The SEC adopted rules on Wednesday last week that will require companies to have a policy to claw back erroneously awarded incentive compensation paid to current or former executives. The policy must also be filed with a company’s annual report.
SEC Chair Gary Gensler said, “I believe that these rules will strengthen the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors.” And, through the rules and working with exchanges, the SEC has “the opportunity to fulfill Dodd-Frank’s mandate and Congress’s intention to prevent executives from keeping compensation received based on misstated financials.”
The SEC originally proposed compensation recovery rules like these in 2015. According to the Wall Street Journal, “Accounting Errors to Cost Executives Their Bonuses Under SEC Rule” – WSJ, the rules passed last week are broader than what was proposed in 2015. The WSJ wrote that the 2015 proposal would have required clawbacks only if companies identified major accounting errors that required financial statements to be restated. The rules that the SEC just adopted also require companies to claw back bonuses paid to executives if they find smaller errors.
We wrote about Special Purpose Acquisition Companies (SPACs) in a Stoll Berne Investor Blog post more than a year ago. At that time, SPACs were attracting attention as a way for businesses to raise funds in public markets without having to use a traditional IPO that would value the company through market-based price discovery. In a SPAC offering, the people behind it are responsible for deciding how to value the operating company and how much the SPAC will pay for it. We cited a Wall Street Journal article that explained SPACs had significantly underperformed companies that went public using a traditional IPO. The recent announcement by Electric Last Mile Solutions that it will file for bankruptcy is another example of dangers for investors in SPACs.
Electric Last Mile Solutions trades on the Nasdaq under the ticker symbol ELMS. ELMS describes itself as a commercial electric vehicle solutions company, focusing on designing, engineering, manufacturing, and customizing electric last mile delivery and utility vehicles. ELMS began trading publicly only a year ago, even ringing the opening bell on the Nasdaq on July 12, 2021.
In a June 12, 2022, announcement about the bankruptcy, ELMS recounted the February 2022 resignations of former CEO Jim Taylor and founder and Executive Chairman Jason Luo. The announcement included that an investigation by ELMS’ board led to the resignations. ELMS “was forced to withdraw financial guidance and declare the Company’s past financial statements unreliable.” Further, “[t]he compound effect of these events, along with a pending SEC investigation initiated this year, made it extremely challenging to secure a new auditor and attract additional funding.”
According to an article on thestreet.com, the board’s investigation found that “prior to the SPAC merger, ‘certain executives’ purchased equity in the company at substantial discounts to market value without obtaining an independent valuation.” Thestreet.com’s article linked to a report by short-seller Fuzzy Panda Research, warning about what Fuzzy Panda Research believed to be misleading statements to investors by the company. For example, Fuzzy Panda Research asserted that ELMS “falsely claimed that their vehicles are ‘produced’ and ‘manufactured’ in the USA.” Fuzzy Panda Research described how ELMS would import vehicles made in China and then change the logo.
ELMS’ internal investigation and bankruptcy are good examples of the dangers of investing in SPACs. The SEC discusses some of the risks, particularly involving disclosures, in its disclosure guidance for SPACs. The SEC’s guidance is a good starting point for a lawyer or investor who is looking into a SPAC.
Dutch Bros, the coffee shop company headquartered in Grants Pass, Oregon issued its Form 10-Q for the quarter ending March 31, 2022. The Form 10-Q is available through the SEC’s EDGAR database. Dutch Bros, sometimes called Dutch Brothers, reported total assets of $884,506,000. For the first three months of the year, the company reported total revenues of $152,156,000 and a loss from operations of $14,225,000. Cash and cash equivalents for Q-1 2022 were down more than $8,000,000 from the same period in 2021.
In a press release announcing the earnings report, the company described itself as “one of the fastest-growing brands in the food service and restaurant industry in the United State by location count.” The company also touted its growth prospects on its Investor Relations webpage—“Dutch Bros is a high growth operator and franchisor of drive-thru shops that focus on serving high QUALITY, hand-crafted beverages with unparalleled SPEED and superior SERVICE.”
Dutch Bros promoted its growth prospects in the lead up to its September 15, 2021, initial public offering (“IPO”). In Amendment No. 2 to Form S-1 Registration Statement Under the Securities Act of 1933, the company reported, “In the past five and a half years, we have increased our shop count from 254 shops in seven states at the end of 2015 to 471 shops in 11 states as of June 30, 2021.” And, “Despite being an established, time-tested brand, Dutch Bros is still in the early stages of rapid growth as we strategically expand our footprint in existing markets and enter new markets.”
Growth depends, at least in part, on identifying and training employees to run new locations. “We plan all our new shop growth around existing, high-performing Dutch Bros broistas ready to assume leadership roles and eventually become shop managers and then operators.” The company reported in the Form S-1, “40% of our company-operated shop employees have been with Dutch Bros for more than a year, and 100% of shop managers for the 179 new systemwide shops opened since January 1, 2018 were existing broistas promoted from within.”
Dutch Bros also referred several times in the Registration Statement amendment to the strength of its brand. Under the heading, “A Powerful, Authentic Brand that Shares the ‘Luv’,” the company described itself as “Fun-Loving,” “Mind Blowing,” and “Making a Massive Difference.”
The company set the IPO share price at $23.00 and raised around half a billion dollars through the offering. The IPO generated significant media attention in Oregon and nationally for the company, including news stories published on oregonlive.com. The news site reported in a March 25, 2022, update to a story first published on September 22, 2021, that Travis Boersma, the co-founder and chairman, held shares worth nearly $4 billion. A private equity firm named TSG Consumer Partners was reported holding shares worth almost $3 billion.
Since the IPO, the share price closed as high as $76.25 on November 1, 2021. But as of May 16, 2022, the share price had fallen significantly, closing at $25.50.
According to data available through Yahoo Finance, the company’s market cap has fallen from $2.16 billion at the end of September 2021 to $1.45 billion on May 15, 2022. This is a drop of over $700 million.
In the press release that accompanied the 10-Q, Joth Ricci, the Chief Executive Officer and President, said, “Still, we were not immune to the record inflation that surpassed our expectations and pressured margins in our company-operated shops. While we believe these margin impacts may be short-term, we have opted to take a more conservative stance regarding adjusted EBITDA for 2022 as we monitor our pricing and the escalating cost environment.”
Dutch Bros’ valuation appears to depend significantly on the company’s ability to expand. Whether the drop in share price and market cap is a result of inflation, accounting decisions, or other factors should become clearer with time.
The SEC adopted rules on Wednesday last week that will require companies to have a policy to claw back erroneously awarded incentive compensation paid to current or former executives. The policy must also be filed with a company’s annual report.
These back-office services can include anything from compliance to risk analysis to identifying investment options. The adviser benefits by outsourcing services and functions that they would otherwise have to take care of in house.
The Oregon Department of Consumer and Business Services published its Summer 2022 issue of Common Ground this week. It includes an article about cryptocurrencies and NFTs and another about a lawsuit against Safeguard Metals, LLC and others that Oregon joined.
We wrote about Special Purpose Acquisition Companies (SPACs) in a Stoll Berne Investor Blog post more than a year ago. At that time, SPACs were attracting attention as a way for businesses to raise funds in public markets without having to use a traditional IPO that would value the company through market-based price discovery.
The United States Supreme Court recently held that waiver of the right to arbitrate is not conditioned on a showing of prejudice. The Supreme Court’s unanimous decision in Morgan v. Sundance, Inc. (May 23, 2022) has important implications for investors who are considering claims against financial advisers or brokers.
The SEC recently published an Investor Bulletin with important information about interest charges on margin accounts. Trading on margin is not free. Like other borrowed money, broker-dealers that lend money to investors to trade on margin charge interest. These interest charges increase risk, reduce an investor’s return, and increase the amount of money an investor must earn to break even.
An investor should understand the interest rate charged by the broker-dealer and also whether the firm uses netting. A broker-dealer that uses netting may sweep cash in an investor’s cash account to the investor’s margin account, reducing the margin loan and the amount of interest that the investor pays. In contrast, a broker-dealer with a no netting policy charges interest on the full amount of the margin loan, while paying what is most likely a lower interest rate on the investor’s cash account. In the no netting scenario, the money in the investor’s cash account does not reduce the amount of the margin loan.
The investor’s margin agreement with the broker-dealer should specify how interest is calculated and whether the broker-dealer uses netting.
The SEC’s Investor Bulletin has a list of questions for investors to ask about interest charges on margin accounts. They are:
What is the interest rate on margin loans?
Can this interest rate vary? If yes, then how often does it change and where can you find those changes?
How often do interest charges accrue on the margin loan balance (daily, weekly, monthly)?
How can you reduce the margin loan balance?
Does the firm net your cash account balances and margin account balances to reduce the interest you pay on margin loan balances? Does it matter whether your cash and margin accounts are set up in a certain way (e.g., as separate accounts or as “sub accounts” with one master account)?
If so, how does the firm’s netting policy work with your accounts?
How do cash or money market sweep programs (where your extra cash is swept into a bank account or money market account) impact the firm’s netting practices?
The SEC Division of Examinations announced its 2022 examination priorities in late March. The announcement is available here. The priorities include a “focus on private funds, environmental, social and governance (ESG) investing, retail investor protections, information security and operational resiliency, emerging technologies, and crypto-assets.”
Regarding private funds, the Division will focus on registered investment advisers, including RIA’s fiduciary duty, compliance programs, fees, conflicts of interest, risk disclosures, and other issues.
For environmental, social and governance investing, the Division said examinations will “typically focus on whether RIAs and registered funds are accurately disclosing their ESG investing approaches and have adopted and implemented” procedures to prevent violating the federal securities laws.
For its retail investor focus, the Division will examine whether advice from broker-dealers and RIAs is in an investor’s best interest. The SEC referred specifically to registrants’ obligations under Regulation Best Interest and fiduciary standards under the Advisers Act.
The SEC said its focus on information security involves reviewing whether broker-dealers and RIAs have appropriate technology and measures in place to protect customer accounts.
Finally, for emerging technologies and crypto-assets, the Division “will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies to review whether the unique risks these activities present were considered by the firms when designing their regulatory compliance programs. RIA and broker-dealer examinations will focus on firms that are, or claim to be, offering new products and services or employing new practices to assess whether operations and controls in place are consistent with disclosures made and the standard of conduct owed to investors and other regulatory obligations; advice and recommendations, including by algorithms, are consistent with investors’ investment strategies and the standard of conduct owed to such investors; and controls take into account the unique risks associated with such practices. Examinations of market participants engaged with crypto-assets will continue to review the custody arrangements for such assets and will assess the offer, sale, recommendation, advice, and trading of crypto-assets.”
According to the SEC, from January 2018 through November 2020, JPMS admitted that its employees communicated about securities-related matters on personal devices using texts, WhatsApp, and personal email accounts. The federal securities laws, including Section 17(a) of the Exchange Act and Rules 17a-4(b)(4) and 17a-4(j), require broker-dealers to preserve these records. JPMS did not.
JPMS’ failure to adhere to recordkeeping requirements was widespread and not hidden. The SEC’s order explains, “To the contrary, supervisors – i.e., the very people responsible for supervising employees to prevent this misconduct – routinely communicated using their personal devices. In fact, dozens of managing directors across the firm and senior supervisors responsible for implementing JPMorgan’s policies and procedures, and for overseeing employees’ compliance with those policies and procedures, themselves failed to comply with firm policies by communicating using non-firm approved methods on their personal devices about the firm’s securities business.” JPMS’ failure to reasonably supervise employees violated Section 15(b)(4)(E) of the Exchange Act.
Perhaps not surprising to lawyers who represent investors in cases against broker-dealers and others in the financial industry, the SEC’s order goes on to explain that in responding to “documents and records requests in numerous Commission investigations…JPMorgan frequently did not search for records” on employees’ personal devices.
The SEC gave notice of intent to issue an order that would increase the minimum assets under management or net worth that a client must have before an investment adviser may charge performance-based fees. Section 205(a)(1) of the Advisers Act prohibits an adviser from being compensated by a client based on capital gains or capital appreciation of the client’s funds. Congress put this protection in place in 1940 to protect against advisers taking undue risks with client money in hopes of increasing the adviser’s fee. Performance-based fees were characterized as “heads I win, tails you lose.” These fees incentivize adviser’s to take risks to increase the adviser’s fee with little or nothing at stake for the adviser.
Congress and the SEC later created exemptions to the prohibition. Under the exemptions, if a client has at least a minimum amount of assets under management or minimum net worth, the prohibition against performance-based fees no longer applies. The theory behind these exemptions is that client sophistication and financial experience increases with the amount of assets under management and net worth and that wealthy clients are able to bear the risks of performance-based fees. In many cases, merely because someone has assets under management of $500,000, $1,000,000, or some other arbitrary threshold, this has little or nothing to do with financial sophistication or risk tolerance.
The SEC now intends to increase the thresholds where the prohibitions against performance-based fees no longer apply to $1,100,000 in assets under management or $2,200,000 in net worth.
Oregon Senator Jeff Merkley and U.S. Representative Bill Foster of Illinois introduced the Investor Choice Act earlier this month. The bill would prohibit broker dealers and investment advisors from forcing investors to agree to mandatory arbitration. The bill also prevents brokers dealers and investment advisors from forcing investors to waive the right to bring a class action lawsuit. The Senate’s version of the bill is available here.
Most agreements with individual investors in the financial services industry force customers into arbitration. Many investor advocates want investors to have the option of pursuing claims in court. Arbitration lacks the transparency of court and is sometimes cost prohibitive.
The SEC recently issued a public statement regarding certain leveraged and complex exchange traded products. The public statement begins by emphasizing that advisers and broker-dealers must actually understand the products they recommend to clients. The SEC wrote, “It is critically important for registered investment advisers and broker-dealers to implement robust and effective policies and procedures reasonably designed to prevent violations of the federal securities laws, which includes ensuring that their financial professionals understand the risks and purposes of the products they advise on and/or recommend to firm clients and customers. Moreover, firms must ensure that their financial professionals, including independent contractors acting on their behalf, actually follow in practice those firm policies and procedures.” The SEC explained that firms should not rely solely on individual advisers or registered representatives to be responsible for analyzing and understanding complex products.
The SEC recommended that “firms should consider which products are complex, suitable only for sophisticated investors, not suitable for investors who plan to hold them for longer than one trading session or not suitable for longer-term investment, so that the firm can take appropriate steps concerning financial professional access, training, and/or compliance monitoring and review.”
Relying on the Regulation Best Interest standard and an investment adviser’s fiduciary duty, the SEC said financial professionals who recommend a complex or risky product “should apply heightened scrutiny to understand the terms, features and risks of the product and whether such product fits within the client or customer’s risk tolerance and specific-trading objective, and whether it would require daily monitoring by the investor or the financial professional.”
The Wall Street Journal reported that the SEC is not moving forward on a measure to require broker dealers and investment advisers to vet individual investors before permitting them to trade leveraged and inverse exchange-traded funds. These funds use debt to try to increase returns. But this leveraged approach to investing also increases the size of potential losses.
Many leveraged and inverse exchange-traded funds are complicated investments and difficult to understand. The Wall Street Journal reported that two companies that offer these investment products, Direxion Investments and ProShares considered the SEC’s proposed vetting requirement a threat to their business model. The Wall Street Journal also reported that between March and July, representatives and lobbyists for Direxion and ProShares met or had phone conferences with the SEC nine times.
SEC Commissioner Allison Herren Lee released a statement criticizing the SEC’s decision not to implement the protection for investors. The Commissioner wrote that she was “deeply disappointed in the failure to advance the proposed sales practice rules, which were designed to address the very real investor harms arising from unsuitable purchases and sales of leveraged and inverse ETFs.” The Commissioner further commented that many enforcement cases at the SEC and FINRA “have shown that even investment professionals often lack a basic understanding of these complex products.”
Investors have access to free electronic search tools through self-regulatory organizations, federal, and state regulators to research investment firms and professionals. This post describes several free tools that give access to information beyond what you can learn using Google and other search engines.
FINRA’s BrokerCheck is a good starting place to learn about registration and reported discipline. BrokerCheck allows you to search for an investment firm or professional by name or CRD number. BrokerCheck will tell you whether a firm is a broker or an individual is a registered representative regulated by FINRA. If regulated by FINRA, a BrokerCheck search will include information about reported disclosures, such as arbitrations or customer disputes, and provide information about registration. Click on the “Detailed Report” link—as the name of the link implies—for more detailed information, including summaries of any complaints. Also, keep in mind that through expungement, a broker can ask FINRA to remove customer complaints and arbitrations from records available through BrokerCheck. This means that an expunged complaint will not show up in your BrokerCheck search. Further, customer complaints are not always timely reported and may be missing from BrokerCheck.
If a firm is registered as an investment adviser or an individual is registered as an investment adviser representative, searching for the firm or individual using BrokerCheck will provide you with a link to the SEC’s Investment Adviser Public Disclosure website. For investment adviser representatives, the SEC’s Investment Adviser Public Disclosure search provides information similar to what FINRA makes available about brokers and registered representatives using BrokerCheck. For investment adviser firms, the SEC’s search tool gives access to the firm’s Form ADV, brochure, and Form CRS. These documents include information about an investment adviser’s business, including information about fees.
You should also check with the division in your state that regulates investment advisers. Some state regulators make available free information about investment advisers licensed to conduct business in the state. For example, the State of Oregon provides a free search tool that gives access to limited license information here: https://www4.cbs.state.or.us/ex/dfcs/dfcslic/adviser/.
On August 26, 2020, the SEC adopted amendments to the definition of “accredited investor.” Many private capital market offerings, including securities offerings conducted pursuant to Rule 506(b) and Regulation D under the Securities Act of 1933, along with certain offerings under state securities laws, are limited to accredited investors. These private offerings are sometimes higher risk than investments available in traditional markets. The amendments expand the definition to allow an individual investor who meets a financial sophistication test to qualify as an accredited investor. An individual may now qualify as an accredited investor based on professional knowledge, experience or certification. Previously, an individual had to meet income or net worth thresholds to be an accredited investor. The amendments also add to the entities that may now qualify to participate in private offerings.
In explaining its rationale for expanding the definition, the SEC said it does not believe wealth should be the only means of establishing financial sophistication of an individual for purposes of the accredited investor definition. Underlying this change is the SEC’s theory that purportedly sophisticated investors are not in need of the same level of investor protections otherwise available under the securities laws and regulations. Advocates for investor rights have criticized the SEC for failing to address the fact that many individual investors who already qualify as accredited investors do not have the financial sophistication and access to information to understand and assess the risks of many private offerings. PIABA, for example, sent the SEC a comment letter in May, emphasizing the SEC’s primary objective of protecting investors and warning that the expanded definition undermines investor protection. PIABA’s comment letter is available here. The SEC’s Final Rule is available here.
Proposed Regulation 21F, that the U.S. Securities and Exchange Commission is currently reviewing, could impact the SEC whistleblower program. To receive a cash award under the program, a whistleblower must voluntarily disclose original information that leads to a successful enforcement in which the SEC obtains an order of monetary sanctions in excess of $1 million. The SEC sets the whistleblower’s award within a range of 10-30% of the sanctions collected. In setting an award, the SEC must comply with Section 21F of the Securities Exchange Act.
In June 2018, the SEC proposed new rules for the whistleblower program that would give the SEC more flexibility in determining awards. For relatively small awards, under $2 million, the new rule would allow the SEC to adjust the award upward. However, if the award is likely to exceed $30 million, the SEC could limit the award to 10% of the sanctions collected.
Under the current rules and Section 21F of the Securities Exchange Act, the SEC is to consider several factors in setting the award, including the degree of assistance and the significance of the information provided by the whistleblower. An emphasis under the proposed rule on the amount likely to be collected, instead of the factors in Section 21F, may discourage whistleblowers from coming forward, especially in very large cases.
To learn more about these and other proposed changes, visit the SEC website.
Beginning June 30, 2020, brokerage firms and their associated persons will have to comply with Regulation Best Interest (Reg BI), which sets a new standard of conduct when working with retail investors. The SEC adopted Reg BI, as the name suggests, to require firms and associated persons to work in the best interest of investor customers, not the firm’s own interest. Along with the overarching requirement that broker-dealers put the customer first, Reg BI includes four major obligations: 1) full disclosure of all material facts (such as of fees); 2) care, including exercise reasonable diligence, skill, as well as care, in making investment recommendations; 3) mitigation and control of conflicts of interest; and 4) compliance. Broker-dealers must implement policies and procedures to ensure these obligations are met. The Reg BI duties apply to investment recommendations, investment strategies, and account changes (such as rollovers).
Reg BI largely replaces FINRA’s suitability rule for many investors and is meant to be a heightened standard that firms must meet. The “care” obligation under Reg BI, however, aligns closely with the existing FINRA suitability rule and preserves suitability concepts. For institutional customers, in contrast to retail investors, the suitability rule is still in effect.
Reg BI also bars broker-dealers from using sales contests, sales quotas, bonuses, and other non-cash compensation based on a representative selling a specific investment or type of investment within a defined period of time.
On June, 3, 2020, the U.S. Securities and Exchange Commission (“SEC”) obtained a preliminary injunction against investment adviser Paul Horton Smith, Sr. and related entities. The SEC alleges Smith and his entities engaged in a Ponzi scheme targeting senior citizens.
The SEC’s complaint refers to three entities associated with Smith: Northstar Communications, LLC, eGate, LLC, and Planning Services, Inc. Through these entities, the complaint alleges that Smith targeted seniors, guaranteeing investors annual interest payments in so called “private annuity contracts.” Smith did not in fact invest the money as promised, the SEC explained, and instead used the money to pay investors in a Ponzi-like fashion. The SEC also alleges that Smith held himself out to be a trusted fiduciary.
The case is Securities and Exchange Commission v. Paul Horton Smith, Sr., et al., Central District of California, No. ED CV 20-1056 PA (SHKx).
The U.S. Securities and Exchange Commission (“SEC”) filed a complaint for fraud against Applied Bioscience Corp. in May 2020. The SEC alleges that Applied Biosciences Corp. sought to exploit the COVID-19 pandemic for profit. In March 2020, the company changed its focus from cannabinoid-based products to pandemic-related products to “help battle the spread of COVID-19.” In late March, the company issued a press release outlining their sales of home test kits to the general public for COVID-19. The SEC determined that no shipments occurred and that the press release was misleading as the company did not disclose the FDA had not approved or authorized the sale of any COVID-19 at home test kits.
The SEC’s complaint charges the company with fraud for violating the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.
The case is Securities and Exchange Commission v. Applied Biosciences Corp., S.D.N.Y., Case No. 20 Civ. 3729.
In September, the SEC alleged that Elon Musk falsely claimed in a series of tweets on August 7, 2018 that he had lined up funding and support to take Tesla private at $420 per share, with backing from Saudi Arabia’s public investment fund. The announcement boosted Tesla’s stock price about 6 percent to close at $379.57 a share that day, although the price has since fallen 28.4 percent, to $271.78, as of Wednesday evening. Continue reading “Tesla Settles with SEC – Other Suits Remain”
According to an article in the publication called The Hill, President Trump’s appointee to the SEC suggested that the SEC may consider removing a ban that has been in place for years that has prohibited securities issuers from putting class action bans in their disclosures relating to IPO’s.
A motion for preliminary approval of a class action settlement was filed in California federal court on December 19, 2017 by investors in Marvell Technology. Under the deal, Marvell will pay pay $72.5 million to end an investor class action alleging the company’s stock dropped 16 percent after inflated revenue projections proved false.
A brief remark from SEC Commissioner Michael Piwowar during a July 17, 2017, Q&A suggests that he believes the U.S. Securities and Exchange Commission might soon allow companies to introduce mandatory arbitration clauses into their corporate charters.