Articles Posted in SEC

In the span of the last two months, a digital piece of art sold for nearly $70 million, Jack Dorsey, CEO of Twitter, sold his first tweet for $2.8 million, and a digital Lebron James basketball card went for $208,000. What do these three massive sales have in common? Each transaction was for a non-fungible token (NFT), and together, they signal rapidly growing interest in the cryptographic asset marketplace.

Starting with the basics, what is a non-fungible token?

An NFT is a type of digital, cryptographic asset which exists on blockchain. Fungibility refers to interchangeability – assets like dollars, gold, and even Bitcoin, are fungible, because each unit is worth the exact same amount, and is thus readily interchangeable. On the other hand, each unit of a non-fungible asset has its own unique value and thus is not readily interchangeable – think of assets like property, artwork, and other collectibles. [1]

This week’s unprecedented winter storm in Texas this is the latest reminder of intensifying weather events across the globe, and the damage left in its wake opens up important questions about whether our financial systems are prepared to withstand the impacts of climate change. One of the most important functions of regulatory bodies like the SEC is to protect the market from systemic risks, and there is a widening consensus that climate change is one systemic risk for which the SEC must prepare.

As defined by SEC Commissioner Allison Lee during her keynote speech at the PLI’s Annual Institute on Securities Regulation in November 2020, a systemic risk is “characterized by the following features: (1) ‘shock amplification’ or the notion that a given shock to the financial system may be magnified by certain forces and propagate widely throughout; (2) that propagation causes an impairment to all or major parts of the financial system; and (3) that impairment in turn causes spillover affects to the real economy.” [1]

Put more simply, a systemic risk is one with the potential to result in the downturn, or even collapse, of an entire market system. The ongoing COVID-19 pandemic is one recent example of such a risk, as we continue to see its economic impacts across every sector of the market. During her speech, Lee noted that although the SEC is not in a position to regulate and slow the actual drivers of climate change, it can – and should – address climate risks through standardization of the environmental, social, and governance (ESG) disclosures that financial institutions make.

As they begin to move into the mainstream, it has become clear that cryptocurrencies pose a unique set of regulatory and legal challenges for investors and regulation agencies alike. In the past week alone, two high-profile securities fraud cases tied to cryptocurrency have come to light, and the total number of enforcement actions by the SEC on similar schemes has risen sharply over the past five years. In 2016, the SEC filed only one “Digital Assets/Initial Coin Offerings” enforcement action – in 2020, they filed 23.

The first cryptocurrency, Bitcoin, was introduced in 2009, and it has since been joined by over 1,900 competitors. Cryptocurrencies operate in a decentralized, purely digital block-chain network. Within the network, a supply cap on “coins” exists, and coin production is left in the hands of collective members of the system through a process known as “mining.” In Bitcoin’s case, there can only ever be 21 million coins mined, of which over 18 million have been mined thus far. Cryptocurrencies like Bitcoin derive their value largely from their limited supply, overall market demand, the cost to produce a bitcoin via mining, and competition from other cryptocurrencies.

Recently, Bitcoin’s price has been on the rise, stirring up a good deal of interest from prospective investors. As of February 6, 2021, one bitcoin is worth $39,255.90 –up about 300% year over year, and 34% year to date. But an investment in Bitcoin, or other cryptocurrencies like it, is unique in its risks. Experts caution that because cryptocurrency is a relatively new technology, and is not yet well understood by the public, prospective investors are at an increased risk of falling victim to fraudulent schemes.

It has been a tumultuous week in the investment world, with rallies among a gaggle of unlikely stocks, spurred on by a group of even more unlikely investors – retail investors who have banded together on the popular social media site, Reddit.

As has been widely reported this week, when Reddit retail investors discovered that hedge fund managers were widely shorting GameStop, AMC, and others, they urged fellow users to begin buying up these stocks. This frenzy of investment activity resulted in a short squeeze, sending GameStop’s stock price soaring, causing hedge funds to incur huge losses on their short positions, and placing popular online trading platforms in a precarious financial situation.  GameStop shares closed the week of January 25, 2021 up 400% in spite of market volatility and restrictions, and without any material change to the prospects of company.

But how did we get here?

In July 2020, the Securities and Exchange Commission made a proposal to vastly change the reporting requirements of hedge funds. The Securities and Exchange Commission’s proposal would permit hedge funds with less than $3.5 billion in assets to stop reporting their holdings in quarterly reports to the Securities and Exchange Commission.  At this time, the Securities and Exchange Commission requires quarterly disclosure of stock positions held by hedge funds that have more than $100 million in assets under management.

According to the Financial Times, during the ‘consultation period’ when the Securities and Exchange Commission considers comments made about their proposed changes, 2.262 letters were submitted to the Securities and Exchange Commission regarding the proposed change to the disclosure rules.  Of these 2,262 comment letters, 99% were against the proposed rule, according to Financial Times. The result of such a large number of letters opposing the rule change is that the Securities and Exchange Commission is expected to withdraw its proposal and keep the current disclosure threshold of $100 million.

The $100 million threshold has been in place since 1975 and it requires hedge funds to file a “13-F” report each quarter to disclose their holdings.  The Securities and Exchange Commission looked at the fact that the US equity market capitalization has grown from $1 trillion to an $35 trillion and decided that it was time to raise the disclosure limit.  The Securities and Exchange commission also claimed that the disclosure requirements at $100 million were a burden to the smaller hedge funds. This reasoning leaves out the impact that its actions would have on the transparency of the markets. The Financial Times reports that hedge fund managers were skeptical of the Securities and Exchange Commission’s reasoning.  The smaller hedge fund managers and even the CFA Institute noted that the costs to file the 13F are negligible and the process was mostly automated by today’s portfolio accounting software programs.

The Wall Street Journal published an article by Jason Zweig and Andrea Fuller on August 31, 2020 explaining their analysis of how financial advisers fell short in meeting their obligations to disclose important information to individual investors like you.[1] The Wall Street Journal analyzed the filings made by investment advisers on the SEC Form CRS.  The article and analysis revealed what seems to be disturbing lack of candor by investment advisers.

It is fundamental to full and fair disclosure that if an individual investor wants to know whether their financial adviser, or a financial adviser they want to hire, has any legal or regulatory problems, that this information is easy for an investor to obtain.  To that end, the Securities and Exchange Commission (“SEC”) sought to simplify the process by which an individual investor can access this information.  The result of the SEC’s efforts was the “Form CRS.”  “CRS” stands for customer (or client) relationship summary.

This information has been available.  However, for the average “Main Street” individual investor, the information was not easy to find.  And when the customer complaint and regulatory history was found, the disclosures were difficult to understand.  The Form CRS[2] was intended to address this complexity and difficulty through simplification.  Thus, the SEC created what SEC Chairman Jay Clayton said in November 2018 would be a “clear and concise” document.  I think they succeeded.  Wall Street, however, failed.

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