Welcome to Saul Ewing’s Public Companies Quarterly Update series. Our intent is to, on a quarterly basis, highlight important legal developments of which we think public companies should be aware. This edition is related to developments during the second quarter of 2023. If you would like to discuss any of these developments, please reach out to any of the authors or your regular attorney contact at Saul Ewing.
What You Need to Know:
- Environmental, social and governance (ESG) proponents still face an up-hill battle but the energy around pro-ESG policies continues to surge—both in the United States and worldwide.
- As artificial intelligence (AI) continues to rapidly evolve and adoption accelerates, public companies need to remain vigilant in disclosing the implications, risks, and opportunities associated with AI technology.
- The Securities and Exchange Commission (SEC) has adopted rule and form amendments to enhance disclosures around share buybacks.
- The SEC continues its pursuit of crypto-related enforcement actions and its push to categorize crypto assets as securities bringing them, and their issuers, under the SEC’s existing regulatory framework and oversight.
- The Supreme Court appears poised to overturn or narrow the Chevron doctrine.
ESG –Has its moment come… Or gone?
Canadian wildfires darken New York City skies in May… Cyclone Freddy kills 400 people in Malawi and Mozambique in March... January 2023 is the sixth warmest on record in the United States. Extreme weather worldwide continues to drive discussions, innovations, proposed regulations and hysteria around environmental, social and governance (ESG) efforts. Every day, businesses confront a changing landscape, both as to the effects of climate change and as to the regulatory environment intended to deal with the problem. Where is this all heading?
The Securities and Exchange Commission (SEC) proposed new regulations in March of 2022 that would require public companies to provide climate-related information in their registration statements and public reports (see here). Initial thinking was those rules would be finalized by the end of 2022 and would phase into effect beginning with fiscal year 2023 for large accelerated filers. As of this writing, the proposed rules have not yet been finalized. However, for companies with international operations, complex regulations have been enacted and are evolving both in the United Kingdom and the European Union. Corporate compliance and regulatory personnel at multi-nationals have a full time job just to keep up.
Meanwhile, the push-back against ESG persists and has increased. Numerous states have passed legislation prohibiting state governments from doing business with financial institutions that adopt ESG policies. In May 2023, Governor DeSantis signed into law a bill barring Florida officials from investing public funds to promote environmental, social and governance goals. The Florida law also prohibits Florida municipalities from selling ESG bonds. Similar measures have been pursued in West Virginia, Texas and other states.
The push-back is being felt in the private sector and the securities markets. In June 2023, an American Airlines pilot initiated a class action suit against American Airlines and others alleging violations of ERISA by offering funds in their 401(k) plans that included ESG factors. The theory is that since these funds focused on factors beyond strictly financial matters, they violated the statute and Department of Labor rules regarding what factors fund managers can consider. If this suit is successful, it would open the door to a wave of litigation which could result in managers of vast amounts of retirement money being prohibited from considering ESG factors in making investment decisions.
Further, on June 1st, the Conference Board, a research group, published a report indicating that support for shareholder proposals related to ESG initiatives is decreasing. The report stated that year-over-year, although the number of shareholder proposals increased, the actual support for greenhouse gas proposals fell by 37% (from 35% average support in 2022 to 22% in 2023) and support for other environmental initiatives generally fell by 50% (from 32% average support in 2022 to 16% in 2023). Thus, the trend seems to be that activists are being successful in getting shareholder proposals related to ESG into proxies, but the proposals themselves are not getting significant support from shareholders.
This is all happening in parallel with decreased judicial deference to the administrative agencies tasked with ESG-related regulation. In West Virginia v. Environmental Protection Agency, 598 U.S. ___ (2022), the Supreme Court embraced the “major questions” doctrine—that courts should not defer to agency statutory interpretations that concern “vast economic or political significance” where Congress has not delegated the issue to the agency specifically and clearly. The Supreme Court has also granted certiorari in Loper Bright Enterprises vs. Raimondo (“Loper”), which asks the court to reconsider and overrule the judicial deference provided to administrative agencies under Chevron v. NRDC, 467 U.S. 837 (1984) (“Chevron”). We discuss the Loper case and its potential implications in more detail below under the heading “Supreme Court to Reconsider Chevron Deference.” That case is expected to be decided in 2024, but this past month, in Sackett v. Environmental Protection Agency, the court did determine the EPA was incorrectly interpreting the Clean Water Act, seemingly signaling which way the court may be leaning on the deference question.
The EPA cases should also be considered in conjunction with recent constitutional challenges to the use of administrative law judges by the SEC and the Federal Trade Commission (FTC). The constitutional arguments are now being considered in federal district courts, after the Supreme Court ruled in April that they need not be first fully litigated in the administrative forum. These cases, like the EPA cases, demonstrate increasing vitality to arguments limiting administrative agency power. All of this is likely to come to bear when the inevitable challenges to the SEC’s ESG regulation winds its way through the courts.
In sum, ESG proponents still face an up-hill battle against those who want to limit or prohibit both ESG reporting and investing, as well as some investors who seem generally disinterested in these initiatives. However, the energy around pro-ESG policies continues to surge—both in the United States and worldwide. ESG regulations and increased market awareness of company ESG efforts are still on an upswing in various jurisdictions and are likely to proliferate. Some delay is inevitable. But no, ESG’s time is not gone.
Artificial Intelligence: Disclosure Implications, Business Risks, and Opportunities for Public Companies
As artificial intelligence (AI) adoption accelerates across industries, public company executives must be mindful of the disclosure implications, business risks, and opportunities associated with AI tools. The rapid growth of AI in critical systems such as defense, health care, and financial services highlights the potential for both benefits and risks on an enterprise scale. However, disclosure by public companies regarding the use and influence of AI within their businesses remains limited. In this update, we provide a briefing on the disclosure implications of AI adoption for public company executives.
Regulatory Enforcement and Litigation Trends
As AI continues to evolve, the number of enforcement and litigation actions regarding AI is growing, and important trends are emerging. Various federal agencies have already demonstrated that enforcement and regulatory actions can and will occur from the use of AI under existing statutes.
Among the agencies actively pursuing enforcement actions from the use of AI are the Department of Justice (DOJ), the FTC and the Food and Drug Administration (FDA). The FTC has asserted enforcement authority over AI in the context of its mandate to curtail unfair or deceptive practices, including the sale or use of racially-biased algorithms. The DOJ has also targeted fraudulent claims about AI products, such as the DOJ’s announcement of criminal charges against a cryptocurrency investment platform for falsely representing the capabilities of an AI trading assistant.
Enforcement activity has also arisen related to the unauthorized use of AI in highly regulated industries like health care. In 2018, the FDA sent a warning letter alleging that a company had marketed an adulterated and misbranded radiological imaging product. The FDA alleged the product improperly included an AI-enabled feature that automatically detected and marked abnormalities on the images.
Private litigants have also honed in on companies’ use of AI. Claims have been brought alleging discrimination, civil rights violations, and deprivation of due process resulting from AI-influenced decisions. As employers increasingly adopt AI-enabled recruiting and hiring tools, economic losses from claims based on algorithmic hiring biases have been forecasted to reach $3 billion over the next 10 years.
Disclosure Implications
The SEC has not proposed prescriptive regulations or provided tailored guidance regarding AI-related disclosures, but it has recognized the potential and risks of AI technology. AI-related disclosures by public companies have been limited, primarily relating to risks associated with AI technology and, to a lesser extent, descriptions of certain AI products and services or competitive advantages related to the use of AI technology.
A recent study of public company disclosures identified over 800 distinct risk factors related to AI. The variety of risk factors evidences the unique impact AI may have on each company and the necessity for every public company to assess the potential risks to their business. A few categories of risks were identified in the study. The most common were those related to (1) AI output and reliability including the inherent complexity of the technology; (2) significant research and development expenditures; (3) unpredictability; and (4) difficulty in identifying and remediating issues. As the adoption rate of AI-enabled tools accelerate, we expect more companies will begin referencing the risks of (1) regulatory enforcement and private litigation arising from their use of AI-enabled tools; and (2) disruption to their business models.
Highlighting the risks posed to a business by AI, public companies utilizing AI should also consider whether other disclosures may be required in their periodic reports. For example, disclosure may be warranted in a public company’s description of its business or in the MD&A in the context of discussing the company’s new products, industry, competitive trends and revenue-generating products or services. Even if not required, a company may voluntarily highlight their use of AI for a variety of reasons, including as a differentiator within their industry. The differentiation can take a variety of forms, for example: acceleration in product development, improvements in customer service, reductions in compensation expense or improvements in the company’s environmental impact through efficiency gains.
As AI continues to rapidly evolve and adoption accelerates, public companies need to remain vigilant in disclosing the implications, risks, and opportunities associated with AI technology. In addition to the economic effects, AI could impact a company from a regulatory, risk management and controls perspective. By providing transparent, accurate and timely information about their use of AI and the risks and opportunities it poses to their business, companies will be better protected from a shareholder lawsuit that may arise following a business model disruption or risk incident as a result of AI.
Recent Amendments to Share Repurchase Disclosure Rules
In early May, the SEC adopted various rule and form amendments designed to enhance disclosures provided by domestic corporate issuers, foreign private issuers and closed-end funds with respect to repurchases of equity securities, or buybacks, made by or on behalf of those issuers through a repurchase plan or program.
Based on SEC estimates derived from EDGAR filings and data obtained from third-party providers, there were nearly $950 billion in buybacks in 2021 by approximately 3,600 corporate issuers (including 300 foreign private issuers), representing approximately 48% of all corporate issuers, and approximately 100 listed closed-end funds, representing approximately 20% of such funds. In mid-June, S&P 500 Dow Jones Indices reported an uptick in Q1 2023 buybacks, notwithstanding the new 1% excise tax—part of the Inflation Reduction Act of 2022—taking effect on January 1, 2023, and by some accounts buybacks are projected to exceed $1 trillion in 2023.
The SEC, in reviewing a number of studies, including its own 2020 report to Congress, came to the conclusion that while buybacks are often made in a manner aligned with maximizing shareholder value, there may be instances where they are motivated by other factors, such as managing earnings to meet forecasts, or as a means of inflating share price or impacting earnings per share-linked compensation targets. Accordingly, the objective of this latest SEC rulemaking release—Share Repurchase Disclosure Modernization—is to enhance the quantitative and qualitative disclosures around repurchase plans and programs so as to provide investors with more useful information by which to evaluate such plans and programs.
New Periodic Quantitative Disclosure Requirements
The rules and amendments require disclosure of total purchases made on a day-by-day basis by or on behalf of an issuer. The information must be provided in tabular, iXBRL format—filed, for domestic corporate issuers, as an exhibit to quarterly and annual reports for the period covered by the report (in the case of an annual report, the fourth quarter), for foreign private issuers, within 45 days of the end of each quarter, on new Form F-RS, and for closed-end funds, in semi- and annual reports on Form N-CRS for the period covered by the report—disclosing in essence the information linked here.
In addition, issuers are required to indicate whether Section 16 officers or directors, in the case of domestic issuers or closed-end funds, or members of senior management or directors, in the case of foreign private issuers, have purchased or sold the subject securities within four business days before or after the announcement of a new, or increase in an existing, repurchase plan or program, by checking a box preceding their tabular disclosure.
New Qualitative Disclosure Requirements
The rules and amendments also require corporate issuers and closed-end funds to provide narrative disclosures regarding (i) the objectives or rationales for a repurchase plan or program as well as the process or criteria used to determine the amount of repurchases, and (ii) any policies and procedures related to purchases and sales by officers and directors during a repurchase program, including any restriction.
In addition, a domestic corporate issuer’s narrative disclosures must address whether, during the most recently completed fiscal quarter (in the case of an annual report, the fourth quarter), the issuer adopted or terminated a plan intended to satisfy the affirmative defense conditions of Rule 10b5-1, including a description of the material terms of any such plan (other than pricing-related terms), the date of its adoption, its duration and the aggregate number of securities to be purchased or sold under the plan.
Information Filed, Not Furnished and Other Changes
Unlike the proposed rules and amendments, the final rules and amendments require that daily repurchase data be filed with, rather than furnished to, the SEC and as such will subject an issuer to liability under Section 18 of the Securities Exchange Act of 1934, will be deemed incorporated by reference into Securities Act of 1933 (“Securities Act”) filings, and will subject an issuer to liability under Section 11 of the Securities Act.
The final rules and amendments also eliminate existing monthly repurchase data disclosure requirements from corporate issuers’ and closed-end funds’ periodic reporting requirements.
Compliance Dates
The rules and amendments are effective July 31, 2023, and domestic corporate issuers are required to comply with both the quantitative and qualitative requirements beginning with the filing of their first quarterly or annual report for the fiscal quarter commencing on or after October 1, 2023. Foreign private issuers are required to comply with the quantitative requirement by filing new Form F-SR quarterly beginning with their first full fiscal quarter commencing on or after April 1, 2024, and with the qualitative requirements beginning with the filing of their first Form 20-F made after their initial Form F-SR filing. Closed-end funds are required to comply with both the quantitative and qualitative requirements beginning with the filing of their first Form N-CSR covering the six-month period commencing on or after January 1, 2024.
SEC Crypto Asset Enforcement Action Update
The current chair of the SEC, Gary Gensler, has been candid about his intentions in using the SEC’s powers to increase oversight of the crypto industry. Some of that increased scrutiny has been manifested in the application of insider trading laws and proposed rule changes but the clear brass ring for the SEC has been the broader categorization of crypto assets as securities (or at least broadening of such assets deemed to be securities), rendering them, and their issuers, “broker-dealers,” “exchanges,” and “clearing agencies” subject to the SEC’s existing regulatory framework and oversight.
2022 and 2023 have seen a string of SEC actions where the SEC is pursuing, among a number of other charges, allegations of the unregistered offering of crypto asset securities deemed to be “investment contracts” under SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”).
In July 2022, in one of the SEC’s higher profile actions, SEC v. Wahi et al., Case No. 22-CV-01009 (W.D. Wash. July 21, 2022) (“Wahi”), the SEC brought insider trading charges against a former Coinbase employee, Ishan Wahi, and his brother, Nikhil Wahi, alleging that they engaged in an insider trading scheme to trade ahead of multiple announcements involving at least nine tokens which the SEC claimed were in fact unregistered securities made available for trading on the Coinbase platform. In Wahi, the SEC alleged that the tokens satisfied the Howey test by “including continuing representations by issuers and their management teams regarding the investment value of the tokens, the managerial efforts that contribute to the tokens’ value, and the availability of secondary markets for trading the tokens.” The Wahi brothers moved to dismiss the SEC’s complaint, arguing the charges were founded in a power grab, and, in relevant part, that the tokens could not be “investment contracts” because following issuance (even if then an investment contract), once the tokens made their way to the secondary market the connection between the purchasing “investor” and the “issuer” was broken because the tokens then become simple assets with no binding promises running from the software developers to the tokenholders. To use the parlance of Howey, the Wahi brothers’ position amounted to the argument that the tokens were no longer like a participation interest in an orange grove, but more closely resembled a simple orange.
The Wahi case was closely watched and criticized by crypto industry participants for the SEC’s view of secondary market trades as regulated transactions involving investment contracts and the position that the authority to regulate the broader digital asset industry is a question requiring congressional authorization.
However, before the court in Wahi could consider the question of whether the crypto tokens constitute securities, even when they lose a direct connection to an issuer, the Wahi brothers reached a settlement with the SEC which was announced on May 30, 2023. The Wahi case does, however, remain illustrative both of the SEC’s broader approach to claiming authority over crypto assets and digital asset transactions and the manner in which they may seek to exert that authority.
Following right on the heels of the Wahi settlement, the SEC announced two high profile actions against prominent crypto asset exchanges. At their core both cases charge violations of critical registration-related provisions of the federal securities laws that turn principally on the unregistered offering for sale of certain crypto assets. In each case the SEC seeks to establish that certain crypto assets constitute “investment contracts” and the unlawfulness of the defendants’ performance of certain exchange, broker, and clearing agency services without compliance with registration requirements. Both of these cases present the potential for the SEC to establish a broader authority by expanding the accepted scope of what crypto assets constitute securities and what activities require registration with the SEC.
On June 5, 2023, in a complaint filed in the U.S. District Court for the District of Columbia, the SEC charged Binance Holdings Ltd., (Case 1:23-cv-01599 (D.D.C.)) which operates the largest crypto asset trading platform in the world, together with its U.S.-based affiliate, and their founder Changpeng Zhao, with a variety of securities law violations. Among other things, the SEC argues (i) that defendants’ sale/offering of so-called exchange tokens, stablecoins, crypto-lending products, and staking-as-a-service program constituted unregistered offers and sales of securities, and (ii) that defendants operated as unregistered exchanges, brokers, dealers, and clearing agencies—earning in excess of $11.6 billion in revenue from U.S. customers—with Zhao liable as a “control person” for the registration violations.
Just one day later, on June 6, 2023, the SEC filed a complaint against Coinbase, Inc., (Case No. 1:23-cv-04738 (S.D.N.Y.)) (and its holding company Coinbase Global, Inc., as a control person) for operating its crypto asset trading platform as an unregistered national securities exchange, broker, and clearing agency and for failing to register the offer and sale of its crypto asset staking-as-a-service program.
Supreme Court to Reconsider Chevron Deference
As noted above, the Supreme Court has agreed to hear Loper Bright Enterprises vs. Raimondo (“Loper”), a case testing the Chevron doctrine, the decision of which may potentially implicate the SEC’s proposed climate disclosure rules.
Chevron establishes a doctrine that allows federal agencies to interpret ambiguous statues and requires a federal court to defer to the agency’s reasonable interpretation of such statutes. The Supreme Court’s conservative majority appears poised to overturn or narrow Chevron, a move that would weaken the federal agencies’ leeway to define the limits of their own statutory authority, including the SEC’s proposed rule requiring public companies to disclose information about carbon emissions and climate risks. The ultimate question is whether the SEC has the actual authority to adopt the climate disclosure rule.
The proposed reporting rule would require public companies to include certain climate data in their audited financial statements, covering items from costs caused by wildfires to the loss of a sales contract because of climate regulations. These disclosures would provide clear reporting obligations for issuers and consistent and helpful information for making investment decisions for investors.
The proposals have been met with extraordinary challenges from various groups. The business community expressed concerns that the changes would bring high costs, complexity and unintended consequences. Many members of Congress have stridently objected to the rulemaking, with one member going so far as to suggest that the climate proposal represented a “weaponization” of the SEC. Even some of the investors the proposed system is supposed to benefit have pushed back.
The Supreme Court’s potential overturning of Chevron would be the latest blow to the SEC’s attempts to address the climate change issue.
Closing Thoughts
The SEC continued to be busy on both the rulemaking and enforcement fronts on these and other matters throughout the second quarter of this year. This update is not intended as a substitute for individualized legal advice. We encourage you to reach out to any of the authors or your regular attorney contact at Saul Ewing if you have specific questions or would like to discuss how these updates or any other recent developments may apply to you. Please subscribe here to receive our future updates, invitations to events, and other useful information from Saul Ewing. View previous editions of our Public Companies Quarterly Update here.
