On Tuesday last week, SEC Chair Gary Gensler gave testimony before the Senate Committee on Banking, Housing and Urban Affairs. His formal testimony covered a number of topics on the SEC’s agenda that Gensler (and others) have addressed numerous times in past: market structure and equity markets, predictive analytics, crypto, issuer disclosure, China, SPACs and Rule 10b5-1 plans. (See, e.g., this PubCo post and this PubCo post.) While the formal testimony covered some well-trod territory, the questioning highlighted the political polarization that we are likely to see continue as these proposals are presented for consideration.
(Based on my notes, so standards caveats apply. )
Ranking Committee Member Pat Toomey began his opening remarks by noting that, during Gensler’s confirmation, he had expressed a number of concerns. Historically, the SEC has been bipartisan, and he feared that Gensler would stray from that tradition by advancing a liberal political agenda to combat climate change and advance social justice, requiring disclosure even if not financially material. Unfortunately, he said, those fears were being realized because that was exactly what Gensler was doing—politicizing the SEC, with requirements for disclosure regarding global warming, human capital and diversity, social justice and other disclosures that push the bounds of the SEC’s authority—disclosures that are not financially material. It’s not the SEC’s role nor its expertise as an independent financial regulator with zero democratic accountability to address these political and social issues, he chastised. Gensler, he said, was also well on his way to politicizing the PCAOB (see this PubCo post), and was the conforming to the left’s paternalistic attitude by restricting investor freedom under the guise of investor protection.
Soon thereafter came Senator John Kennedy, who invested that same message with a bit more vitriol. After complimenting Gensler on his WSJ commentary regarding the Holding Foreign Companies Accountable Act (see this PubCo post), Kennedy began with “I don’t mean any disrespect”—always an ominous sign. “As to the people and companies you regulate as chair of the SEC,” he asked, “do you consider yourself to be their daddy?” “No, no,” Gensler calmly answered. Kennedy persisted: “Then, why do you act like it?” Gensler responded that he tries to take the oath of office seriously and that the SEC is set up to promote investor protection, facilitate capital formation and that which is in between. Kennedy persevered: “Why do you impose your personal preferences on social and cultural issues on companies, customers and workers—like climate change and the Second Amendment. [Hmmm, I didn’t see that one on the SEC’s reg-flex agenda.] I’m sure you have a personal view on abortion—do you plan to impose those values on companies too?” Gensler countered that he didn’t think he was doing that: rather, what he has been trying to do is say that if investors want information about climate risk—and it looks like tens of trillions of dollars under management do—then the SEC has a role to issue a proposal for notice and comment, do the economic analysis and see what investors say. “It’s in that narrow set of chalk lines that we operate,” he concluded.
Most of the questioning was otherwise on topic.
Committee Chair Sherrod Brown began by contending that the current standards for human capital disclosure were much too vague and open-ended. If companies pay employees a reasonable wage but subcontract out half of their labor requirements to companies that pay little and offer “stingy” benefits, that’s not even required to be disclosed. Investors will want more information. He adverted to the bill introduced by Senator Mark Warner, S.1815, the Workforce Investment Disclosure Act of 2021. According to Warner, businesses uniformly describe their employees as their greatest asset—“every CEO says that my biggest asset walks out the door each day”—but there is almost no public reporting required about that asset. In addition, when companies “offload” their workers as contractors, he said, “they’re really not putting their money where their mouth is.” He hoped the SEC would use the bill as guidance in connection with its own human capital disclosure proposal; in his view, investors wanted to know about issues such as employee retention, skills and training by employers. Here, he also referred to his bill that would create a tax credit for companies that “upskill” low and moderately paid workers (S. 1422, the Investing in American Workers Act).
Of course, the SEC has also targeted human capital disclosure on its agenda, and Gensler agreed that human capital is a critical asset. When he worked at Goldman, he recalled, and they worked on the sale of companies, they always included a section in the private offering memos about employees and what they were paid, the number that were part-time or full-time, employee retention and the like. It’s even more important in the 2020s, he said, because it’s so critical to the valuation of companies. (See this PubCo post.) Brown also asked about completion of the rest of the Dodd-Frank mandate—it’s been 11 years. Gensler said that he thought it was important to complete that mandate.
Senator Jack Reed observed that cybersecurity is one of the greatest threats we face, both as a security threat and an economic threat. He noted the SEC’s 2018 guidance on cybersecurity disclosure and referred Gensler to his cybersecurity bill, S. 808, which would mandate that companies disclose whether they had a cybersecurity expert on the board and if not, why not. Did Gensler think that the bill would provide an appropriate framework for cybersecurity disclosure? Gensler responded that he has asked the staff to look into two initiatives on cybersecurity, one directed at funds and the other at companies. With regard to the proposal for companies, he had asked the staff to consider whether the Reed bill should be included as part of the recommendation, but he had also asked the staff to consider two other components—cyber “hygiene,” i.e., how the company is managing risks related to cybersecurity, and incident reporting, i.e., if the company does have an event or has to pay ransomware, when is that reported and what is disclosed. Warner observed that the intell committee has as much insight into cybersecurity as anyone. That committee is working on a bipartisan bill for mandatory incident report for critical infrastructure for federal contractors.
Toomey observed that an important question about crypto was whether it was a security. Gensler, he said, had indicated that sometimes it is and sometimes not. Toomey was frustrated by the lack of clear public guidance on this question from the SEC. He understood that the SEC will sometimes give private guidance, but why not make it public? Instead, he said the SEC has been relying on regulation by enforcement, which he found objectionable and potentially stifling of innovation. In his opening, Gensler indicated that he did not believe there was enough investor protection around crypto—it was like the wild west. Senator Elizabeth Warren discussed problems with unregulated crypto platforms where volatility, high unpredictable fees and outages left especially small traders very vulnerable. She expected the SEC to step up and address the regulatory gaps.
Senator Cynthia Lummis requested that the SEC consider issuing more no-action relief to innovators. Gensler replied that innovators needed to come in and talk with the staff if the rules don’t quite fit, for example, because of the shift from brick and mortar to digital. The SEC wants to support responsible innovation by right-sizing protections within the core public policy framework to prevent fraud and manipulation and benefit competition. He recognized that innovation is at the heart of our success.
Warner agreed that more guidance was needed for crypto. The crypto area was really like the “wild, wild” west. Moreover, as a member of the intell committee, what he sees regarding the use of crypto from the intell side “scares the dickens” out of him. Gensler observed that that intersection almost functions as a way to subvert the anti-money-laundering laws.
On the other hand, Senator Steve Daines was concerned about the SEC’s posture on crypto, and wanted to see lighter-touch regulation. Gensler responded that companies need to operate through the public policy framework, to either register or get an exception. If they operate outside the framework, in his view, they won’t persist.
Political spending disclosure
Senator Jon Tester commented that, in his view, Citizens United was one of SCOTUS’s worst decisions ever, allowing billions of dollars to pour into the political system with no transparency. It did not help our democracy, he said. Aside from the provision in the current appropriations bill preventing the SEC from acting on this issue, the SEC otherwise has power to require disclosure of corporate political spending. While those donations may or may not be financially material to the corporation, they could be material to the recipient of the donation and the information about these donations is potentially material to shareholders. Shouldn’t they have access to it? Gensler replied that, if investors view the information as important, and increasing numbers suggest that they do, then the SEC has the same role as discussed earlier in terms of developing a proposal and soliciting public comment.
Tester also remarked that this had been his 44th harvest on his farm and, because of drought and other extreme weather conditions, it was his worst harvest ever. Climate will cost the country billions, if not trillions of dollars, he said, and he considered it irresponsible not to disclose the impact of climate, It isn’t going away, he said, it’s actually getting worse. He asked how Gensler viewed his role in this context? Gensler replied that his role is prescribed by Congress, and that it is to bring consistent, comparable disclosure about climate risk where investors want it. And investors have been asking for that information. Currently, about 80% of the Fortune 500 provide some information, but the SEC can bring consistency and comparability to information about both physical risk and transition risk.
Senator Brown expressed concern that many of the institutional investors in SPACs are not in it for the long term and that workers will be hurt as a result. He focused on a particular Ohio manufacturer where he believed some outside investors viewed the investment, not as a long-term investment in a community with a proud manufacturing heritage and talented workforce, but as a way to realize a quick return with no follow-through. In a situation like that, he said, when investors pull out, companies break promises and workers and communities pay the price. Should we be encouraging risky financial mechanisms? Gensler replied that, in this context, many of the institutional investors do sell and leave much of the dilution and other risk to retail investors. He has asked the staff to develop a proposal for better disclosure.
Payment for order flow
A number of senators addressed payment for order flow. Toomey asked what the harm was in payment for order flow, which helps brokers offer commission-free trading. Commission-free trading, he said, has been a great boon to retail investors, but Gensler’s opposition to payment for order flow could result in its elimination. According to Toomey, payment for order flow allows a broker to keep a portion of the price improvement obtained by routing transactions to a wholesaler. The SEC has not shown what’s wrong with that. This is a great time for retail investors, he said, because a person of modest means can participate in the potential gains of the market with negligible transaction costs. And what’s wrong with making investing fun though “gamification”? The SEC’s job, Toomey said, is not to make retail investing more unpleasant or difficult. In his view, the SEC was trying to fix problems that don’t exist. Gensler responded that the problem with payment for order flow is in broker conflicts. When rebates are paid, the result may be less efficient markets and less competition. When one wholesaler has 50% of the market, that can eliminate order-by-order competition. As a result, investors may not get the best execution. The goal, Gensler said, is to lower cost and raise efficiency. Warner commented that the limiting payment for order flow has been discussed for decades.
Senator Tim Scott was also concerned that SEC actions would jeopardize the path to wealth that is part of the American dream. The goal is to make the market more affordable. Before, the fees were too high for many retail traders. How can you ensure, he asked, that the average retail trader will continue to benefit? Gensler responded that retail investing is positive, but payment for order flow just results in hidden costs for investors.