For the past four years, a majority of SEC commissioners have been Republican.
While the commissioners agreed unanimously on many technical and enforcement issues, policy votes divided on party lines. In 2020, more than half of final rule-makings were partisan affairs with dissents from Democratic commissioners.
Partisan politics is part of Washington, D.C. Yet now a window is open for a restart if Joe Biden appoints a diplomatically minded SEC chair who can build a strong consensus among the four other commissioners. Balanced rulemaking can deepen the SEC’s legitimacy, improve staff morale and enhance its ability to resolve difficult problems.
Here are five issues for a consensus agenda set by the new Chair:
1. Open private securities markets intelligently: The SEC has long allowed only sophisticated investors to buy private securities, because these securities have minimal liquidity and private issuers provide investors with little information about the risks involved.
In the past few years, the Commission seems to have bought the argument that the average Joe should be able to invest in the next Google before it went public. But most startups fail, and successes go through multiple rounds of complicated funding that are difficult to evaluate.
The main guards against the dangers of alluring speculation in private securities have been quantitative requirements for “accredited” investors — $200,000 in annual income or $1 million in net worth. Unfortunately, the SEC has declined to update these requirements; originally adopted in 1983, they have shriveled by two-thirds from inflation. Instead, the SEC added a way around these requirements for investors who take any of various broker tests. Except that many of the tests permitted do not focus on risks, valuation and governance in private offerings.
Worse, the SEC missed an opportunity to build better requirements with a loss absorption test — linking the amount of permissible illiquid private investments to an investor’s net worth. This approach has been workable in so-called “Reg A+” offerings, which allow companies to raise $50 million from a broad array of investors, including ordinary ones. It should be a nonpartisan point of agreement for the new SEC chair to press for smarter rules, tailoring low-information offerings to investors who can afford to absorb losses as needed.
2. Improve the voting system to promote competition: Instead of addressing basic flaws in the “plumbing” of the voting system, the SEC added substantial costs and risks for proxy advisers, which analyze voting issues for institutional investors. The justification for this new rule — beyond disclosure of potential conflicts by proxy advisers — was flimsy. There was little evidence showing proxy advisers make widespread errors, and many letters seemingly from retail investors favoring the proposed rule turned out to be generated indirectly by lobbyists. Real investors — who need independent analysis to vote intelligently — strongly opposed the proposal.
The SEC backed off its proposed requirement that proxy advisers submit draft recommendations to the subject company before sending them to their clients. Nevertheless, the SEC mandated that advisers include a link in their proxy recommendations to any opposing view by the subject company. This mandate is unnecessary since the company will include its opposition in its proxy statement, which is sent to all its shareholders. And proxy advisers will have to wait for the mailing of the company’s proxy statement to include the mandated link.
The SEC also primed the voting arena for litigation, weaponizing its antifraud rule against advisers. Rather than mandate end-to-end vote confirmations that could improve proxy “plumbing,” the SEC set out examples of how proxy advisers could be sued. Such litigation threats will discourage competition in the already concentrated industry of proxy advisers. It should be a nonpartisan point of agreement to revise this rule to promote free speech and healthy competition in the market for voting advice.
3. Bring regulatory parity to financial advisers: When individuals employ professionals to help make investments, most do not know whether they are hiring investment advisers (IAs) or broker-dealers (BDs). Even fewer know that conduct of different professionals is governed by different rules — a higher fiduciary standard for IAs and a lower suitability standard for BDs. After an admirably consultative process, the SEC had a chance to clear up confusion by leveling the playing field and applying a fiduciary standard to all retail professionals. Instead, the SEC adopted the “best interest” standard for BDs.
Confusingly, the new standard is not what it appears. As with suitability, the standard applies only when specific recommendations are made. By contrast, IAs are always governed by fiduciary duties. Even when the new standard applies, BDs may recommend securities that generate higher BD compensation than plausible alternatives. Such conflicts are permissible for BDs (but not IAs) if disclosed and BDs make “reasonable” efforts to mitigate them.
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While the new standard is tougher than the suitability standard, we doubt retail investors will understand the new BD disclosures. Indeed, the SEC added to investor confusion by choosing a name for the new standard suggesting — incorrectly — that BDs will always act in investors’ best interests, rather than their own interests. It should be a non-partisan point of agreement that retail investors deserve clarity about the standards applicable to any professional. The SEC could apply the fiduciary standard to any professional advice to retail investors, and reserve BD status for those serving institutional clients and those providing execution-only services.
4. Improve the use of non-GAAP measures, especially in compensation disclosures: Many companies use non-GAAP measures in earnings releases, earnings calls and compensation committee reports. While non-GAAP measures can be useful in understanding a company’s performance, they can be misused. For example, non-GAAP metrics often exclude expenses for stock compensation, annual restructurings and litigation settlements. Almost always, companies try to use non-GAAP measures to increase earnings — sometimes turning losses to profits.
The SEC has for some time required companies to give equal prominence to GAAP and non-GAAP as well as to reconcile the numbers, and has brought at least one enforcement action for failure to do so. Yet the SEC has not taken a similar approach for compensation committee reports, which also often use non-GAAP measures. Investors struggle to make sense of how companies assess performance in approving large compensation packages. Outside of formal filings, the SEC has not aggressively enforced its views on the value of giving equal prominence of GAAP and non-GAAP numbers in quarterly press releases and earnings calls.
In April 2019, the Council of Institutional Investors filed a petition with the SEC asking that compensation reports explain why non-GAAP measures are better for determining executive pay than GAAP, and that they include a reconciliation of these two sets of numbers. The SEC ignored the petition.
It should be a nonpartisan point of agreement to start a rulemaking process on the use of non-GAAP measures in compensation committee reports, while bolstering enforcement of the equal prominence doctrine outside of formal SEC filings.
The SEC should play an active role in developing ESG disclosures for U.S. companies.
5. Rationalize and make comparable ESG disclosures: In 2020, the SEC adopted broad-based amendments to modernize basic disclosure requirements for public companies. Regulation S-K contains topics covered in prospectuses and annual reports, including the framework for management’s discussion of results and prospects. In the rulemaking, many commentators called for a rationalized, uniform set of disclosure requirements for diversity and climate change. Although the SEC did add human capital as a general topic, it adopted no requirements to enable comparisons across companies.
These proceedings were missed opportunities for the SEC to play a meaningful role in the development of consistent disclosures on the financially significant topics of diversity and climate risk. Although an increasing number of companies already include disclosures on these topics, executives and investors alike complain about the myriad of different standards. If the SEC continues to watch passively, other countries will press ahead and indirectly shape disclosures in the world’s largest capital market. There should be a nonpartisan agreement that the SEC should play an active role in developing ESG disclosures for U.S. companies.
The SEC does not have to tackle the task of creating new disclosure requirements from scratch. Instead, it could ask public companies to choose from recognized standards for disclosure — such as those of the Sustainability Accounting Standard Board or the Task Force on Climate-Related Financial Disclosures — and then monitor and assess how investors are using the new disclosures. Through such an approach, the SEC could in effect run pilot programs to ascertain which standards provide the most useful information to investors. On the basis of such pilots, the SEC could evolve a consistent and comparable set of disclosure requirements on diversity and climate risks.
Coming into the role, the new SEC chair can best serve investors by building a bipartisan consensus on reforming three recent rules — on accredited investors, proxy advisers and broker conduct — as well as proposing rules on non-GAAP metrics in compensation committee reports, proxy plumbing, and financially material information about climate change and diversity. Together these action items would provide a full but workable agenda for the SEC.
Robert Pozen is a senior lecturer at the MIT Sloan School of Management and formerly vice chairman of Fidelity Investments. John Coates is the John F. Cogan Professor of Law and Economics at Harvard Law School.