Welcome to Saul Ewing’s Public Companies Quarterly Update series. Our intent is to, on a quarterly basis, highlight important legal developments of which we think public companies should be aware. This edition is related to developments during the third quarter of 2023. 

What You Need to Know:

• The SEC adopts new disclosure requirements aiming to protect investors from cybersecurity breach harms. 
• New CD&Is provide clarity to recent amendments to rules around 10b5-1 plans and related disclosure.
• The SEC continues to bring enforcement actions against issuers who violate 12b-25 by not making the appropriate disclosures when filing Form NT in connection with late periodic filings.
• Ongoing securities class action serves as a reminder to accurately describe ongoing litigation and avoid the temptation to minimize potential negative outcomes.
• The SEC has issued additional guidance on China-related and eXtensible Business Reporting Language (XBRL) disclosures.
• The SEC seeks to qualify crypto non-fungible tokens as investment contracts under Howey.
• Landmark Court Ruling Declares the SEC’s Rejection of a Spot-Traded Bitcoin ETF to be “Arbitrary and Capricious.” 

New SEC Rules Related to Cybersecurity 

On July 26, 2023, the U.S. Securities and Exchange Commission (SEC) adopted disclosure requirements aiming to ensure investors receive adequate information about the harms that a cybersecurity breach could cause. The new rules require registrants to (i) disclose their processes for assessing, identifying and managing risks from material cybersecurity threats in their annual reports, and (ii) disclose material cybersecurity incidents on a Form 8-K within four business days of determining that an incident is material. The SEC also adopted rules requiring foreign private issuers to make comparable disclosures. The new rule supplements prior SEC cybersecurity disclosure guidance but does not replace it.

The final rule requires that, in annual 10-K filings, companies detail their cybersecurity program, including information about board oversight and management’s role and expertise in assessing and managing risks from cybersecurity threats. It also requires prompt and mandatory filing – within four days – of a Form 8-K reporting material cyber incidents when they occur. Under the rule, “cyber incident” means an unauthorized occurrence (or series of related occurrences) on or conducted through a registrant’s information systems that jeopardizes the confidentiality, integrity, or availability of a registrant’s information systems or any information residing therein.

Disclosure requirements for risk management, strategy and governance become effective for all registrants for fiscal years ending on or after December 15, 2023. The material incident disclosure requirements become effective on December 18, 2023 (however, smaller reporting companies have a 180-day deferral).

As suggested by recent SEC enforcement actions, organizations that do not comply with the new rule will likely face serious consequences. These enforcement actions include large fines against companies for not disclosing breaches sufficiently or in a timely manner. With the new requirements, there are two distinct avenues for enforcement: first, whether organizations have appropriate disclosures under the requirements, and second, whether they have controls and procedures in place to escalate necessary items for determination regarding whether disclosures are required.

New CD&Is Related to Insider Trading Plans and Related Disclosure

On August 25, 2023, the SEC released five compliance and disclosure interpretations (“C&DIs”) related to recent amendments to Rule 10b5-1 and disclosures surrounding insider trading plans. 

Pursuant to Rule 10b5-1, trading plans for directors and officers require a cooling-off period of the later of (1) 90 days following adoption or modification of the plan, and (2) two business days following the disclosure in periodic reports of the company’s financial results for the fiscal quarter in which the plan was adopted or modified, and in any event no longer than 120 days following plan adoption or modification. C&DI 120.29 states that the filing date of the periodic report does not count as the first day of the cooling-off period and the cooling-off period starts the next business day following the filing of the report. 

According to C&DI 120.30, if a participant relies on Rule 10b5-1 to participate in a company’s 401(k) plan, a separate open-market transaction conducted at the direction of the plan administrator to match the participant’s original contribution, that was not made at the direction of the plan participant would not be an overlapping plan for purposes of Rule 10b5-1 that would disqualify the person’s reliance on Rule 10b5-1. 

C&DI 120.31 clarified that the Rule 10b5-1(c) check box on Form 4 for transactions made pursuant to a Rule 10b5-1 trading plan does not apply to trading plans that were adopted prior to the effective date of the amendments to Rule 10b5-1 (February 27, 2023).

In regards to disclosures surrounding insider trading plans, Regulation S-K requires that, in its periodic reports, a company disclose the adoption or termination of any trading plan of a director or officer during the preceding quarter. C&DI 133A.01 states that the company is not required to disclose the termination of a trading plan if such plan ended due to expiration or completion of the plan without any action by the plan participant. Moreover, C&DI 133A.02 states disclosure of a trading plan is required if a director or officer has made the decision to adopt or terminate a plan and also has a direct or indirect pecuniary interest in the plan that is reportable under Section 16.

SEC Enforcement Actions For Violation of Rule 12b-25

On August 22, 2023, the SEC charged five companies with deficient or untimely filings as required by Rule 12b-25 under the Securities Exchange Act of 1934 (“Exchange Act”).  The Commission had previously brought charges against eight companies for similar violations in April 2021.

Exchange Act Rule 12b-25 requires public companies with securities registered pursuant to Section 12 of the Exchange Act to file a Form 12b-25 “Notification of Late Filing” (commonly referred to as “Form NT”) when such companies are not going to be able to timely file a Form 10-Q, Form 10-K or similar periodic reports and are seeking additional days to file such reports. The disclosure required on Form NT includes reasonable detail as to why the company’s periodic reports could not be filed timely and an explanation of anticipated, significant changes in the company’s results of operations.

In each of these five cases, the SEC found that the companies announced restatements or corrections to financial reporting after making Form NT filings despite failing to provide information in the Form NT that anticipated restatements or corrections were among the principal reasons for their late filings. The orders also found that the companies failed to disclose on Form NT, as required, that management anticipated significant changes in results of operations.

The orders found that the listed companies violated Section 13(a) and Rule 12b-25 by failing to make the required Form NT disclosures. Without admitting or denying the Commission’s findings, the companies agreed to cease-and-desist-orders and agreed to pay penalties ranging from $35,000-$60,000.

The specific orders were in the following cases: In the matter of Blake Spade Acquisition Co., Admin. Proceeding File No. 3-21572, In the matter of Alpine 4 Holdings, Inc., Admin. Proceeding File No. 3-21573, In the matter of Omnia Wellness Inc., Admin Proceeding File No. 3-21574, In the matter of Reshape Lifesciences Inc., Admin. Proceeding File No. 3-21576, and In the matter of Vivic Corp., Admin. Proceeding File No. 3-21577.

To avoid these charges going forward, issuers making Form NT filings need to be careful to make the required disclosures at the time of the filing, particularly where the company anticipates that restatements or correct financial statements are anticipated. 

Adding Insult to Injury: Litigation Disclosures 

A public company’s $2 billion loss at trial in a case where the claims were described to investors as “without merit” serves as a reminder for companies to carefully craft and maintain their litigation-related disclosures. Plaintiff’s lawyers, on behalf of the public company’s shareholders, have seized on the company’s description of the litigation as the basis for a securities class action claim against the company and its CEO and CFO. 

In the underlying case, after years of litigation, Pegasystems Inc. (“Pega”) was found to have willfully and maliciously misappropriated the trade secrets of its competitor, leading to a $2 billion judgment against Pega. For about two years, the litigation was ongoing without mention in Pega’s annual reports on Form 10-K. When Pega did ultimately include a description of the litigation in its annual report, it characterized the competitor’s claims as “without merit.” Pega’s stock price dropped significantly following the disclosure of the litigation and even more significantly following the judgment.

As is so often the case after an event-driven drop in a company’s stock price, Pega, its CEO and CFO then became the subjects of a securities class action lawsuit alleging the disclosure misled investors about the litigation (In City of Fort Lauderdale Police and Firefighters’ Retirement Sys. v. Pegasystems, Inc., 2023 WL 4706741 (D. Mass. July 24, 2023)). Over the summer the district court judge denied a motion to dismiss the claim against Pega and its CEO.

The court’s decision focused on Pega’s characterization of the misappropriation case as being “without merit.” The court drew a distinction between stating that a claim is without merit and merely stating that a company has legal defenses against a claim. In the court’s view, the former statement could “justifiably have [been] understood [by a reasonable investor] … as a denial of the facts underlying [the] claims.” In contrast, a statement that Pega had legal defenses against a claim does not necessarily take any position as to the facts and could be interpreted as merely a legal conclusion. 

In this case, the CEO was aware of, involved in, and directed Pega’s corporate espionage against the competitor, the very facts denied by the statement that the claim against Pega was “without merit.” Accordingly, the court allowed the securities claims against the CEO and Pega to proceed on the basis that the false denial was substantially likely to mislead a reasonable investor along with the causal connection between the initial disclosure and judgment at trial on the one hand and Pega’s stock price on the other.   

Companies are routinely required to provide investors disclosure regarding ongoing litigation. They must thread a needle to avoid both misleading investors, either through a misrepresentation or omission, and prejudicing themselves in the underlying litigation by including statements about contested facts or legal issues.   

While a company can disclose its intention to oppose a lawsuit or state that it has substantial defenses against it, assuming it reasonably believes those to be true, companies and their executives should be extremely cautious about making any public statements regarding the underlying facts of a lawsuit. That includes considering whether statements may be interpreted by a reasonable investor as pertaining to those underlying facts. Companies and their executives should also refrain from minimizing the potential consequences of litigation or overstating the strength of their company’s position. Especially in those cases where the company and executives have reason to believe the litigation may turn out unfavorably, attempts to slow-roll the public disclosure may not only result in delaying the inevitable but could also compound the litigation exposures.

Additional Guidance on China-Related Disclosure and XBRL Data

The SEC’s Division of Corporation Finance released additional China-specific and XBRL (eXtensible Business Reporting Language) disclosure guidance this quarter, as well as two sample comment letters related to that guidance. The sample letters provide illustrative comments that the Division may issue as part of its filing review process.

The China-specific disclosures guidance and related sample comment letter focus on three China-related matters of increasingly broader application:

• Commission-Identified Issuer’s (“CII”) Supplemental Submissions and Disclosure. CIIs are companies that the SEC identifies on an annual basis (as required under the Holding Foreign Companies Accountable Act) as having retained an auditor in a foreign jurisdiction and where the PCAOB has determined that it is unable to inspect or investigate the auditing firm completely because of a position taken by an authority in the foreign jurisdiction. CIIs are required to make certain supplemental submissions to the SEC in connection with the filing of their annual reports to establish that they are not owned or controlled by a foreign government. In addition, CIIs that are foreign issuers are required to include disclosure related to the percentage of shares owned by a foreign government, the identity of all Chinese Communist Party (CCP) officials who are on the issuer’s board, and whether the issuer’s organizational documents contain any charter of the CCP.
• People’s Republic of China (“PRC”) Risk Factor Disclosure. For not only CIIs, but for all companies based in or with a majority of their operations in the PRC (“China-based Companies”), the Division is seeking additional risk-related disclosure around any material impact that an intervention or control by the PRC has or may have on a company’s business or the value of its securities. The Division also points to some of the prior disclosure-related guidance, sample comments letters and public statements for China-based Companies.
• Uyghur Forced Labor Prevention Act (“UFLPA”) MD&A Disclosure. The UFLPA went into effect in June 2022 and, among other things, prohibits all companies from importing goods into the United States that are manufactured wholly or in part with forced labor in the PRC, particularly in the Xinjiang Uyghur Autonomous Region (“XUAR”). Accordingly, in its guidance the Division is urging all companies to evaluate the material impacts of the UFLPA on their business, including, without limitation, any material compliance risk or material supply chain disruptions that a company may face when operating in, or relying on counterparties that operate in, the XUAR.

The XBRL disclosures guidance and related sample comment letter focus on compliance with iXBRL requirements, consistent presentation, appropriate iXBRL tagging, and the use of custom tags.

Enforcement Action Relating to an Unregistered Offering of NFTs

In less than a month, in cease-and-desist orders issued August 28, 2023 and September 13, 2023 (the “Orders”), the SEC has charged two companies, Impact Theory, LLC (“Impact Theory”) and Stoner Cats 2, LLC (“Stoner Cats”), with conducting unregistered offerings of crypto asset securities in the form of non-fungible cryptocurrency tokens (“NFTs”). Impact Theory and Stoner Cats, without admitting or denying the SEC’s findings in the Orders, both accepted the Orders and agreed to the payment of civil penalties (used to establish a Fair Fund to return money to injured investors), to destroy NFTs remaining in their possession or control, and to publish notice of the Orders on their respective websites and social media channels. 

The Orders constitute the first (and second) time that the SEC has formally sought application of the Howey_¹ investment contract analysis to NFTs, and continues the SEC’s ever-broadening campaign to bring cryptocurrencies and other crypto assets under the established regulatory framework for securities. The SEC determined that the NFTs issued by Impact Theory and Stoner Cats constituted investment contracts with investors purchasing tokens having “a reasonable expectation of obtaining profit based on [the companies’] managerial and entrepreneurial efforts.”

In both cases, the SEC supported its conclusion with several key facts in line with the Howey test, first finding that there was an investment of money as investors purchased NFTs from Impact Theory and Stoner Cats in exchange for Ether (a form of cryptocurrency). With regard to Impact Theory, the SEC focused on the company’s statements that it would deliver “tremendous value” to NFT purchasers and would use offering proceeds for “development,” “bringing on more team,” and “creating more projects” in using the money raised from the sale of NFTs to build “the next Disney.” In Stoner Cats’ case, funds from the NFT offering were to be used for the production of an animated web series called “Stoner Cats” with purchasers of the NFTs receiving special access to the web series, unspecified future entertainment content, an online community, and ownership of a unique still image of one of the characters in the series. Further, in both cases, purchasers of the NFTs were able to trade their NFTs on secondary markets.

Commissioners Hester M. Peirce and Mark T. Uyeda, who dissented in both the Impact Theory and Stoner Cats settlements, are concerned that the SEC’s approach amounts to something of an ad-hoc retroactive application of the Howey test, rather than following a meaningful examination of whether and how the Howey test should apply in the NFT context. Commissioners Peirce and Uyeda drew a similar distinction to traditional investment contracts in both cases, likening the NFTs to the purchase of collectibles like watches, paintings, or Star Wars collectibles with an incidental aspiration that such collectibles may appreciate in value from the building of a brand. While the collectibles analogy of Peirce and Uyeda may be an over-simplification, it is illustrative of the tensions the SEC will be grappling with in application of the Howey test to NFTs and other crypto assets; i.e., articulating a common enterprise and reasonable expectation of profit from the efforts of another without heading down a slippery slope or over-reaching to the point that the purchase of action figures requires a registration statement. 

SEC in the News: Grayscale Investments’ Bitcoin ETF Saga 

In the ever-evolving landscape of cryptocurrency investments, the pursuit of a spot-traded Bitcoin exchange-traded fund (“ETF”) has been a hot topic of discussion. Grayscale Investments, LLC (“Grayscale”), a digital asset management company renowned for its cryptocurrency investment products, including the Grayscale Bitcoin Trust (“GBTC”), recently found itself at the center of this discourse. This article explores Grayscale’s proposed Bitcoin ETF, the SEC’s rejection, and the consequential court ruling that overturned the SEC’s decision.

In October 2021, Grayscale filed an application with the SEC to launch a spot-traded Bitcoin ETF aimed towards providing mainstream investors a regulated and secure way to invest in Bitcoin. The proposed ETF purports to track the performance of Bitcoin and make it more accessible to a wider audience. Grayscale’s reputation in the cryptocurrency space, along with the success of the GBTC, made the proposal highly anticipated.

In June 2022, the SEC rejected Grayscale’s proposed Bitcoin ETF citing several key concerns, the most prominent being the potential for market manipulation in the cryptocurrency space given the relatively unregulated nature of cryptocurrency markets and the risk of price manipulation. The SEC went on to question the maturity and stability of the cryptocurrency market, considering its inherent volatility and susceptibility to sudden price swings. Given that traditional securities markets are subject to strict regulations, the SEC also expressed concerns about the adequacy of investor protection measures in cryptocurrency investments. 

The rejection disappointed many in the cryptocurrency community, especially given that the SEC had previously accepted applications from companies such as Valkyrie and Teucrium to operate ETFs trading in Bitcoin futures contracts. Futures-traded Bitcoin involve contracts that speculate on the future price of Bitcoin, with the underlying asset being Bitcoin itself but with a predetermined future delivery date and price. In contrast, spot-traded Bitcoin refers to the purchase or sale of actual Bitcoin on the current market at the prevailing market price, with immediate settlement and ownership transfer. Arguably, the SEC’s cited concerns in rejecting Grayscales’ ETF proposal would be more prominent in the futures trading context than in the spot trading context. This discrepancy led Grayscale to pursue a legal challenge, alleging that the SEC had not provided sufficient reasoning for its decision and had misapplied existing legal standards.

In a landmark decision on August 29, 2023, a three-judge panel of the District of Columbia Court of Appeals overruled the SEC’s rejection of Grayscale’s Bitcoin ETF proposal. The Court found that the SEC’s concerns were not supported by sufficient evidence, particularly given the approval of futures-traded ETFs and, among other things, Grayscale’s assertion that the spot-traded and futures-traded bitcoin markets are 99.9 percent correlated. Thus, the Court found the SEC’s rejection was arbitrary and capricious.

The SEC has 45 days – until October 13, 2023 – to appeal the ruling. Absent an appeal, the court can be expected to issue a mandate specifying how its decision should be executed, which could consist of an instruction to approve the application or revisit its decision (meaning, ultimately, the SEC could go on to reject it on other grounds). Should the SEC choose to appeal, however, the case would go either to a review by the entire D.C. appeals court or to the U.S. Supreme Court. 

Though cryptocurrency investments are still in a regulatory gray area, the Court’s decision may set a precedent for future cases involving cryptocurrency ETFs and the broader securities treatment of cryptocurrency. Several other asset managers, including BlackRock, Fidelity, and Invesco, have similar filings pending with the SEC for a spot Bitcoin ETF. The success of a spot-traded Bitcoin ETF would signal growing acceptance and adoption of cryptocurrencies in the mainstream financial markets. This trend could influence corporate strategies, including considerations for accepting Bitcoin as a form of payment, investing in blockchain technology (such as strategic investment in a Bitcoin ETF, which may make it easier for companies to acquire exposure to Bitcoin without directly holding the cryptocurrency, simplifying investment strategies and risk management), or exploring business opportunities in the digital asset space.

Closing Thoughts

The SEC continued to be busy on both the rulemaking and enforcement fronts on these and other matters throughout the third quarter of this year. This update is not intended as a substitute for individualized legal advice. 

[1] See SEC c. W.J. Howey Co., 328 U.S. 293 (1946). Courts apply the “Howey test” to determine whether an asset constitutes an “investment contract,” and therefore a security under U.S. securities laws by testing whether the asset in question (in the instant discussion, a digital asset) is characterized by the following element: (i) an investment of money (ii) in a common enterprise (iii) with the reasonable expectation of profits to be derived from the efforts of others.