The SEC looks poised to issue new rulemaking in the next 12 months or so to address the gamification of trading, the long-delayed universal proxy initiative, and corporate insider trading plans. These new rules could have a massive impact on how online brokers interact with their customers, how contested director elections are conducted, and how insiders trade under Rule 10b5-1 corporate stock trading plans.
The SEC’s GameStop Report Hands the Ball to Gensler
In January, unprecedented, coordinated trading via online brokers by retail investors in so-called meme stocks like GameStop drove up the price of targeted shares by eye-popping amounts, hurt hedge funds who had shorted (i.e., bet against) those stocks, and caused online brokers such as Robinhood, Interactive Brokers Group Inc. and E*Trade to halt trading in the affected stocks because they were unable to meet their margin calls (i.e., to put up the required collateral) to settle trades, harming those investors who could neither buy nor sell during the frenzy.
The incident brought numerous issues to the fore:
- the gamification of trading by brokers through their trading apps;
- the disadvantaging of retail investors who receive less than optimal pricing from their commission-free brokers—who themselves receive a payment for retail order flow (PFOF) from wholesalers as an incentive to do trades with inferior pricing;
- coordinated trading by retail investors creating massive volatility, astronomical price increases, and the potential for fraud and abuse;
- collateral requirements and settlement times; and
- the sudden, unilateral suspension of trading by brokers, leaving their customers to twist in the wind as the market turned against them.
Many investors and market observers had hoped an SEC staff report issued Oct. 18 would light the way forward by suggesting new rules to fix the issues that arose. It didn’t. The report serves as an explainer of what happened, but makes no specific policy recommendations. In doing so, the report gives Gensler the task—and the opportunity—to propose new rulemaking in those areas in a manner to his liking.
Based on what Gensler has already said publicly, the Commission appears likely to take action in the following areas.
Digital Engagement Practices, now called “DEPs” (which includes Gamification of Trading). The SEC is actively looking for violations of broker-dealer responsibilities to their customers, and Gensler may seek expanded enforcement mechanisms. The SEC may look into whether broker-dealers are fully adhering to Regulation Best Interest.
Broker Restriction on Customer Trading. The SEC may put forth new rules laying out the conditions for when a broker-dealer may suspend the trading it affords its customers. The focus of its efforts will likely be to prevent or reduce the likelihood brokers experience a repeat of the huge margin calls that precipitated the trading suspensions. This could be accomplished by shortening the settlement cycle duration (e.g., shortened from T+3 days to T+1 day or shorter). The Commission could increase margin requirements and perhaps tinker with rules affecting how brokers manage their liquidity and risk.
Payment for Order Flow (PFOF). The SEC has permitted brokers to receive payment for their order flow to wholesalers for quite some time. However, the GameStop phenomenon has thrust into the spotlight this essential conflict of interest among brokers benefiting from wholesalers’ payments in exchange for giving their customers inferior pricing. Given this history, the agency is unlikely to begin prohibiting payment for order flow in new rulemaking. Rather, efforts are likely to be focused on ensuring that broker-dealers give their customers best execution of their orders, as they are legally required to do. Expect the SEC to bring more enforcement actions to get brokers complying with best execution, maintaining internal controls and oversight, and providing adequate disclosures to customers.
Expect SEC to Close Gaps in Rule 10b5-1 Plans
Rule 10b5-1 stock trading plans are intended to prevent corporate executives from trading in their company’s shares in a way that benefits from their access as a company insider to the company’s material non-public information (MNPI), such as financial performance and planned acquisitions. In practice, gaps in the rule’s coverage have created opportunities for abuse, which many have exploited. Gensler has publicly lamented the deficiencies in the rule, and the time appears nigh for some action.
The SEC is in a position to propose new rulemaking that largely conforms to draft recommendations to change Rule 10b5-1 plans, as provided to the Commission by an advisory committee on Aug. 26. Expect new rulemaking to address the problems with stock trading plans in the following four areas:
Cooling-off period. The Commission will likely propose a mandatory cooling-off period (i.e., a moratorium) of four to six months, during which no trades pursuant to the plan are permitted, after a Rule 10b5-1 plan is initiated or modified.
Cancellation restrictions. The Commission may propose, at a minimum, to enhance disclosure of plan cancellations via Form 8-K. Other enhancements could include restrictions that prevent opportunistic plan cancellations.
Limits on multiple plans. The Commission is likely to prohibit more than one trading plan from being in effect at any given moment, to prevent picking and choosing to the insider’s advantage.
Mandatory plan disclosures. The Commission will probably require electronic filing of Form 144, certain enhanced proxy disclosures, and Form 8-K filings. Additional information on Form 4 is likely, as is extending Form 4’s filing requirements to any securities listed on U.S. exchanges, including foreign companies.
Checking the Mandatory Universal Proxy Rulemaking Box
The SEC has revived its initiative to propose a mandatory universal proxy to be used for all contested director elections not exempt under Rule 14a-2(b). A universal proxy card is a single ballot used in the election of members of a company’s board of directors. It lists not only the candidates nominated by the company but also candidates supported by others. Changes to proxy statement disclosure and proxy cards are proposed, waiting for a final rule to be adopted.
A universal proxy is supported by many investors. Commissioner Allison Herren Lee has praised the increased clarity and efficiency that a universal proxy card would bring. It would arguably level the playing field in director votes. Companies and business groups tend to oppose universal proxies, arguing three things: that the election of dissident directors could hurt the board’s effectiveness, that including dissident candidates on the same card could be viewed as an endorsement of those candidates, and that universal proxy cards are unnecessary because dissidents may attend shareholder meetings if they wish to freely choose among the board candidates.
The current Commission is inclined to write rules friendly to shareholders. The SEC proposal addresses opponents’ concerns by requiring that cards clearly distinguish between company-supported and issuer nominees. Universal proxies would more closely resemble how shareholders can vote when they attend a shareholder meeting in person.
The SEC is likely to update its current proposal, taking inspiration from the comments received from the reopened comment period and adjusting for market condition developments. Overall, the proposal ought to be little changed when the Commission adopts a final rule. Universal proxies could have a significant impact on proxy contests, enabling greater shareholder activism, putting more dissidents on public corporate boards, and creating headaches in the C-Suite.
Access additional analyses from our Bloomberg Law 2022 series here, including pieces covering trends in Litigation, Regulatory & Compliance, Transactions & Contracts, and the Future of the Legal Industry.
If you’re reading this on the Bloomberg Terminal, please run BLAW OUT <GO> in order to access the hyperlinked content, or click here to view the web version of this article.