SEC Over-regulation?


At the National Association of Corporate Directors-New England breakfast on Tuesday, one guest had the temerity to suggest to the Director of SEC’s Boston Office, and to Secretary of the Commonwealth Bill Galvin (who controls the State’s Securities Division), that the government was over-reaching in its regulation of financial institutions. Much of the corporate crowd mumbled in agreement; not surprisingly, the regulators did not.

Paul Levenson has been head of the SEC Boston office since October. His list of hot regulatory topics: large-scale pyramid schemes (something not normally within the SEC bailiwick); constant pressure on public issuers to hit earning targets, resulting in liberal accounting; migration of broker/dealers into registered investment advisory functions, giving people trained in sales a fiduciary obligation which they may not be attuned to filling.

The latter point is interesting; much litigation by regulators against broker/dealers is aimed at pointing out that they already are fulfilling a fiduciary agency role with respect to customers.

Secretary Galvin focused on consumer protection; most of his cases bubble up from citizen complaints. His key areas are pyramid schemes, insider trading, and an anticipated rush of claims based upon recent SEC liberalization of the rules for private placements (new SEC Rule 506(c) permits public advertising of formerly “private” security sales to sophisticated purchasers).

There were a couple of takeaways for boards of directors:

  • Cyber security is not a matter of “whether” your company will be hacked, but what your response mechanisms are. The importance of a board making sure that cyber security systems are in place varies with the company; if you are selling bumpers for automobiles you are less sensitive than if you possess consumer charge card data.
  • Are banks too big and complex to actually regulate (a question from the audience based upon the billons of dollars banks already have paid in settling SEC claims)? Levenson was unremitting in this regard. For directors, you must understand that security law breaches derive from actions of your employees. Take a look at your corporate organizational chart. Can you obtain a confident feeling that high ethical standards can be policed through the organization as currently structured? Is your organizational chart so complex and over-lapping that there is no way you can conceive of a workable compliance program?

Finally the SEC, since the 2010 Dodd-Frank Act, has been relying more heavily on adjudicating securities law violations through administrative law judges appointed by the SEC itself. This avoids the troublesome task of actually going to court and having a trial where you have to convince the jury of someone else’s guilt. Levenson’s explanation: going to a jury is a waste of time and money, these are sophisticated issues which sophisticated administrative law judges can resolve more efficaciously. This trend is therefore liable to continue. Trial by jury does not seem to be high on the SEC hit parade.

M&A at Akamai

Akamai Technologies, Inc. of Cambridge, Massachusetts is one of the true internet success stories, with $1,600,000,000 of annual revenues and EBITDA of about 44%. A disciplined pursuit of M&A opportunities has driven part of this growth, as reported by Vice President of Corporate Development Jeremy Segal at the May 29th ACG meeting here in Boston.

Some of the criteria applied by Akamai, in evaluating a target, are standard and not surprising: business fit, cultural fit, non-dilution of earnings. Several other articulated benchmarks have not yet proven significant given the size of deals undertaken, although with $1.5B of cash in the bank they may ultimately become germane: for example, Akamai asks “is the acquisition more than 10% of our market cap” and “will the acquisition increase our head count by more than 10%.”

Segal’s presentation showed a mix of organic growth and a measured pace of M&A. He claims that 90% of IP traffic by 2015 will be media over IP, he sees a huge explosion of internet-connected devices of all sorts, and he notes his company’s movement into protecting the integrity of the internet based upon a 50 times increase in cyber-attacks since 2009.

Akamai also is increasing investments in emerging technology companies, likely for the first time considering A Rounds (as opposed to more mature situations). In making investments, they look for a board observer and a right to receive notice of potential transactions (he observed that rights of first refusal are not realistic in venture capital environments).

One interesting touch-point in Akamai’s M&A practice involves cultural integration after an acquisition. Akamai starts looking at that issue early, typically at the LOI stage, to make sure that upon closing the integration is far along, while also identifying specific cultural touch-stones in the target which are to be preserved.

Trends in Board Governance

All directors, whether of non-profits or for-profits, face the same problem: how to focus on the essence of board function, strategy, while besieged with the pressures of an increasingly complex world?

Some interesting perspectives surfaced at the National Association of Corporate Directors-New England Chapter meeting at the Newton Marriott yesterday.

Boards should be more proactive in identifying the information they need and the topics that should be discussed. Management must be selective, so as to prevent the sending of too much non-critical information.

Management no longer is setting board agendas. The focus should be on discussion, not “death by power point.” The discussion should be strategic, and inherent in that discussion will be a measurement of enterprise risk.

What kind of boards will we have in the future? There is growing awareness that diversity of experience is essential. As more and more companies restrict their CEOs from serving on outside boards (or limit service to a single board), more board members will be drawn from the ranks of the retired; this in turn creates an upward creep in the average age of directors and a concomitant increase in the mandatory board retirement age.

U.S. boards are slow to move to the European approach of having different stake holders represented on the board: labor, consumers, community. It was not clear to the panel whether this trend would be manifested in the United States.

More and more meetings will be handled electronically, particularly committee meetings which are increasingly important and take a lot of time. It’s almost impossible to do proper service on an active board and still hold a “day job.”

What major changes will we see on boards by the year 2018? The panel did not have an answer. Everyone agreed that maintaining “board culture,” free ability to speak with candor, will remain important. And what about participation by the digital generation? Some companies are establishing advisory boards to deal with the digital revolution. To my view, this is a mistake. Viewing digital issues as something around which a fence can be built is too narrow an approach. Digital data, digital reputation, digital marketing, digital cyber risk, everything in the future is going to be digital; the grayer heads I believe should swallow hard and blend in members of the digital generation, because their input is needed within the board itself – particularly if, as noted, the average age of board members is creeping upwards for other reasons.

Reducing Medical Care Costs — Ain’t so Easy

How can you drive down the cost of medical services?  This is my final post based upon the MassMEDIC Annual Conference held on May 7th at the UMass Boston Campus. 

The goal, per the conference,  is not to bring down the aggregate cost of medical care for society.  The drive is to bring down the per-patient cost, so that more people are served for the same aggregate dollars. 

The task will not be easy.  The aging population does not help.  75% of all U.S. medical costs are in the treatment of chronic diseases which proliferate with age. Additionally, medical devices, aside from being both cost justified and outcome efficient, will have to be marketed to emerging larger health care systems, as the individual or small-scale purchaser of medical devices in a fee-for-service system becomes far less typical. 

Ways to reduce cost:

  • Use big data.  Look at patient behavior.  How do you reward patients for good behavior?  What does good behavior look like? 
  • Use that data to measure outcomes.  Use big data to drive enrollment in trials. 
  • Work on alternate financing.  Venture capital investment in this space is way down.  Reliance should not be placed on crowd-funding, because retail investors will soon learn, as have VCs, that pay-offs can be scarce and deferred, and that risk in this space is high. 
  • Recognize the consummerization of health care.  Patients will be called upon more and more to manage their own care.  Devices much be made simpler and cost less to be delivered into the hands of the new class of practitioner: the patient. 

What about ObamaCare?  Not a lot of discussion, based upon what appears to be no conclusive data with respect to cost and outcomes.  There is low expectation that collected premiums under the system will in fact cover costs, and certainly ObamaCare (and other regulatory initiatives such as statutory limitations on gifts to physicians, the medical device tax and payment reform), has created uncertainty in the device marketplace.

Investing in Med Devices

I have previously posted on changes in the medical device clinical trial landscape noted at the MassMEDIC Annual Conference held May 7th at UMass Boston.  Another area of discussion focused on financing emerging medical device companies. 

It is no secret that the investment community has become much more risk adverse.  It is necessary early on, even at the angel or A Round stage, to address matters that at one time were deferred for analysis at a later stage after technology was proven: cost of goods sold, pricing, reimbursement, designing a less expensive trial (perhaps utilization of statistical sampling to reduce onsite monitoring costs). 

What are the current major investor touch stones?  Reimburseability.  Path to regulatory approval.  Identifying a device that improves outcomes or saves money.  Copycat devices, replacement designs of an existing device without palpable outcome improvement or demonstrable cost savings, are dead in the water.

Med Device Clinical Trial Trends

The medical device marketplace is all about FDA clinical trials, determining whether a device creates good patient outcomes and is reimbursable, and the avoidance of economic risk.  These factors, interestingly, bear in a significant way on the manner in which clinical trials for medical devices are conducted, according to speakers at the May 7th Annual Meeting of MassMEDIC held at the UMass Boston Campus.  (MassMEDIC is the association of manufacturers of medical devices). 

First it should be noted that some devices can be FDA approved if they are sufficiently similar to prior devices, without conducting clinical trials.  Further, extended double blind clinical trials are generally less indicated for devices than for drugs; drugs are ingested into the system and may impact safety in “off target” areas, while the impact of devices typically is local and can be observed directly and more simply. 

One of the pushes in designing faster U.S. trials is the presumed trend to conduct trials in the first instance in Europe, of even in Asia, where regulatory difficulties are less extreme.  In the United States, particularly if there is a “dangerous” possibility in the trial, satisfying FDA is indeed a longer process and consequently bringing a product to market will take longer here. 

All that said, various trade groups are working with the FDA to speed up the process by using “single arm” trials (a single treatment is evaluated).  Another push is to speed the process by going directly to human testing, without prior animal studies, with respect to smaller groups of subjects. 

Cutting through all of this is the reality that United States studies often fail to achieve targeted enrollment; 45% of proposed studies, according to a 2013 Harvard University survey, failed to fully fill; 15% of these studies received absolutely no participation. 

Another trend is toward “adaptive” study design.  The FDA has been approving these studies in certain cases, eliminating pilot studies, collapsing the process, and allowing the design of the study to be modified, as it proceeds, based upon the data obtained in preliminary indications.  This allows speeding up the study that is clearly promising, or reducing the sample size as you go forward.

The Supreme Court — Social Battleground

In the political, religious and cultural battles fought out before the United States Supreme Court these days, sometimes the cases that do not reach the court have the greatest impact. 

Steve Shapiro, Chief Counsel for the American Civil Liberties Union, noted in Boston remarks Tuesday that keeping certain cases off the Supreme Court docket, where the decisions below have struck a blow for civil liberties, is sometimes important.

Thus, working for the Supreme Court to deny cert for cases that strike down city ordinances preventing rental of apartments to undocumented aliens, striking down an Arizona statute that makes illegal any abortion after twenty weeks (clearly prior to the recognized point of fetus viability), preventing review of the 9th Circuit decision striking down a Florida executive order requiring executive employees of all agencies to undergo drug tests, keeping the Supreme Court away from revisiting a free speech case in which a Pennsylvania high school student was cleared of violating school rules by wearing the popular bracelet “I love boobies,” all represent a victory for civil liberties positions. 

Turning to cases the Supreme Court did hear this term: 

The Court has struck down race as one of the factors in admission to University of Michigan.  This case generated an impassioned dissent by Justice Sotomayor, suggesting that the Court majority was out of touch with the realities of discriminatory effects which need be addressed in an affirmative manner. 

The Court has also: supported the right of town councils to begin each meeting with a sectarian prayer; and, struck down a statutory cap on the aggregate of political donations given by an individual to all candidates during a given year.  These latter two decisions were by 5-4 vote. 

In the election donation decision, the government argued that a donor making contributions to numerous candidates of one party would thereby obtain tremendous power within the party and excessive access to the political process.  Chief Justice Roberts stated that the purpose of the donation laws was to prevent corruption by means of “bribery;” access to the political process is politics and not corruption, he maintained. 

At this dictation there are still pending for decision a variety of cases including two key ones: 

  • A Massachusetts case involving the 35’ buffer zone around abortion clinics, being challenged as an infringement on free speech;
  • A challenge to the Affordable Care Act (ObamaCare) by private company Hobby Lobby, wherein the owner of Hobby Lobby maintains that, when the Act requires him to provide health insurance for employees wherein contraceptive devices are included without a co-pay, this violates his personal religious rights. 

The latter case is interesting legally; the corporation is the employer and not the individual, and one of the questions is whether a corporation will be treated as a “person” for purposes of determining matters of religious freedom.  It is one thing, under the Citizens United Case, to say that corporations are persons for purposes of political donations; but religious freedom is a matter of conscience, and there is a real question as to whether a corporation has a “conscience” in a constitutional sense. 

In general discussion, it was noted that the Supreme Court itself has a great lack of diversity, divided among six Catholics and three Jews who have attended only two law schools, with only one Justice ever having tried a criminal case, only one Justice from West of the Appalachians, and with no Justice from the South.  Query whether such a demographic is conducive to the best delivery of “Justice.”

Accredited Investors Definition–SEC Changes under Consideration

Yesterday I posted about remarks from Keith Higgins, head of CorpFin at the SEC, concerning general solicitation in securities placements for private companies.  Higgins also discussed SEC changes being considered in the definiton of Accredited Investor (that class of people who are favored in being able to invest in private placements under SEC Rules).

Today, for individuals, accredited status derives from net worth excluding primary residence of at least $1M per household, or annual earnings of $200,000 ($300,000 with spouse).  The Dodd Frank Act in 2010 required the SEC to revisit this definition in 2014, and the SEC is considering the following additional measures to achieve accredited status (no guarantee of what will be recommended ultimately):

First, possesson of a professional certification or degree such as CFA, CPA, a securities license (he pointedly did NOT mention attorneys– wonder if there is a message there?).

Second, ownership of other investment securities as an indication of an ability to exercise informed judgment (what if you hold a large portfolio and everything is down?).

Third, reliance on an intermediary such as a registered broker in making investment decisions (borrowing the sophistication of a third party to bolster one’s own sophistication).

Higgins promised a balancing between intelligent criteria and putting vulnerable investors at risk.  This focus on protecting invidual investors in placements is an interesting counterpoint to the front page of today’s WSJ:  seems that over the last 6 years as much as 60% of all stock trades were effected by “high frequency” trading firms.  While protecting individuals from fraud in private company placements is not ignoble, you have to wonder if there are not bigger regulatory fish to fry….

Angels and General Solicitation in “Private” Securities Offerings

Keith Higgins, recently an SEC lawyer here in Boston, and now Director of the Corporate Finance Division of the SEC (“Corp Fin”), addressed the Angel Capital Association in Washington last week, touching upon several matters affecting angel investors.  Interestingly, he spent most of his time attempting to dispel misimpressions of the use of new SEC Rule 506(c), which Rule in some instances permits the use of general solicitation in the unregistered sale of company securities.

In spite of predictions that angels and other start-up investors would flock to the new exemption as a way to get broader participation in admittedly risky enterprises, the new Rule has been sparsely used.  Offerings under 506(c) since last September have numbered less than 900, raising $10B; the “old” 506(b) exemption, prohibiting solicitation, had 9,200 offerings raising over $233B.  Why?

Issuing companies must “verify” that investors are accredited, and self-declaration of accredited status is not enough.  BUT Higgins points out that companies can rely on alternate methods of verification without digging deep into investor finances, including: general information on hand; pre-secreening recommendation from a known reliable third party; investing a large amount (presumably, available only to wealthy and thus accredited investors). 

Some companies were unclear on what constituted “general solicitation,” a concern that Higgins found inexplicable given the plethora of historical interpretations of that phrase (in the context of the SEC declaring that companies could NOT undertake such actions under “old” Rule 506(b)).

Other companies feared that, since the rules for 506(c) offerings were experimental and that the SEC quite likely would amend them in the future, they might find themselves having violated a new SEC refinement.  Higgins assured that the SEC would not apply new regulatory requirements retroactively.

Seems like the SEC expected quite a flood of publicly solicited securities placements, particularly given the pressure for the new 506(c) format and the publicity surrounding its adoption, and is confused by experience to date.  To my mind, the state of the market simply reflects the caution applied to pushing new SEC initiatives which look and feel theoretically inconsistent with SEC history –  put another way, a fear you cannot teach that old SEC dog any new tricks.

The East is Green — Emerging Economies

Harry Broadman, PWC’s Chief Economist and leader of its emerging markets practice, makes an overwhelming case that the economic future of the world lies in the Far East, including but not limited to China and India (which between them have 1/3 of the world’s population).

In remarks delivered this weekend in Philadelphia, Broadman demonstrated that emerging countries are the engines of global growth, and that the trend is increasing.  The growth of the economies of emerging countries is not cyclical; it is a long-term structural change driven by the world being flat, the speed of communication and change, and the rise of the middle class.  Indeed, emerging economies fared better than established economies in resisting the 2008 economic collapse. 

According to Broadman, we need a strategy which he calls “China 2.0.”  It is not just China; it is Vietnam, Myanmar, Philippines, South Korea, Indonesia. 

A related trend in emerging economies is more sophisticated buying.  Noting that equipment purchased at low cost often is of lower quality, buyers in emerging markets are moving toward buying the best possible equipment, as the amortized true cost over time is less. 

The key to marketing emerging economies is that you need a package; the country may need railroads, but it also needs banking, water management, IT and the like.  Larger companies servicing the emerging market must cobble together a package responsive to a broad spectrum of needs. 

Finally, we have to stop thinking about emerging economies as markets, or as labor pools.  To a growing extent, innovation itself is coming out of emerging markets, including out of Africa. 

So we used to say glibly that the “East is red” but, at least to PWC and Broadman, it looks more like greenbacks.  There are lessons for United States manufacturers, service firms and, indeed, mid-term and long-term investors in the equities markets.  Ladies and Gentlemen: replace your bets.