclosure requirements based on materiality to prescriptive disclosure requirements on topics that the SEC considers by their nature to be material to investors.
The Republican commissioners have criticised Chair Gensler’s regulatory agenda, which they claim focuses on ‘hot-button’ issues on the periphery of the SEC’s mandate, fails to focus on retail investors, generally adds further regulation to the capital formation process and omits core regulatory issues for cryptoassets. The Republican commissioners also criticise the speed and volume of proposed rule-makings, and particularly that the SEC would revisit topics for which it has passed rules in the past two years.14
Russia’s invasion of Ukraine and the evolving international response impacted a range of businesses. On 3 May 2022, the SEC staff released a sample letter of comments the staff may make to issuers about their potential disclosure obligations under the securities laws concerning the invasion.15 The primary areas for disclosure identified in the letter were: (1) exposure to Russia, Belarus or Ukraine through operations, employees, investments, securities traded in Russia, sanctions against Russian or Belarusian individuals or entities or legal or regulatory uncertainty associated with operating in or exiting Russia or Belarus; (2) reliance on goods or services sourced in Russia or Ukraine, or in countries supportive of Russia; (3) disruptions in the company’s supply chain; or (4) business relationships, connections to, or assets in, Russia, Belarus or Ukraine. Specific disclosure issues set out by the staff include impacts on the business, including reactions of investors, employees, customers or other stakeholders and potential impacts of government nationalisation of assets; risks of cyberattacks; changes in cash flows and liquidity; additional uncertainties in critical accounting estimates, such as asset impairments, bad debts or revenue recognition; impacts of import or export bans and supply chain disruptions; inappropriate adjustments to accounting revenue or expenses; and changes to disclosure controls and procedures.
In August 2022, the SEC finalised a rule requiring disclosure in proxy statements of information showing the relationship between executive compensation actually paid and financial performance of the issuer.16 The rule was long awaited: the rule was mandated in 2010 by the Dodd-Frank Wall Street Reform and Consumer Protection Act, initially proposed by the SEC in 2015 and then the comment period reopened by the SEC in February 2022.17
The final rule adds to Item 4.02 of Regulation S-K a requirement for tabular disclosure for each of the past five years of the principal executive officer’s total compensation and average compensation for other named executive officers as reflected in the summary compensation table already required by Item 4.02 and a new ‘executive compensation actually paid’ measure for the principal executive officer and the average for other named executives. This measure is calculated as total compensation adjusted for certain items related to defined benefit and actuarial pension plans, option awards and stock appreciation rights. Four financial performance metrics must be set out: total shareholder return for the issuer, total shareholder return for a group of peers, the issuer’s net income and a ‘company-selected measure’ that the issuer considers is the most important financial performance measure to link compensation actually paid to its executive officers to company performance. The rule also requires a description of the relationship between executive compensation and the company performance measures included in the table and a comparison of the issuer’s cumulative total shareholder return to that of the peer group, in each case, across the years presented. The description must also include three to seven financial performance measures representing the most important financial performance measures used by the issuer to link compensation actually paid to the executive officers to company performance for the most recent year.
The new rule applies to fiscal years ending on or after 16 December 2022, meaning most public companies with a 31 December year-end would be required to comply with the new rule in 2023.
The SEC and staff each released guidance over the past decade about how existing disclosure requirements apply to cybersecurity matters.18 In March 2022, the SEC proposed formal rules about disclosure of cybersecurity risk management, strategy, governance and incidence reporting by public companies. Proposing formal rules reflects the SEC’s concerns about the growing proportion of business activity occurring through digital technology and electronic communications and the escalating significance of cybersecurity threats and incidents. The SEC was also concerned that disclosure by public companies may contain insufficient detail, be inconsistent, not be timely, be difficult to locate and not be comparable across issuers.19
The SEC’s proposed amendments to ‘enhance and standardise’ these disclosures include:
In March 2022, the SEC proposed rules mandating disclosure of climate-related information in registration statements for securities offerings and periodic reports, including additional information in financial statements.20 The SEC released guidance in 2010 on how existing disclosure requirements may require an issuer to disclose climate-related information in its filings.21 The SEC expressed concern in its guidance and the proposed rule about the consistency and comparability of climate-related disclosures because issuers often voluntarily disclose climate-related information outside of their SEC filings and based on differing third-party frameworks. The SEC’s proposed rule aims to establish a single framework for issuers within the liability regime applicable to SEC filings. The SEC proposals draw from frameworks developed by the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol (GHG Protocol). The proposed non-financial disclosures require a section of registration statements and periodic reports headed ‘Climate-Related Disclosure’ that includes:
An issuer will also be required to disclose its ‘Scope 1’ and ‘Scope 2’ greenhouse gas emissions and may be required to include an attestation report covering these disclosures from a greenhouse gas emissions attestation provider. Scope 1 emissions are emissions from operations owned or controlled by the issuer. Scope 2 emissions are indirect emissions from energy consumed by such operations. An issuer is required to disclose its ‘Scope 3’ emissions if they are material or if the issuer has set an emissions reduction target covering Scope 3 emissions. Scope 3 emissions are other emissions occurring in the upstream or downstream activities of the issuer’s value chain. An attestation report would not be required for Scope 3 emissions.
The financial statement disclosures required under the proposed rule include:
Special purpose acquisition companies (SPACs) first appeared in the US capital markets in the 1990s and usually accounted for a small minority of IPOs. The volume of SPAC listings soared in 2020 and 2021. There were 248 SPAC IPOs in 2020 and 613 SPAC IPOs in 2021.22 SPACs have been touted as a faster, more flexible path to listing compared to traditional IPOs that would expand investment opportunities while allowing SPAC sponsors and underwriters to earn significant returns. But the recent performance of many SPACs and companies taken public by merging with a SPAC during this period has fallen short of expectations for investors and sponsors.
A SPAC starts as a newly formed shell company with no assets. A sponsor contributes ‘at-risk’ capital to fund the SPAC’s initial activities in exchange for warrants and a ‘promote’ generally comprising 20 per cent of the SPAC’s common stock. The sponsor generally forfeits its warrants and promote if the SPAC fails to complete an initial business combination within 24 months. The SPAC issues its remaining common stock and warrants to public investors in an IPO, though the right to vote on directors is typically wholly retained by the sponsor until after the business combination. Because a SPAC will initially have no business operations to describe, and most SPAC IPOs have similar terms, the SEC review of a SPAC’s IPO registration statement can be completed quickly (typically within two or three months) or the SEC staff might not review a SPAC’s IPO registration statement at all. Proceeds of the IPO are deposited in a segregated trust account with an independent trustee pending the business combination, redemption by public shareholders or liquidation of the trust account. Proceeds are usually invested in government treasury obligations or money market funds that invest in these obligations. After its IPO, the SPAC hunts for a target for its initial business combination. The SPAC’s management negotiates the terms of the business combination, including the price. Following execution of a definitive business combination agreement by the target and the SPAC, the SPAC files a preliminary proxy statement or registration statement on Form S-4 or Form F-4 (which includes a preliminary proxy statement and prospectus) to solicit the public shareholder approval of the business combination and register the exchange of securities in the business combination. The proxy statement or registration statement for the business combination is subject to close review by the SEC staff and often requires at least two or three amended preliminary filings to address all of the SEC staff’s comments. Once SEC review is complete, the SPAC files a definitive proxy statement (or proxy statement/prospectus) that is mailed to its public shareholders, and a special meeting of SPAC shareholders is held to approve the business combination and related proposals. If approved at the special meeting, the business combination is typically consummated shortly thereafter, and the target continues operations as a listed public company. Public investors can decline to participate in the business combination by selling their shares or warrants, or by electing for the issuer to redeem their shares. Investors who redeem their shares receive their initial proceeds plus investment returns earned on the proceeds in the trust account. This redemption risk requires the SPAC to arrange backstop financing for the business combination, which is typically a private-investment-in-public-equity (PIPE) commitment.
This year has been sobering for SPACs. There have been significantly fewer SPAC IPOs. The shares of many SPACs that completed their initial business combination in 2020 and 2021 are trading at prices significantly below their initial offering price. Many SPACS are yet to complete their initial business combination at all. As of 31 August 2022, there were 565 SPACs still seeking an initial business combination.23 These SPACs and their sponsors are running out of time, and some are pursuing extensions, which typically involves the sponsor or another party depositing additional funds into the trust account for the benefit of the public investors. Even after finding a target, many SPACs are struggling to close the deal. Recent SPAC business combinations have experienced high levels of public shareholder redemptions, leaving little trust account proceeds to finance any cash consideration payable in the acquisition, pay transaction expenses or fund the target’s balance sheet. The PIPE market has faced significant illiquidity challenges, leaving few options for backstop financing apart from expensive convertible preferred or debt financing arrangements. Some sponsors are offering part of their promote to entice public investors to stay in the deal and not exercise their redemption rights.
Part of the change in mood for SPACs may reflect a view that the current structure is too favourable for the sponsor. The sponsor generally receives 20 per cent of the SPAC’s equity for a nominal amount. The perception of some observers is that sponsors can still win even if the target and terms of the initial business combination mean public investors lose. The large supply of SPACs trying to complete their initial business combination in the near-term may also find limited suitable acquisition target opportunities.
Another factor contributing to the slower SPAC market is the SEC’s regulatory actions. The SEC staff saw potential pitfalls for investors, and, as SPAC IPOs boomed, the SEC’s response became increasingly assertive and chilled the market from time to time. The SEC accounting staff twice released statements challenging accounting practices for aspects of the SPAC structure. The first statement challenged the accounting classification of warrants typically issued by SPACs as equity rather than liabilities.24 This led to a period of determining whether the SPAC structure should be revised, SPACs having to determine whether they could undertake transactions based on their existing financial statements, and a wave of restatements of SPAC financial statements. The second statement notified auditing firms that the redemption features in public shares issued by SPACs in their IPOs meant that the shares should be classified as temporary equity rather than permanent equity. A consequence of this accounting change was that SPACs did not meet the minimum shareholders’ equity requirement to be eligible to list on the Nasdaq Capital Market (NCM), so SPACs looking to list on the Nasdaq were required to list on the higher Nasdaq Global Market tier.
In March 2022, the SEC proposed wide-ranging rules and amendments relating to SPACs, shell companies and the use of projections in SEC filings that, if finalised, would reshape the regulatory landscape for SPACs.25 The proposed rules and amendments address concerns previously raised by the SEC staff about the SPAC structure, including:
The overall themes of the proposed rules include eliminating a perceived ‘regulatory arbitrage’ for a private company to list by merging with a SPAC rather than undertaking a traditional IPO and improving transparency of the sponsor’s incentives and potential conflicts of interest. The SEC’s rule proposal is yet to be finalised, but the potential for heightened liability has tempered enthusiasm for participation in SPAC transactions, particularly for investment banks.
In August 2022, the Inflation Reduction Act of 2022 introduced a new 1 per cent excise tax on stock repurchases and redemptions by certain domestic public companies.26 A US-incorporated SPAC may be required to pay the tax for redemptions by public shareholders even though redeeming shareholders are generally recovering their investment plus any interest earned. The SPAC might be able to offset the tax on some or all of such redemptions if they occur in the same taxable year that the SPAC undertook its initial public offering or PIPE investment. The tax might also apply in the case of a SPAC extension vote or the liquidation of a SPAC that is unable to complete an initial business combination.
US regulators continued to make substantial progress with the replacement of US dollar LIBOR as a floating rate benchmark with the Secured Overnight Financing Rate (SOFR). Further developments on changes in the replacement of LIBOR are discussed below under ‘US regulators have taken actions related to the LIBOR discontinuation’.
In recent years, US regulatory changes in relation to derivatives, securitisations and other structured products have been focused on rule changes mandated by the Dodd-Frank Act, including Section 619, commonly known as the Volcker Rule. There has also been focus on financial markets’ transitioning from LIBOR as the principal benchmark for floating interest rates. Following the 2020 presidential election and the resulting change in administration and follow-on leadership changes at the SEC and other regulatory authorities, actual rule-making and other policy initiatives related to derivatives, securitisations and other structured products have been limited, as the related regulatory agenda looking forward has evolved.
The Volcker Rule comprises statutory provisions and implementing regulations that restrict banks from engaging in proprietary trading and from acquiring ownership interests in, or sponsoring, hedge funds, private equity funds and certain other private issuing entities – defined as ‘covered funds’. Following a significant series of amendments completed in July 2020, the SEC, the Federal Reserve Board (FRB) and other US federal agencies charged with administering the Volcker Rule have paid little attention in 2022 to amending the rule further.
Since their effective date several years ago, the rules implementing the Exchange Act’s risk retention requirements have not been amended. Court cases have also been quite limited in that time. As with the Volcker Rule, the SEC, the FRB and other US federal agencies charged with administering the US risk retention requirements have given little concrete attention to those requirements in 2022.
US dollar LIBOR will be discontinued as a floating-rate benchmark, as has already been the case with IBORs in other currencies. The challenge for the US market has been twofold: (1) migrating hundreds of trillions of dollars of existing financial products from LIBOR to robust replacement rates before LIBOR ceases to be published on a representative basis for all tenors after 30 June 2023; and (2) encouraging market participants to embrace robust replacement rates for new financial products. US regulators have taken various actions to facilitate US dollar LIBOR discontinuation. In 2014, the FRB and the Federal Reserve Bank of New York (FRBNY) established the Alternative Reference Rates Committee (ARRC), a group of financial market participants that has largely guided the transition away from US dollar LIBOR in cash markets through its publication of a paced transition plan, various best practices and fallback language for different types of cash products. By contrast, the International Swaps and Derivatives Association (ISDA) has taken the lead on transition efforts for derivatives contracts, including the standardisation of fallback language through its IBOR Fallbacks Protocol and IBOR Fallback Supplement.
In 2017, the ARRC endorsed the Secured Overnight Financing Rate (SOFR) as its recommended alternative for US dollar LIBOR in various financial contracts. SOFR is a broad measure of the cost of borrowing funds in overnight transactions that are collateralised by US Treasury securities and is calculated daily by the FRBNY based on transaction-level repo data for overnight repos collected from various sources. Because SOFR is based on a large volume of secured funding transactions, it has been supported by the ARRC as a robust and less manipulable alternative to LIBOR. Multiple variants of SOFR-based rates have emerged for use in financial markets, including overnight SOFR (which can be averaged in a simple form or compounded), published SOFR averages and forward-looking term rates. The ARRC has published conventions and best practices for the use of these different variants in financial contracts.
In July 2021, the ARRC formally recommended CME Group‘s forward-looking term SOFR rates (Term SOFR Rates) as the replacement for US dollar LIBOR for certain purposes.27 As a result, many existing financial contracts with US dollar LIBOR obligations (i.e., cash market products) that incorporate ARRC-recommended hardwired fallback language are expected to transition to Term SOFR Rates at the LIBOR replacement date under the contract, though notably the ARRC’s recommendation will generally not affect existing LIBOR swaps that include ISDA fallback language (because it does not refer to Term SOFR Rates). Other fallback provisions may operate differently to result in a conversion to a different SOFR variant or to a different non-LIBOR rate.
Recognising that numerous existing US dollar-based contracts include no or deficient fallback language, US legislators enacted a law on 15 March 2022 to address a broad range of obligations that have rates determined by reference to US dollar LIBOR that have no fallback rate provisions or have fallback rate provisions that will not work as intended after US dollar LIBOR is discontinued.28 The effect of the legislation on covered obligations will be either to automatically replace LIBOR with a SOFR-based rate identified by the FRB or, if the obligation designates a person to select an alternative benchmark, to authorise that person to select the applicable SOFR-based rate as the LIBOR replacement and, in each case, to provide conforming changes. The federal legislation provides a litigation safe harbour to certain specified contract parties where the statutory replacement identified by the FRB replaces LIBOR as described in the statute. The federal legislation further provides that it supersedes similar state laws, including a similar New York law enacted in April 2021. A regulation to implement the federal law is expected to provide further clarity on the legislation following a comment period. It remains to be seen whether the FCA will compel the ICE Benchmark Administration (LIBOR’s administrator) to publish a non-representative ‘synthetic’ LIBOR for a period of time after 30 June 2023, which could extend the remediation period for contracts with no or inadequate fallback language that are not covered by the US legislation, namely non-US law-governed contracts that reference US dollar LIBOR.
Regulators have also played a role in reducing the use of LIBOR in new financial contracts. For instance, US banking regulators encouraged supervised banks to cease US dollar LIBOR issuances after 31 December 2021. The ARRC has stated its support for the use of Term SOFR Rates (in addition to other forms of SOFR) for new business loan activity, and the US loan market (particularly the syndicated loan market) has gravitated towards Term SOFR Rates in new issuances. The ARRC has also recognised that Term SOFR Rates may be appropriate for certain new securitisations that hold underlying business loans or other assets that reference Term SOFR Rates and where those assets cannot easily reference other forms of SOFR. However, for other new floating rate contracts, the ARRC has recommended, as a general principle, that market participants use overnight SOFR and SOFR averages rather than Term SOFR Rates. The ARRC has stated that the following kinds of new transactions should use overnight SOFR and SOFR averages rather than Term SOFR Term: floating rate notes; consumer products (including adjustable rate mortgages and student loans); and most securitisations (subject to certain exceptions). In addition, the ARRC does not support the use of Term SOFR Rates for the derivatives markets (with narrowly limited exceptions).
During 2022, US federal courts have rendered decisions of interest to capital markets practitioners, some of which are discussed below. An important issue continues to be the extraterritorial application of US laws and the jurisdictional reach of US courts.
Since the decision in Morrison v. National Australia Bank,29 US courts have typically held that foreign issuers whose securities are represented and traded in the United States as American depositary receipts (ADRs) or American depositary shares (ADSs) cannot be sued under Section 10(b) of the Securities Exchange Act and Rule 10b-5 by purchasers or sellers of a company’s stock traded abroad but can be sued by buyers or sellers of ADRs30 if the suit is based on a purchase or sale on a US exchange or that otherwise takes place in the United States (such as an over-the-counter (OTC) trade or private placement in which the parties commit to the trade within the United States). However, those cases have typically addressed sponsored ADR facilities, in which there could be no question of the foreign issuer’s involvement.
In 2016, the decision of the US District Court in Stoyas was the first to expressly rule on how Morrison applies to unsponsored ADR facilities. The defendant, Toshiba, had only stock listed on the Tokyo and Nagoya exchanges and ADRs traded on US OTC markets – specifically, OTC Link – through an unsponsored ADR facility set up without the involvement of the company; it did not list or trade any securities in the United States.31 The plaintiffs in Stoyas argued that it was enough that the issuer had complied with disclosure requirements in Rule 12g3-2 (an exemption from Exchange Act registration for foreign-listed issuers) ‘and never objected to the sale of its securities in the United States’.32 The Ninth Circuit described the unsponsored ADR issuance as ‘without Toshiba’s “formal participation” and possibly without its acquiescence’.33
The Stoyas court held that a foreign issuer’s lack of involvement in the unsponsored facility means it cannot be sued in the United States for statements that it made to the markets overseas.34 On appeal in 2018, the Ninth Circuit reversed, holding that an issuer can be sued by purchasers of ADRs through an unsponsored facility.35 The Ninth Circuit declined to decide, as to Morrison‘s reference to Section 10(b) covering domestic exchanges,36 whether OTC Link is a domestic exchange, but disagreed with the District Court that only national securities exchanges, as defined in the Exchange Act, qualify under Morrison. Additionally, the Ninth Circuit criticised the Second Circuit’s reasoning in ParkCentral and concluded that the Exchange Act covers any ADR transaction in the United States regardless of whether the facility is sponsored.37 However, that was not the end because the Ninth Circuit concluded that a claim could be stated only if there were sufficient facts pleaded to show a sufficient connection between the issuer and the transaction – a requirement that may in practice insulate some foreign issuers who had no involvement in an unsponsored ADR facility.38 The Ninth Circuit sent the case back to let the plaintiffs plead more facts on this point.39 It did not, however, suggest that investors other than ADR purchasers could ever sue.
On 14 January 2019, the Supreme Court invited the Solicitor General to file an amicus brief in the Stoyas case to express the views of the United States.40 The Solicitor General submitted the amicus brief in May 2019, urging the Supreme Court to deny certiorari. In its brief, the Solicitor General argued that the Ninth Circuit’s holding in Stoyas was correct because the Section 10(b) claim at issue originated from a domestic transaction under Morrison.41 Therefore, in the Solicitor General’s opinion, Stoyas did not represent ‘an impermissible extraterritorial application of Section 10(b)’ because neither party disputed that the purchases of the unsponsored ADRs took place in the United States.42 The Solicitor General also agreed with the Ninth Circuit, however, that the case should be remanded to allow for factual development.
On 24 June 2019, the Supreme Court denied certiorari in the Stoyas case, allowing the Ninth Circuit’s decision to stand and the case to be remanded for further development of the facts.43
On remand, the District Court denied Toshiba’s motion to dismiss.44 The court found that the complaint pleaded sufficiently that the ADRs were purchased in domestic transactions, meaning that ‘the parties incurred irrevocable liability within the United States’,45 based on the complaint’s allegations ‘regarding the location of the broker, the tasks carried out by the broker, the placement of the purchase order, the passing of title, and the payment made’.46
The District Court also applied the Ninth Circuit’s ‘in connection with’ language to address the nature of the non-US issuer’s involvement or lack of involvement in the establishment of the unsponsored ADRs. The District Court found that there were sufficient facts pled to support that Toshiba provided some consent to or participated in the establishment of the ADRs even if Toshiba had not actually sponsored the ADR programme.47
The case continues to proceed before the District Court. The plaintiffs moved to certify the class, which the defendants opposed. On 7 January 2022, the District Court denied class certification in its entirety.48 A requirement under Federal Rule of Civil Procedure 23 is that the ‘claims or defenses of the representative parties are typical of the claims or defenses of the class’.49 In denying certification, the District Court held that the named plaintiffs were atypical class representatives because they did not acquire the unsponsored ADRs in a domestic transaction. In so holding, the court rejected the plaintiffs’ argument that the ADRs were acquired in a domestic transaction and found that the plaintiffs’ ‘ability to acquire ADRs was contingent upon the purchase of underlying shares of common stock [in Japan] that could be converted into ADRs’ and once the underlying common stock was acquired, the plaintiffs were ‘bound to take and pay for the ADRs, once converted’.50 In a footnote, the District Court reiterated that ‘the undisputed evidence here demonstrates that the underlying shares of Toshiba common stock were purchased in Japan, on the Tokyo Stock Exchange, prior to conversion’.51 Class certification was also denied with respect to the plaintiffs’ Japanese law claims concerning Toshiba’s common stock, finding that those claims were ‘more appropriate to a motion for summary judgement’.52
This past spring, the US District Court for the Southern District of New York held in Anderson v. Binance that a digital exchange located abroad was not a national exchange subject to US securities laws.53 The plaintiffs were US investors who bought digital tokens on Binance, a digital exchange headquartered in Malta and whose CEO resided in Taiwan.54 The defendants allegedly promoted, offered, and sold tokens in the US through Binance.55 According to the investors, Binance’s representations did not make it clear that the tokens were securities; the investors became aware of the tokens’ status only after the SEC issued a report in 2019 categorising digital tokens as securities.
In addition to claims brought under state law, the investors alleged that the defendants improperly failed to register Binance as an exchange or broker dealer with the SEC, and that Binance failed to file a registration statement with the SEC for the securities it sold. The investors were thus allegedly deprived of the protections of the securities laws and were not adequately informed of the risks of their investments.56
After first concluding that the investors’ claims were time-barred under the relevant statutes of limitations, the District Court proceeded to dismiss the claims on the basis that Binance was not a domestic exchange subject to the jurisdiction of the United States. Specifically, the only US-based infrastructure the defendants allegedly used were Amazon Web Services computer servers, which hosted Binance’s website, and Ethereum blockchain computers, which facilitated certain Binance transactions.57 Citing other decisions, Binance held, ‘Such third-party servers and third parties’ choices of location are insufficient to deem Binance a national securities exchange’.58 The District Court was not convinced by the investors’ argument that Binance’s ‘inclusion of English language’ on its website, California-based employees, and job postings in the United States were sufficient to constitute a domestic exchange, and found it significant that the investors cited no supporting authority for their position.59
Binance next held that the investors’ token purchases did not qualify as domestic transactions. A transaction is domestic if ‘irrevocable liability is incurred or title passes within the United States’.60 Here, it was insufficient that the investors bought tokens while they themselves were located in the United States, or that title to the tokens allegedly passed in whole or in part on the US computers servers that hosted Binance’s website.61 The District Court cited in support a decision from the US Court of Appeals for the Second Circuit that held that trades of foreign securities on foreign exchanges were not considered domestic simply because the purchaser placed the order in the United States.62 On these same grounds, the District Court dismissed the investors’ claims under ‘blue sky laws’, which are state securities laws. Noting that blue sky laws are analysed ‘in relation to their federal counterparts’, the District Court held that because ‘the federal claims fail due to extraterritoriality, the state claims are also dismissed because the relevant laws do not apply extraterritorially’.63
The plaintiffs filed an appeal with the US Court of Appeals for the Second Circuit on 2 May 2022; briefing is underway.
During 2022, the SEC’s Division of Enforcement continued to investigate and enforce violations of the federal securities laws. Priorities for the Division of Enforcement include cryptoassets, cybersecurity controls and reporting of risks and incidents, and ‘gatekeepers’ such as accountants and attorneys.64 Two prominent SEC enforcement actions are described below.
In September 2022, the SEC announced a settlement with Barclays Bank over charges that highlight the potential risks for issuers in failing to meet the registration requirements in securities offerings.65 In 2017, Barclays lost its status as a ‘well-known seasoned issuer’. A well-known seasoned issuer can register unspecified amounts of securities on immediately effective automatic shelf registration statements, while other issuers must specify the amount of securities registered on their shelf registration statements. Barclays did not track the amount of securities issued under its registration statements and issued approximately US$17 billion of securities in excess of the amounts specified in its registration statements. These securities were issued in violation of the registration requirements of the Securities Act, and Barclays restated its audited financial statements previously filed with the SEC to reflect potential liability for the over-issuance of securities. The SEC fined Barclays US$200 million as a civil penalty for the violations of the Securities Act registration requirements and violations of the Exchange Act requirements for an issuer to file accurate annual reports and maintain adequate books and records, internal accounting controls and disclosure controls. The Securities Act also provides that investors in securities offered in violation of the registration requirements may rescind the transaction. Accordingly, Barclays conducted a rescission offer under which affected investors in the US$17 billion of securities could ‘put’ their securities back to Barclays at their original offer price.
In September 2022, the SEC announced charges against 16 financial firms over widespread use of non-official communication channels, such as text messages and WhatsApp messages, in violation of the SEC’s record keeping requirements.66 The Exchange Act and related rules require broker-dealers to preserve business communications for at least three years and to supervise its employees to ensure compliance with the Exchange Act requirements. These record-keeping requirements underpin the SEC’s investigatory powers. Financial firms implement these requirements by mandating that employees only communicate using specific communication channels. The SEC order described the discovery of widespread communications between employees of affected firms using unauthorised channels. The 16 financial firms agreed to pay combined penalties of more than US$1.1 billion and implement improvements to their policies and procedures.
In light of the discontinuation of LIBOR, the US Internal Revenue Service (IRS) and Department of the Treasury published final regulations (the Final Regulations) on 4 January 2022, providing guidance on the tax consequences of the discontinuation of LIBOR and certain other interbank offered rates (IBORs). In particular, the guidance relates to whether a modification of a debt instrument to replace a discontinued IBOR with a replacement rate (such as SOFR) results in a taxable exchange. The Final Regulations generally provide that a ‘covered modification’ (discussed below) will not result in a tax realisation event. The Final Regulations retain the basic approach of the proposed regulations published on 8 October 2019 (the Proposed Regulations), with certain structural revisions to simplify the rules and several technical changes further discussed below.
The Final Regulations provide that a covered modification of a ‘contract’ (a term that includes a debt instrument, derivative contract, stock, insurance contract and lease agreement) will not result in a tax realisation event because: (1) it is not treated as an exchange of property for other property differing materially in kind or in extent for purposes of Treasury Regulations Section 1.1001-1(a); and (2) it is not treated as a significant modification for purposes of Treasury Regulations Section 1.1001-3.67
A covered modification is generally a modification of the terms of a contract that:
To qualify as a ‘covered modification’, a modification cannot be one of the listed excluded modifications. The Final Regulations also include as a ‘covered modification’ an incidental cash payment intended to compensate a counterparty for small valuation differences resulting from a modification of the administrative terms of a contract, such as the valuation differences resulting from a change in observation period.
The Proposed Regulations were silent with respect to whether a modification by which the parties add or amend a fallback provision needs to be tested only at the time of the addition or amendment of the fallback provision or also separately at the time of activation of the fallback provision. In the preamble to the Final Regulations, the IRS clarified that any change to the terms of a contract that results from the activation of a fallback provision must be tested separately at the time of activation as well.69
The Final Regulations refer to IBORs generally, without naming the specific IBORs for which relief is available. But the Final Regulations limit the relief to ‘discontinued IBORs’. Generally, an IBOR is a discontinued IBOR if its administrator has announced that it has or will cease to provide the IBOR. Starting one year after an IBOR’s discontinuation, the IBOR will no longer qualify as a discontinued IBOR under the Final Regulations (and thus changes made to an effected contract following the one-year period will not be eligible for relief under the Final Regulations). If an IBOR is published on a ‘synthetic’ basis following the date of its general discontinuation, the one-year period will commence when the ‘synthetic’ IBOR is no longer published (rather than on the earlier general discontinuation date).
The Final Regulations remove the requirement included in the Proposed Regulations that the fair market value of the contract before and after the change has to be substantially equivalent for a replacement rate to be a qualified rate. The Final Regulations also expand the list of rates eligible to be qualified rates and provide that a single qualified rate may be composed of more than one fallback rate.
The Final Regulations provide a grace period during which a covered modification of a component of a transaction integrated under Treasury Regulations Sections 1.1275-6, 1.988-5(a), or 1.148-4(h) does not result in legging out of that integrated transaction, notwithstanding any mismatch in timing or amount of payments that results from the covered modification during the grace period.
To address the concern that a covered modification of preferred stock could cause the stock to satisfy the definition of fast-pay stock, which could give rise to a ‘listed transaction’, the Final Regulations provide that a covered modification of stock is not a significant modification in the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances for purposes of Treasury Regulations Section 1.7701(l)-3(b)(2)(ii).
The Final Regulations apply to any modification of the terms of a contract that occurs on or after 7 March 2022. A taxpayer may choose to apply the Final Regulations to modifications of the terms of contracts that occur before this date, provided that the taxpayer and all its related parties (e.g., subsidiaries and certain affiliates) apply the Final Regulations to all modifications of the terms of contracts that occur before that date. The Final Regulations do not appear to require that all parties to a contract modified prior to the effective date treat the transaction consistently.
On 12 August 2022, Congress passed the Inflation Reduction Act of 2022, HR 5376, which includes a new 1 per cent excise tax on stock repurchases by certain publicly traded corporations (the Excise Tax).70 The Excise Tax applies to repurchases of stock by publicly traded domestic corporations (including certain publicly traded inverted foreign corporations treated as ‘surrogate foreign corporations’)71 and domestic subsidiaries of publicly traded foreign corporations occurring after 31 December 2022. The stated purpose of the Excise Tax is to discourage publicly traded corporations from engaging in stock buybacks that aim to increase share prices and, instead, encourage these corporations to invest in their workers and businesses.72
The Excise Tax is generally imposed on any ‘covered corporation’, which is a domestic corporation whose stock is traded on an established securities market.73 There is no minimum ‘market cap’ requirement applicable to covered corporations. As a result, even small ‘micro-cap’ corporations or corporations in financial distress or bankruptcy will be subject to the Excise Tax. The Excise Tax is also imposed on a covered corporation if a ‘specified affiliate’ repurchases the covered corporation’s stock.74
Additionally, the Excise Tax is imposed on a domestic corporation or partnership (including a foreign partnership with a direct or indirect domestic entity as a partner) when such corporation or partnership purchases any stock of its foreign parent corporation if (1) the foreign parent corporation has stock traded on an established securities market and (2) the domestic corporation or partnership is a specified affiliate of the foreign parent corporation. Lastly, the Excise Tax is imposed on a foreign corporation if (1) the foreign corporation is a ‘surrogate foreign corporation’ pursuant to the inversion rules of Section 7874(a)(2)(B) of the Internal Revenue Code of 1986, as amended (the Code) and (2) the stock of such foreign corporation is traded on an established securities market.75
For purposes of the imposition of the Excise Tax, a ‘repurchase’ occurs when a corporation (or its specified affiliate) redeems or otherwise acquires the corporation’s stock from a shareholder in exchange for property. Additionally, the Secretary of Treasury (the Secretary) is authorised to specify in regulations that certain transactions are economically similar to redemptions and will therefore be treated as redemptions subject to the Excise Tax.76
The amount of the Excise Tax is initially determined based on the fair market value of all of the stock repurchased (or treated as repurchased) by a covered corporation during a taxable year. Thus, even if there are losses in the stock or the covered corporation has no earnings and profits, the Excise Tax applies. This amount is then reduced by the fair market value of any stock issued by the covered corporation during the taxable year, including any stock issued or provided to employees and any stock issued upon the exercise of an option. This would appear to include stock issued as a stock dividend, but regulations may narrow the scope to stock issued for property or services. For inverted foreign corporations and domestic specified affiliates of foreign corporations that are subject to the Excise Tax, the reduction is limited to the fair market value of the stock issued or provided to employees of the inverted foreign corporation or the specified affiliate, respectively.
The Excise Tax will not apply in any one of the following six situations:
The US Bankruptcy Court for the Southern District of New York (the Bankruptcy Court) recently ruled on two important issues affecting the use of Chapter 15 of the Bankruptcy Code (Chapter 15) to recognise and enforce foreign insolvency proceedings in the United States. In In re Modern Land (China) Co Ltd, the Bankruptcy Court addressed whether: (1) recognition of a foreign proceeding under Chapter 15 is sufficient to discharge US-governed debt; and (2) the centre of main interests (COMI) for a Cayman-incorporated entity operating in China could be found in the Cayman Islands to permit recognition of the Cayman restructuring as a foreign main proceeding.77
Modern Land (China) Co Ltd (Modern Land) is a holding company for a large group of property development businesses, which are mostly incorporated in the Cayman Islands or British Virgin Islands but have their business operations located in China. After experiencing liquidity pressures, Modern Land reached an agreement with a group of its bondholders to restructure the bonds and leave the company’s remaining liabilities unaffected. To effectuate the restructuring, Modern Land filed a petition with the Cayman Court, requesting, among other things, the sanctioning of the proposed scheme of arrangement. Under the proposed scheme, the existing bonds and related claims would be released, and the bondholders would receive certain cash consideration and newly issued bonds. The foreign representative for Modern Land commenced a Chapter 15 proceeding approximately six weeks later, seeking recognition of the Cayman proceeding and recognition and enforcement of the proposed scheme.
Prior to the recognition hearing in Modern Land’s Chapter 15 proceeding, the High Court of the Hong Kong Special Administrative Region Court of First Instance issued a ruling in an unrelated case taking the view that recognition of a foreign proceeding under Chapter 15 is limited in territorial effect to assets and creditors within the United States, and does not discharge the underlying debt.78 In considering recognition of Modern Land’s Cayman proceeding and proposed scheme, the Bankruptcy Court viewed the Hong Kong court’s statement as ‘a critically important issue’ to clarify given that many restructuring plans or schemes feature the modification or discharge of existing debt and related claims governed by New York law. The Bankruptcy Court confirmed that the Hong Kong court misinterpreted US law, and reiterated that, ‘provided that the foreign court properly exercises jurisdiction over the foreign debtor in an insolvency proceeding, and the foreign court’s procedures comport with broadly accepted due process principles’, the decision of the foreign court approving a scheme or plan that modifies or discharges debt governed by New York law can be enforceable through a Chapter 15 proceeding.79
The Bankruptcy Court additionally addressed whether it could recognise the Cayman proceeding as a ‘foreign main proceeding’ given the fact that Modern Land’s business operations are in China. Under Chapter 15, there is a presumption that, ‘in the absence of evidence to the contrary’, a debtor’s COMI is its place of incorporation,80 but the Bankruptcy Court expressed concern whether Modern Land could establish COMI in the Cayman Islands as of the filing date for the Chapter 15 proceeding.81 Ultimately, the Bankruptcy Court concluded that under the circumstances, Modern Land sufficiently demonstrated COMI in the Cayman Islands to permit the recognition of the Cayman proceeding as a ‘foreign main proceeding’. In making this determination, the Bankruptcy Court focused on the goals of Chapter 15, the affected creditors’ expectations, the insolvency activities occurring in the Cayman Islands, the Cayman choice of law principles, and the debtor’s ‘good faith’ petition for recognition.
The Bankruptcy Court emphasised that the affected creditors (i.e., the bondholders) expected that any insolvency proceedings for Modern Land would involve Cayman Islands law given that it was a Cayman company, and the debtor and bondholder group specifically negotiated the restructuring agreement to contemplate the Cayman proceeding. The proposed scheme had significant creditor support, with holders of approximately 95 per cent of the outstanding bonds voting in its favour, and petition for recognition and enforcement of the scheme was not contested in the Chapter 15 proceeding. The Bankruptcy Court also considered the restructuring activities of Modern Land that occurred in the Cayman Islands, and found that the restructuring was the primary business activity of Modern Land at the time of the Chapter 15 filing. Accordingly, the Bankruptcy Court recognised the Cayman proceeding as a ‘foreign main proceeding’, and recognised and enforced the proposed scheme that discharged the US-governed bonds. While the Modern Land case suggests a less stringent standard for establishing COMI in the debtor’s country of incorporation, the significant creditor support and lack of objection factored heavily in the Bankruptcy Court’s ruling. In a contested proceeding, a foreign representative or debtor may face greater challenges in establishing COMI in its country of incorporation if its regular business activities are located elsewhere.
In the PG&E bankruptcy case, the Ninth Circuit recently reversed the decisions of the lower courts regarding the rate of post-petition interest to be paid on unsecured claims in cases where the debtor is solvent and able to pay creditors in full.82 PG&E filed for bankruptcy in 2019 following catastrophic wildfires in northern California. While PG&E was solvent at the time of its filing, it commenced the bankruptcy proceeding to resolve its liabilities related to the wildfires. In its Chapter 11 plan, PG&E classified general unsecured trade claims as ‘unimpaired’ and provided that such claims would be paid in full with post-petition interest at the federal judgment rate of 2.59 per cent. Under Section 1124(1) of the Bankruptcy Code, a claim can be classified as ‘unimpaired’ if the plan ‘leaves unaltered the legal, equitable, and contractual rights’ of the creditor with respect to the claim.83 Unimpaired claims are deemed to accept the plan of reorganisation, and are not entitled to vote on the plan.84 A group of trade creditors argued that the federal judgment rate is significantly lower than the rate creditors were entitled to be paid under their contracts or California’s statutory default interest rate on unpaid claims (10 per cent). As a result, their claims were not ‘unimpaired’ and they should not have been deemed to accept the plan. Prior to the Ninth Circuit’s ruling, no circuit court had ruled on this specific issue, and the bankruptcy courts that have ruled have not taken a consistent approach.85
The bankruptcy and district courts took the position that under Ninth Circuit precedent and the Bankruptcy Code, unsecured creditors were not entitled to interest beyond the federal judgment rate, and approved the plan of reorganisation. The Ninth Circuit disagreed, and concluded that although unsecured claims generally do not accrue interest as a result of a bankruptcy, under the ‘solvent-debtor exception’ unsecured creditors ‘possess an equitable right to receive postpetition interest at the contractual or default state law rate, subject to any other equitable considerations’ before the debtor or its equity holders may collect the estate’s surplus value.86 The Ninth Circuit distinguished its prior ruling in In re Cardelucci,87 in which the court ruled that under Section 726(a)(5) of the Bankruptcy Code, unsecured creditors are only entitled to ‘interest at the legal rate’, meaning the federal judgment rate, after allowed unsecured claims are paid in full. The Ninth Circuit emphasised that Section 726(a)(5) of the Bankruptcy Code only governs what unsecured creditors are entitled to receive in a Chapter 7 liquidation proceeding, and, by extension, what ‘impaired’ unsecured creditors must receive to confirm a plan of reorganisation.88 However, as the court noted, ‘impaired’ creditors are entitled to certain statutory protections, such as the right to vote to accept or reject the proposed plan. The court highlighted that PG&E’s plan proposed to provide ‘unimpaired’ unsecured creditors with the same recovery as an ‘impaired’ unsecured creditor, but without the statutory protections afforded to ‘impaired’ creditors.
The court rejected PG&E’s argument that the Bankruptcy Code, and not the plan of reorganisation, affected the creditors’ legal, equitable and contractual rights, such that the claims could still be classified as ‘unimpaired’ under Section 1124 of the Bankruptcy Code. The court cited long-standing common law providing that, in the event of a solvent debtor, creditors possess an equitable right to receive post-petition interest at the contractual or state law rates before equity can receive or retain value. The court ruled that the enactment of the Bankruptcy Code did not abrogate the solvent-debtor exception under common law, based on the court’s conclusion that the text of the Bankruptcy Code did not provide any clear intent to do so. As a result, the court held that to be classified as ‘unimpaired’ claims that are not entitled to vote on a plan of reorganisation, unsecured claims must receive post-petition interest at the contractual or state default rate.
While solvent-debtor cases are relatively rare, the PG&E ruling provides unsecured creditors with greater leverage in negotiating plans of reorganisation by ensuring that, unless the plan provides for payment in full of the claim and post-petition interest at the contractual or state default rate, the creditors are entitled to vote on the plan and assert certain objections to plan treatment.
The Fifth Circuit recently issued a long-awaited decision in the Ultra Petroleum bankruptcy case addressing whether creditors are entitled to recover contractual make-whole premiums in a bankruptcy case where the debtor is solvent and able to pay creditors in full.89 While the Fifth Circuit opinion ultimately affirmed the Southern District of Texas bankruptcy court’s allowance of the make-whole premiums under the particular facts of the Ultra Petroleum case, the opinion significantly departs from the bankruptcy court’s reasoning and would only allow make-whole or similar premiums in solvent-debtor cases.
Many credit agreements and indentures include a contractual early payment premium (a ‘make-whole’) due upon acceleration or prepayment of the debt, which amounts are typically designed to provide lenders with the present value of the future interest payments that would have come due over the life of the loan if the loan was not repaid before the intended maturity date. Over the past several years, the question of whether these make-whole amounts can be included in a creditor’s claim in the event of a bankruptcy has been vigorously contested, and the uncertainty of this legal issue has led many parties to reach settlements rather than risk an unfavorable outcome after protracted litigation. One of the primary challenges to these claims are that make-wholes are tantamount to unmatured interest, which is disallowed under Bankruptcy Code Section 502(b)(2).90 In October 2020, the bankruptcy court in Ultra Petroleum concluded that the make-whole amount was not unmatured interest, or its economic equivalent.91 The bankruptcy court reasoned that interest is consideration accruing over time for the use or forbearance of another’s money, and, in contrast, the make-whole premium was a liquidated damages provision that accrued upon the early payment. Under the bankruptcy court’s ruling, contractual make-whole amounts would not be disallowed under Section 502(b)(2).
The Fifth Circuit disagreed. It concluded that make-wholes are precisely the economic equivalent of unmatured interest, and are accordingly disallowed under Section 502(b)(2). The Fifth Circuit emphasised that, regardless of how the underlying agreement labelled the amount, or how the premium was calculated, a provision that enabled lenders to receive their expected return following an early repayment of the debt was functionally unmatured interest.92 The Fifth Circuit found that these amounts generally must be disallowed under the Bankruptcy Code, even if characterised as liquidated damages or recast as principal under the applicable agreement.
However, like the Ninth Circuit in PG&E, the Fifth Circuit also held that the ‘solvent debtor exception’ survived the enactment of the Bankruptcy Code and trumps Section 502(b)(2). Despite the unambiguous language in Section 502(b)(2) disallowing unmatured interest, the majority reasoned that the Bankruptcy Code did not expressly abrogate the common law doctrine requiring a solvent debtor to pay its creditors all amounts owed under their contracts before equity holders can receive a distribution.93 Because Ultra Petroleum was solvent, the creditors were entitled to receive their contractual make-whole premium despite the make-whole being disallowed under the Bankruptcy Code. The Fifth Circuit further determined that, under the same reasoning, in a solvent debtor case the Bankruptcy Code does not prevent unimpaired creditors from receiving post-petition interest at the contractual default rate.
While the ruling is a win for the unsecured creditors in Ultra Petroleum, the decision will make it much more difficult for creditors to assert claims for make-whole amounts in other bankruptcy cases. The Fifth Circuit’s broad interpretation of what constitutes unmatured interest (or its economic equivalent) will also make it more challenging for parties to structure make-whole provisions in credit agreements and indentures in a manner that avoids disallowance in the event of a potential bankruptcy.
The sharp decline in the digital asset markets has created uncertainty when cryptocurrency is expanding and moving closer into the mainstream of global financial markets. Notably, two cryptocurrency platforms filed for relief under the US Bankruptcy Code within a few weeks of each other during the summer of 2022, following the commencement of liquidation proceedings against Three Arrows Capital in the British Virgin Islands,94 Voyager Digital Holdings, Inc (Voyager) and Celsius Network LLC (Celsius) each filed proceedings under Chapter 11 of the Bankruptcy Code in the US Bankruptcy Court for the Southern District of New York95 with the goal of reorganising and continuing operations, rather than liquidating. The bankruptcy cases are expected to address several legal issues unique to the intersection of cryptocurrency and bankruptcy, including the central question of whether digital assets held for customers are part of the bankruptcy estate. The legal status of the digital assets has broad implications for the platforms’ customers. If the digital assets are part of the bankruptcy estate, customers would be treated as creditors with unsecured claims against the platform for the value of the digital assets, but would not be able to access the digital assets held for their accounts. Additionally, if the digital assets held for customers are property of the bankruptcy estate, the debtors may seek to recover any digital assets (or equivalent value) withdrawn by customers in the period leading up to the bankruptcy in order to maximise recoveries for all creditors and customers. Another key question is whether customers’ entitlements will be paid in-kind, or in cash, and how and when these entitlements will be valued, particularly given the significant fluctuation in cryptocurrency prices. Further, Voyager and Celsius filed for bankruptcy with the intent to pursue reorganisation through potential sale or investment transactions that would permit the platforms to continue providing cryptocurrency programmes to their customers. To be successful, Voyager and Celsius likely will need to restore customer confidence and trust, which could be a difficult task if customers are not able to access the digital assets held for their accounts and if the customers are only able to recover a fraction of their entitlement. Whether and how Voyager and Celsius are able to reorganise and how customer assets and claims are treated will likely have meaningful ramifications for other distressed cryptocurrency platforms as well as digital asset markets.
A securities exchange may register with the SEC to be a ‘national securities exchange’ and a clearing agency may register with the SEC to be a ‘registered clearing agency’.96 As of 30 September 2022, there were 24 registered national securities exchanges, four national securities exchanges registered for trading securities future products and nine registered clearing agencies.97
A national securities exchange or registered clearing agency is a ‘self-regulatory organisation’ (SRO) under the securities laws.98 SROs are supervised and examined by the SEC, and SROs share regulatory powers over their members and participants with the SEC. The securities laws include requirements for SROs and the SEC to coordinate their regulatory efforts and share information.99 SROs can propose rules for approval by the SEC.100 SROs can discipline members and participants, but such actions are subject to review by the SEC.
Credit rating agencies register with the SEC to be a ‘nationally recognised statistical rating organisation’.101 As of 30 September 2022, there were 10 nationally recognised statistical rating organisations.102
The regulation of credit rating agencies, including nationally recognised statistical rating organisations, was improved in the Dodd-Frank Act. Congress’s overarching approach in the Dodd-Frank Act was to treat credit rating agencies as critical ‘gatekeepers’ that should be subject to the same standards of liability and oversight that apply to auditors, securities analysts, and investment bankers. The regulation of nationally recognised statistical rating organisations sets out requirements on areas such as conflicts of interest, internal controls, corporate governance, record-keeping, compliance functions, training and experience of analysts, and presentation of ratings and related disclosures. The SEC’s Office of Credit Ratings examines nationally recognised statistical rating organisations at least annually.
In June 2022, the SEC brought charges against a nationally recognised statistical rating organisation for violating the conflict of interest requirements because the rating agency’s founder and owner was involved in both sales and marketing activities with a client and determining the rating for the client. The SEC also charged that the rating agency violated the conflict of interest requirements by issuing or maintaining a rating for a client that represented more than 10 per cent of the rating agency’s revenue.103
The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board (PCAOB) to oversee audits of public companies subject to the US securities laws in response to accounting scandals in the early 2000s.104 The PCAOB’s mandate is to inspect registered public accounting firms for compliance with the PCAOB’s auditing standards and rules on audit quality control and ethics. The PCAOB had been unable to inspect audit work papers and practices in several countries due to local regulations, including China and Hong Kong. The PCAOB’s oversight of Chinese companies attracted attention in 2020 when revelations that a China-based company with American Depositary Receipts (ADRs) listed on the Nasdaq had fabricated its accounting records led to significant losses for investors and SEC enforcement action against the company.105
In response, Congress passed the Holding Foreign Companies Accountable Act in December 2020.106 This law can ultimately prohibit a company from listing and trading its securities on any US securities exchanges or through any other method regulated by the SEC if the PCAOB cannot fully inspect the company’s auditors. The law requires the SEC to identify issuers of securities on US securities exchanges that issue audit reports prepared by registered public accounting firms with offices located in foreign jurisdictions and that do not allow PCAOB to conduct an audit of the reports prepared by the accounting firm because of a position taken by an authority within the foreign jurisdiction. Once identified, these issuers must report whether or not they are owned or controlled by a foreign government in the foreign jurisdiction in which the public accounting firm has an office. A foreign issuer must also disclose:
If such a company’s foreign audit firm cannot be inspected by the PCAOB for three consecutive years, the SEC must prohibit the company’s securities from being traded on any US exchange or other method regulated by the SEC, including the over-the-counter market. Both houses of Congress have passed amendments to accelerate the trading prohibition from three consecutive years to two consecutive years, meaning Chinese companies could face delisting as early as 2023.107
Over 2021 and 2022, the SEC established the framework required by the law to identify companies subject to the reporting requirements of the Exchange Act that are audited by a foreign audit firm that cannot be inspected by the PCAOB.108 In December 2021, the PCAOB determined that it is unable to inspect or investigate completely registered public accounting firms headquartered in mainland China and Hong Kong.109 The factors cited in the PCAOB’s determination report included a 2013 enforcement memorandum of understanding with Chinese authorities that established a mechanism for the parties to request and receive assistance in accessing information, but the PCAOB stated that the assistance actually provided to it under this memorandum of understanding was insufficient.
As of 30 September 2022, there were 262 Chinese companies listed on major US stock exchanges, including companies such as Alibaba, which has a market capitalisation of approximately US$280 billion.110 The SEC started to identify issuers of securities on US securities exchanges that use such accounting firms to audit their financial statements.111
In August 2022, the PCAOB announced that the PCAOB had signed a statement of protocol with the China Securities Regulatory Commission and the Ministry of Finance of the People’s Republic of China that, if abided by, provides the PCAOB with sufficient access to inspect and investigate registered public accounting firms in mainland China and Hong Kong.112 The PCAOB has stressed that the protocol is merely a first step, that inspections began in mid-September and that the real test is whether complete access is actually provided for those inspections.
Some state-owned Chinese companies reacted to these developments by announcing they would voluntarily delist from US exchanges.113 PCAOB Chair, Erica Williams, noted that ‘voluntary delisting is not an escape hatch for avoiding PCAOB scrutiny’ because PCAOB inspections and investigations are retrospective.114 Other companies have sought to avoid the threat of delisting by replacing their lead auditor with a US firm or a firm in another jurisdiction that allows full PCAOB inspections. The SEC’s Acting Chief Accountant staff cautioned that audit firms accepting such engagements must ensure they can fulfil their professional requirements and responsibilities, including for supervision and retention or access to supporting documentation for work completed by other auditors, such as a local audit firm or an associated office or affiliate of the lead audit firm, and failure by the lead auditor to meet its responsibilities could mean significant liability for the auditor, its personnel and the issuer.115 In September 2022, Chair Gensler reinforced concerns about local audit quality as underscoring the need for PCAOB inspections when the SEC charged the Chinese affiliate of the Deloitte global network of accounting firms with failing to comply with US auditing requirements while undertaking audit work for US-listed companies with operations in China as the lead auditor and on behalf of its US affiliate.116
The status of digital assets as securities for the purposes of the Securities Act continues to be a focus for issuers and regulators alike.117 The SEC has typically analysed the offer and sale of digital assets under the test set forth in SEC v. W J Howey Co118 for determining whether an arrangement is an investment contract, and thus a security.119 The SEC has brought a number of enforcement actions against token issuers for conducting unregistered offerings, suggesting that a generally agreed-upon bright line test does not exist for determining when a token is a security.120 Even within the SEC, there is disagreement as to when the securities laws should apply. Notably, Commissioner Peirce has been outspoken about the regulation of digital assets and publicly disagreed with the analytical framework applied by the SEC in its approach to the Telegram case.121 Historically, registration of digital assets as securities has presented certain challenges. However, there were qualified offerings of tokens pursuant to Regulation A+ in 2019 and the first registered IPO of a digital asset security in 2020.122 There are also signs that the broker-dealer market necessary to support liquid markets in digital asset securities is slowly developing, in response to recent regulatory guidance.123
The investment contract analysis is not the sole test for whether a digital asset is a security. For instance, Chair Gensler has recently stated that stablecoins, which are digital assets designed to have fixed value and could be pegged or linked to the value of a fiat currency such as one token being equal to one US dollar, may ‘be securities and investment companies’ (similar to money market funds).124 The future evolution of this market within the United States will depend, in part, on identifying clear and consistent criteria for determining when a digital asset is a security, as well as the continued development of the market infrastructure necessary to support digital asset securities.
In December 2021, the SEC proposed rules to address perceived shortcomings in the current insider trading regime.125 Rule 10b5-1 under the Exchange Act prohibits the purchase or sale of securities on the basis of material non-public information. Rule 10b5-1(c) provides an affirmative defence to insider trading for securities purchased or sold under a trading plan that was adopted at a time that the person did not have material non-public information and that was entered into in good faith. In proposing its amendments, the SEC cited research indicating that corporate insiders trading under such plans consistently outperform trading by executives and directors not under such plans. The SEC also noted concerns about manipulations of trading plans by insiders establishing multiple overlapping trading plans and then selectively cancelling plans, issuers inflating stock prices with stock repurchases immediately before sales by corporate insiders under trading plans, coordinating stock option grants to executives with the disclosure of material non-public information, and corporate insiders giving gifts while aware of material non-public information.
The SEC’s proposed amendments to address these concerns include:
While some of the SEC’s proposed amendments reflect current market practice, some of the proposed amendments, such as the 120-day cooling-off period, are significantly more stringent.
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