Small Business Advocate Urges Capital Raising Relief
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
I’ve written a five-part series detailing the rule changes, the first of which can be read HERE. My plan to publish the five parts in five consecutive weeks was derailed by the coronavirus and more time-sensitive articles on relief for SEC filers and disclosure guidance, but will resume in weeks that do not have more pressing Covid-19 topics.
On April 2, 2020, the SEC Small Business Capital Formation Advisory Committee held a special meeting (remotely) to discuss the potentially severe and immediate impact of Covid-19 on small businesses. Although the Committee did not make specific rule-change recommendations, it did urge the SEC to take immediate action to ease online private capital raising rules to assist businesses in accessing capital quicker and from a larger body of investors.
Committee members argued for an ease in crowdfunding restrictions to allow small businesses to quickly access potential investors. Commissioner Peirce agreed with the approach, noting that allowing companies to raise funds over the internet is in line with current social distancing initiatives. Pierce suggested allowing a new micro-offering exemption for quick access to capital with few restrictions.
SEC Chair Jay Clayton gave opening remarks, stressing the unprecedented challenges faced by small businesses. Although he also offered no specific solutions, he did stress the importance of preserving the flows of credit and capital in our economy to better fight and ultimately recover from Covid-19.
Although no one brought it up, I think that quick rules which allow the payment of finder’s fees to unregistered individuals and entities would be extremely beneficial, and could be accomplished while maintaining investor protections. Many small business owners (or even larger business owners) simply do not even know where to begin when it comes to capital raising, and many are uncomfortable asking for money.
I would advocate for rules that include (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.
I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the FINRA Securities Industry Essentials Exam for finders that are otherwise exempt from the full broker-dealer registration requirements.
New C&DI on Filing Deadlines
As I wrote about in my last two blogs, the SEC has provided relief such that periodic filings that would have been due from between March 1 and July 1, 2020 can avail themselves of a 45-day extension (see HERE). In order to qualify for the extension, a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
On April 6, 2020, the SEC issued a new C&DI explaining how the extension impacts a company that excludes particular information in its Form 10-K intending to incorporate that information in its subsequently filed proxy or information statement. In particular, a Form 10-K allows a company to include Part III information in its subsequently filed proxy or information statement for its annual meeting as long as the proxy or information statement is filed within 120 days of the end of the fiscal year. In the event that a proxy or information statement containing the Part III information is not filed by the 120th-day deadline, then an amended Form 10-K must be filed by that date with the omitted information.
The SEC confirms that if a company is unable to file the Part III information by the 120th-day deadline, it may avail itself of the 45-day extension for companies affected by the Covid-19 crisis as long as the deadline is within the relief period (March 1 through July 1, 2020).
A company that timely filed its annual report on Form 10-K without relying on the Covid-19 Order should furnish a Form 8-K with the disclosures required in the Order by the 120-day deadline. The company would then need to provide the Part III information within 45 days of the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
A company may invoke the Covid-19 Order with respect to both the Form 10-K and the Part III information by furnishing a single Form 8-K by the original deadline for the Form 10-K that provides the disclosures required by the Order, indicates that the company will incorporate the Part III information by reference, and provides the estimated date by which the Part III information will be filed. The Part III information must then be filed no later than 45 days following the 120-day deadline.
A company that properly invoked the Covid-19 Order with respect to its Form 10-K by furnishing a Form 8-K but was silent on its ability to timely file Part III information may (1) include the Part III information in its Form 10-K filed within 45 days of the original Form 10-K deadline, or (2) furnish a second Form 8-K with the disclosures required in the Order by the original 120-day deadline and then file the Part III information no later than 45 days following the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
« Relief For Persons Affected By The Coronavirus Disclosures Related To COVID-19 »
Relief For Persons Affected By The Coronavirus
Last week I published a blog summarizing the relief granted by the SEC for public companies and capital markets participants impacted by the coronavirus (Covid-19) (see HERE). Just as Covid-19 rapidly evolves, so have the regulators response. The SEC has now expanded the relief and issued guidance on public company disclosures related to Covid-19.
While we work to complete the usual filings while in quarantine, a new conversation is starting to develop at a rapid pace. That is, the conversation of opportunity and the accelerating of a more technologically driven economy than ever before. Businesses and service providers must stay nimble and ready to serve the ever changing needs of entrepreneurs and the capital markets – I know we are!
Extension in SEC Reporting Filing Deadlines
On March 25, 2020, the SEC extended its prior conditional relief order such that periodic filings that would have been due from between March 1 and July 1, 2020 can avail themselves of a 45 day extension. The prior order only offered an extension for filings due between March 1 and April 30, 2020.
The extension is only available under certain conditions. In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough. In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis. For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines
The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.
If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.
For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report. For more on S-3 eligibility, see HERE.
Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.
The extension actually changes the due date for the filing of the report. Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.
Disclosures Regarding Covid-19 Impact
In an earlier press release the SEC reminded companies of the obligations to disclose information related to the impact of Covid-19 on their businesses. SEC Chair Jay Clayton had stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”
The SEC Division of Corporation Finance has now issued Disclosure Guidance Topic No. 9 regarding the SEC’s current views on disclosures and the obligations that companies should consider with respect to Covid-19. The overarching messaging is that a company must consider its Covid-19 impact in its disclosure documents and make necessary material disclosures using a principal’s based strategy.
Certainly the actual impact and risks are difficult to ascertain and may be unknown or dependent on third parties, but the SEC encourages material disclosure on what management expects the virus’ future impact will be, how management is responding to evolving events, and how it is planning for COVID-19-related uncertainties. Examples of areas of reports that may be impacted and thus require disclosure include management’s discussion and analysis, the business section, risk factors, legal proceedings, disclosure controls and procedures, internal control over financial reporting, and the financial statements.
Topic No. 9 suggests that management consider the following non-exclusive list in considering Covid-19 related disclosures:
- How has Covid-19 impacted the financial condition and results of operations? How do you expect COVID-19 to impact your future operating results and near-and-long-term financial condition? Do you expect that COVID-19 will impact future operations differently than how it affected the current period?
- How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook? Consider if the cost of or access to capital and funding sources has changed and whether it is likely to change or continue to change. Have sources and uses of cash been materially impacted? Has the ability to continue to meet ongoing credit agreements changed or is it materially likely it will change? Disclosure should also be made as to the course of action a company has taken or proposes to take in light of the material impact on its financial resources.
- How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets? For example, will there be significant changes in judgments in determining the fair-value of assets measured in accordance with U.S GAAP or IFRS?
- Do you anticipate any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on your financial statements?
- Have COVID-19-related circumstances such as remote work arrangements adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures? If so, what changes in your controls have occurred during the current period that materially affect or are reasonably likely to materially affect your internal control over financial reporting? What challenges do you anticipate in your ability to maintain these systems and controls?
- Have you experienced challenges in implementing your business continuity plans or do you foresee requiring material expenditures to do so?
- Do you expect COVID-19 to materially affect the demand for your products or services?
- Do you anticipate a material adverse impact of COVID-19 on your supply chain or the methods used to distribute your products or services?
- Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?
- Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve your business goals?
Trading on Material Non-Public Information
The combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading). Like the prior issued exemptive order, Topic No. 9 reminds all companies of its obligations. If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.
Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made. Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate. Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).
Reporting Earnings and Financial Results
Topic No. 9 encourages companies to proactively address financial reporting matters earlier than usual. Many companies will rely on the available 45 day extension and will be grappling with the accounting complexities of the Covid-19 impact including short term dramatic changes in expenses and revenues. The SEC suggests engaging needed experts and beginning an analysis of the potential impacts as quickly as possible to be prepared to meet filing deadlines, even with the extensions.
Many companies, although not obligated, choose to issue earnings releases (for more on earnings releases see HERE. In addition to other considerations, the SEC reminds companies of their obligations under Item 10 of Regulation S-K and Regulation G related to the presentation of non-GAAP financial measures. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information. For more on Item 10 and Regulation G see HERE.
Topic No. 9 specifically acknowledges that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by a Covid-19 related adjustment that may require additional information and analysis to complete. In these situations, the SEC would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results. For example, if a company intends to disclose EBITDA on an earnings call, it could reconcile that measure to either its GAAP earnings, a reasonable estimate of its GAAP earnings that includes a provisional amount, or its reasonable estimate of a range of GAAP earnings. In filings where GAAP financial statements are required, such as on Form 10-K or 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.
The SEC also cautions companies against using the Topic No. 9 guidance and current SEC flexibility to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.
Furnishing of Proxy and Information Statements
The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible. The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.
Virtual Annual Meetings
Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law. Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not. New York has historically been one of the states that does not have easy provisions for virtual meetings. Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings. Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.
Relief for Registered Transfer Agents
The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020. The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.
The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists. The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.
To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.
« Conditional Relief For Persons Affected By Coronavirus Small Business Advocate Urges Capital Raising Relief »
Conditional Relief For Persons Affected By Coronavirus
As the whole world faces unprecedented personal and business challenges, our duty to continue to run our businesses, meet regulatory filing obligations and support our capital markets continues unabated. While we stay inside and practice social distancing, we also need to work each day navigating the new normal. Thankfully many in the capital markets, including our firm, were already set up to continue without any interruption, working virtually in our homes relying on the same technology we have relied on for years.
We all need to remember that the panic selling frenzy will end. Emotions with even out and the daily good news that comes with the bad (for example, the number of cases in China is falling dramatically; some drugs are working to help and the FDA is speeding up review times for others; early signs China’s economy is starting to recover already; scientists around the world are making breakthroughs on a vaccine; etc.) will begin to quell the fear. No one knows what the economic damage will be but we do know that new opportunities will appear, the buying opportunity is already being hinted at for capital markets, and entrepreneurs will continue.
In the meantime, besides the economic stimulus packages that have already passed in some states and that are fighting their way through the federal partisan political system, regulators have provided some relief for our clients and the capital markets participants.
Extension in SEC Reporting Filing Deadlines
The SEC has issued an exemptive order providing public companies with an additional 45 days to file certain disclosure reports that would otherwise be due between March 1 and April 30, 2020. The extension is only available under certain conditions. In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough. In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis. For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines
The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.
If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.
For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report. For more on S-3 eligibility, see HERE.
Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.
The extension actually changes the due date for the filing of the report. Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.
Disclosures Regarding Covid-19 Impact
The SEC press release regarding the exemptive Order reminds companies of the obligations to disclose information related to the impact of Covid-19 on their businesses. SEC Chair Jay Clayton stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”
Furthermore, the combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading). The exemptive order reminds all companies of its obligations. If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.
Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made. Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate. Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).
Furnishing of Proxy and Information Statements
The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible. The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.
Virtual Annual Meetings
Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law. Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not. New York has historically been one of the states that does not have easy provisions for virtual meetings. Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings. Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.
Relief for Registered Transfer Agents
The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020. The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.
The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists. The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.
To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.
« SEC Proposed Rule Changes For Exempt Offerings – Part 1 Relief For Persons Affected By The Coronavirus »
SEC Proposed Rule Changes For Exempt Offerings – Part 1
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The June concept release sought public comments on: (i) whether the exemptive framework as a whole is effective for both companies and investors; (ii) ways to improve, harmonize and streamline the exemptions; (iii) whether there are gaps in the regulations making it difficult for smaller companies to raise capital; (iv) whether the limitations on who can invest and amounts that can be invested (i.e., accredited investor status) pose enough investor protection and conversely create undue obstacles to capital formation; (v) integration and transitioning from one offering exemption to another; (vi) the use of pooled investment funds as a source of private capital and access to those funds by retail investors; and (vii) secondary trading and re-sale exemptions.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with this first blog focusing on integration.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
In recent years the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke up Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors and the Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the current most often used offering exemptions.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Integration
The current Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. That is, where two or more offerings are integrated, there is a danger that the exemptions for both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
The current integration rule (Securities Act Rule 502(a)) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Furthermore, yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
The amended rules would completely overhaul the integration concept such that each offering would be viewed as discrete regardless of whether it was completed close in time to a second offering. Under the new rules, where a regulatory safe harbor exists such safe harbor could be relied upon. For all other offerings, the new integration rules would look to the particular facts and circumstances of the offering, and focus the analysis on whether the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Of course, where exempt offerings allow general solicitation, they must include the regulatory legends required for such offering.
In making the analysis as to whether an offering complies with an exemption, where solicitation is not allowed, the company must have a reasonable belief that the investors were either not solicited or that such investor had a substantive relationship with the company prior to commencement of the offering. Generally a substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication and established accreditation. That is, a substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
Moreover, the SEC is proposing four new non-exclusive safe harbors from integration, including: (i) any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation (this 30-day test would replace the six-month test across the board); (ii) offerings under Rule 701, under an employee benefit plan or under Regulation S will not integrate with other offerings; (iii) a registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering that terminated more than 30 days before the registration statement was filed; and (iv) offerings that allow for general solicitation will not integrate with a prior completed or terminated offering.
The determination of whether an offering has been terminated or completed will vary depending on the type of offering. A Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering will be terminated or completed on the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities. As to Regulation A offerings, such will be terminated or completed when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering. Offerings under Regulation Crowdfunding will be terminated or completed upon the deadline of the offering set forth in the offering materials.
Registered offerings will be terminated or completed upon the (i) withdrawal of the registration statement; (ii) filing of an amendment or supplement indicating the offering is completed and withdrawing any unsold securities; (iii) entry of an order by the SEC; or (iv) three years after the filing of an S-3. Although the same termination and completion analysis for each offering would be preferred, the differing natures of the offering mechanics do not make that feasible.
To avoid an abuse of the 35 unaccredited limitation under Rule 506(b), where a company conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
To avoid abuse involving Regulation S offerings, where there is a concurrent Rule 506(c) offering, the company will need to prohibit resales to U.S. persons for a period of six months except for QIBs or IAIs.
The new integration principles and safe-harbors would be aggregated in Securities Act Rule 152. Moreover, Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions) will be amended to cross reference the new amended rule 152. Other rules (Rules 255(e), 147(h) and 147A(h)) will be eliminated as the provisions will be covered in Rule 152.
Current Exemption Overview Chart
The SEC proposed rule release published the following chart, which was also included in the June concept release, of the most commonly used offering exemptions…
« SEC Small Business Advocate Releases First Annual Report Conditional Relief For Persons Affected By Coronavirus »
SEC Small Business Advocate Releases First Annual Report
The SEC’s Office of Small Business Advocate launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat. The Office recently issued its first annual report (“Annual Report”).
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyzing the potential impact of regulatory changes on small businesses and their investors; (v) conducting outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
A highlight of the achievements of the office under the leadership of Martha Legg Miller include: (i) hosted and participated in various engagement events with entrepreneurs and investors; (ii) published its business plan; (iii) participated in National Small Business Week including the Small Business Roundtable and meeting of the Small Business Capital Formation Advisory Committee; (iv) launched explanatory videos on how to participate in and comment on rule making; and (v) hosted the annual Government-Business Forum on Small Business Capital Formation, a forum I have had the pleasure of attending in the past.
The Office’s Annual Report contains discussions on: (i) the state of small business capital formation; (ii) policy recommendations; and (iii) the Small Business Capital Formation Advisory Committee.
The State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in reliance on Rule 506(b) of Regulation D ($1.4 trillion for FYE June 30, 2019) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).
The industries raising the most capital include banking, technology, manufacturing, real estate, energy and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Florida and Texas are responsible for higher amounts of capital raised in aggregate.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited. The SEC recently proposed a change in the definition of accredited investor to open up investment opportunities to additional qualified investors (see HERE).
The Annual Report discusses costs for early-stage companies to raise capital, including attorneys’ fees. According to the report, attorneys’ fees are between $5,000 and $20,000 for very early-stage companies and from $20,000 to $40,000 for venture-stage entities. The Report is in line with fees in my firm.
Interestingly, the Annual Report notes a correlation between the increased availability of venture capital funding and job growth in metro areas. Generally, venture-capital or private-equity-backed companies enter the public markets – 44.8% of companies currently listed on the Nasdaq were formerly backed by a venture-capital or private-equity firm.
The Report contains information related to the much–talked-about growing delay in public offerings (see more information HERE and HERE.) According to the Annual Report, companies are going pubic later in their life cycle, which also results in less funds being raised in the public markets via follow-on offerings. The Annual Report indicates 204 IPO’s from July 1, 2018 through June 30, 2019 and 294 small public company follow-on offerings for the same period. Not surprisingly, 61% of exchange traded companies with less than a $100 million market cap have no research coverage.
Woman are founding more start-ups than previously, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. On the investor side, 29.5% of angel investors are women, 11% of VCs are women, and 71% of VC firms had no female partners.
There has also been a big uptick in minority-owned businesses. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. On the investor side, only 5.3% of angel investors and 1% of VCs are minorities.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.
Policy Recommendations
Modernize, Clarify and Harmonize Exempt Offering Framework
Following up on the SEC’s June 2019 concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework (see HERE), the Office of Small Business Advocate recommends a simplification to the exempt offering structure. The securities laws, including exempt offering regulations, are complex and difficult to navigate. The fact is that without competent securities counsel, the chances that a capital raise will be compliant with the securities laws is nonexistent.
The Office of Small Business Advocate suggests the following guiding principles to consider in restructuring the current exempt offering framework: (i) the rules, including all guidance on compliance, should be readily accessible and written in plain English; (ii) the rules should allow a company to progressively raise money throughout its growth (meaning very easy structures for small start-up capital raises); (iii) consider the Internet and technology advancements in communication (perhaps allow more open solicitation and advertising); (iv) dollar caps should be flexible for future review and adjustment and consider factors such as industry, geography and life-cycle stage; and (v) the principles underlying the current regulatory structure for exempt offerings should be re-examined.
Investor Participation in Private Offerings (the Accredited Investor Definition)
Most offering exemptions limit participation to accredited investors or if unaccredited investors are allowed, the number of such investors may be limited (506(b)), the disclosures required much more robust, or the investment amounts limited. As a result, the question of a change to the hard-line-in–the-sand accredited investor definition has been debated for years and answering the call, in December 2019, the SEC published a proposed amendment (see HERE).
The Annual Report notes that the definition of an accredited investor is designed to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. However, the current definition results in eliminating opportunities for retail investors to diversify their portfolios and participate in the growth of companies in the private markets. Public mutual funds rarely invest in private companies and private-equity, hedge funds and venture-capital funds raise capital using the same offering exemptions as private businesses and thus have the same accredited investor limitations. Also, as a result of poor drafting, some sophisticated entities such as American Indian tribal corporations have been left out of the definition, regardless of their asset value.
The Office believes that although investor protections are important, the current definition prioritizes risk of loss over sophistication and creates too strong a barrier to capital for small and emerging-growth companies. Furthermore, the current accredited investor definition structure (and prohibitions on advertising and solicitation) makes it difficult and time-consuming for accredited investors to source investment opportunities even when they want to.
Supporting the proposed rule changes, the Office agrees that adding financial professional licenses and education goalposts to the current accredited investor definition would be beneficial. Likewise, they would not support an increase in the current financial thresholds. Rather than add to the list of entities that could qualify, the Office suggests that any entity, regardless of corporate form, should be able to qualify if it has over $5 million in assets. The Office recommends that the changes be easy to navigate, providing simplicity and certainty in ascertaining qualification to avoid increasing transaction costs. Although not included in any current rule proposal, the Office also suggests modifying the Investment Company Act rules to allow for more public mutual funds to invest in private companies.
Finders
As all capital markets practitioners know, one of the biggest challenges to raising capital is finding and being introduced to potential investors. Although larger companies engage the services of broker-dealers, there simply aren’t many options for smaller or early-stage entities. Because of the very big need, an industry of unlicensed finders has developed. This is a topic I’ve written about many times (see HERE). Some finders operate within the parameters of the law, such as by providing a multitude of valuable services such as creating pitch materials, consulting on capital structure, helping with general business goals and objectives and marketing materials, and importantly, not collecting a success or separate fee for capital introductions. However, many violate the law, causing a host of potential issues for both the finder and the company utilizing their services. Despite pleas from industry participants, the ABA, committees within the SEC and numerous other groups, the need for a workable regulatory structure remains unanswered.
The Office calls for a clear finder’s framework. In implementing a framework for finders to support emerging businesses’ capital needs and provide clarity to investors participating in the market, it is critical that the rules be clear for marketplace participants to reduce confusion, defining in plain English the activities that do not trigger registration and delineating when the scope of activities rises to the level that registration is appropriate. The framework should make clear what offering exemptions are eligible, whether the introduced investors must be accredited, the nature of compensation the finder may receive, the types of other incidental activities that the finder may engage in on behalf of the business, and the respective roles of federal and state regulators.
As I’ve mentioned several times, I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even support a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.
Crowdfunding
Since 2012, Regulation CF has provided a method for businesses to raise a small amount of capital (capped at $1,070,000) from numerous investors over the Internet utilizing the services of a funding portal. The Annual Report suggests that crowdfunding has been a success, helping many entrepreneurs that may otherwise not have been able to access capital. However, the Annual Report points out some issues with the process including the inability to properly advertise and market and thus drive investors to the opportunity and higher-than-necessary compliance costs. The Office reports that the system overseas is better, with companies raising more capital at a lower cost.
The Office suggests: (i) increase the $1,070,000 cap (no amount is suggested); (ii) remove the investment cap for accredited investors; (iii) revise the various disclosure obligations to reduce compliance costs; (iv) enable the use of special-purpose vehicles for investment; and (v) reduce the compliance burdens for funding portals.
Disclosure Requirements for Small Public Companies
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer, negatively impacting the U.S. public marketplace.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on recent proposed changes to the management’s discussion and analysis section of SEC reports, see HERE. That blog also contains a complete breakdown of the SEC’s ongoing disclosure effectiveness initiative. In addition to supporting the recent initiative, the Office advocates for further changes to reduce compliance costs for smaller reporting companies.
The Small Business Capital Formation Advisory Committee
The Small Business Advocate Act also created the Small Business Capital Formation Advisory Committee, which replaced the SEC’s voluntarily created Advisory Committee on Small and Emerging Companies. The new Advisory Committee is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters related to emerging, privately held small businesses to publicly traded companies with less than $250 million in public market capitalization; trading in securities of such companies; and public reporting and corporate governance of such companies.
The Advisory Committee has made two recommendations to the SEC. In particular, related to the recent SEC’s proposed rule changes to the reporting requirements for the acquisitions and dispositions of businesses (see HERE), the Advisory Committee suggests that the rule change provide differing treatment for Regulation A companies and make Management’s Adjustments optional or not required at all. Overall the Advisory Committee supports the rules changes but would make some tweaks.
The second recommendation relates to the SEC’s proposed amendment to the definitions of “accelerated filer” and “large accelerated filer” (see HERE ). Although the Advisory Committee supports the change, it would go further to add more companies that would qualify as a non-accelerated filers by raising the revenue threshold (currently proposed to be $100 million), increasing the time for such revenue (from the last year to three years) and considering whether all smaller reporting companies should be non-accelerated filers.
« Hester Peirce Proposal For Treatment Of Cryptocurrency SEC Proposed Rule Changes For Exempt Offerings – Part 1 »
Hester Peirce Proposal For Treatment Of Cryptocurrency
SEC Commissioner Hester M. Peirce, nicknamed “Crypto Mom,” has made a proposal for the temporary deregulation of digital assets to advance innovation and allow for unimpeded decentralization of blockchain networks. Ms. Peirce made the proposal in a speech on February 6, 2020.
The world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector with the SEC’s announcement that a cryptocurrency is a security in its Section 21(a) Report on the DAO investigation. Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
However, although capital raising seems clear, the breadth of the SEC’s jurisdiction and involvement are much less so. Not all token issuances and digital assets are used for capital raising, but rather these digital assets are fundamental to the operations of decentralized applications. Amazing new networks are being built and traditional applications are being disrupted at every turn. However, the ability to publicly issue the digital tokens that drive these networks continues to challenge the best practitioners, with all avenues leading back to some form of registration. The SEC’s temporary injunction against Telegram and its Grams digital token, the one token everyone firmly believed was a pure utility, together with the successful Regulation A offering of Blockstack’s token, has made Regulation A the clear choice for a public token issuance.
In theory, an S-1 would work as well, though to date no one has tried and likely will not do so in the short term. The issue with an S-1 is testing the waters and gun jumping (see HERE). Public communication in advance of an S-1 is strictly limited whereas most token offerings rely heavily on pre-marketing. Regulation A broadly allows pre-offering marketing, offers and communications (see HERE).
Currently, those who operate in the digital asset space must carefully navigate rough, uncharted waters while doing everything possible to comply with federal regulations. Although Regulation A+ works for the public issuance of a token, the issue of transitioning from a security to a utility a Hester Peirce Proposal For Treatment Oft this point requires a leap of faith. The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security. The question remains: how can a token that begins as a security, be utilized and traded freely in a network, in its utilitarian purpose, such to allow the network to grow in decentralization?
The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license (see, for example, HERE). Currently there is no active secondary trading market for digital asset securities in the U.S., though we are getting closer. However, secondary trading is different than use in a network for a token’s intended purpose.
Although there is no written guidance or pronouncement from the SEC Division of Trading and Markets, it appears that the SEC will allow a token that is a security to be used in a network without compliance with the registration or exemption provisions of the federal securities laws. The basis for this conclusion is the clearance of Blockstack’s Regulation A offering, which announces that the token can be used on the network and informal calls with FinHUB (see HERE) and digital asset legal practitioners. This does not provide the sort of comfort that a business investing millions of dollars into technology wants to rely upon.
That is one huge gap in the digital asset regulatory framework, but many more exist, leading Commissioner Peirce to throw out the first of what will probably be several proposals that hopefully bring us to a working structure.
Commissioner Peirce’s Proposal
Ms. Peirce begins by pointing out what I and every other practitioner have pointed out while trying to traverse the law’s application to digital assets, and that is that compliance with the law while furthering the meritorious digital asset technology is an unwinnable struggle. Ms. Peirce states, “[W]hether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin, providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, our securities laws stand in the way of innovation.”
Although the issues are widespread, Ms. Peirce focuses on the issue of getting tokens into the hands of potential network users without violating securities laws. Where a token is a security, the ability to grow a network and utilize a token within the network is unreasonably hampered.
Furthermore, although many tokens may be bundled in such a way as to create an investment contract under Howey, she thinks the SEC has gone too far in its analysis. The mere fact that a token is marketed as potentially increasing in value should not make it a security. If that were the case, quality handbags, designer sneakers, fine art and good wines would all be securities under the purview of the SEC.
The options available for digital asset technology innovators are limited. A network could simply open source the code and allow mining to create the initial tokens. A network could also take its chances and conclude that a token is not a security and proceed with the issuance, although that did not work out well for Telegram. The option most networks have chosen is to either avoid the U.S. altogether or rely on Regulation D and/or Regulation S for token issuances, and recently Regulation A for a more public issuance.
The safe harbor proposed by Commissioner Peirce is designed for projects looking to build a decentralized network. The safe harbor is admittedly in a draft form. Commissioner Peirce hopes for active public input as well as involvement within the SEC to help take her draft and formulate a workable plan that is either a rule or a no-action position, but that the market can rely on in moving forward.
The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempt from the federal securities laws as long as certain conditions are satisfied. In particular, (i) the offer and sale of tokens would be exempted from the provisions of the Securities Act of 1933 (“Securities Act”) other than the anti-fraud provisions; (ii) tokens would be exempt from registration under the Securities Exchange Act of 1934 (“Exchange Act”); and (iii) persons engaged in certain token transactions would be exempt from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.
In order to qualify for the safe harbor, several conditions must be met including: (i) the development team must intend the network to reach maturity, either through full decentralization or token functionality, within three years of the date of the first token sale, and act in good faith to meet that goal. I note that good faith is a hard standard to prove; (ii) the team must disclose key information on a freely accessible public website; (iii) the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network; (iv) the team must take reasonable efforts to create liquidity for users; and (v) the team would have to file a notice of reliance on the safe harbor on EDGAR within 15 days of the first token sale.
Determining decentralization requires an analysis of whether the network is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control. Functionality would be when holders can use the tokens for the transmission and storage of value or to participate in an application running on the network.
The key information that would need to be disclosed on a public website includes (i) the source code; (ii) transaction history; (iii) purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding); (iv) information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism; (v) the governance mechanisms for implementing changes to the protocol; (vi) the plan of development, including the current state and timeline for achieving maturity; (vii) financing plans, including prior token sales; (viii) the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team; (ix) the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future; (x) the sale by any member of 5% or more of his or her originally held tokens; and (xi) any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.
The requirement to make good-faith efforts to create liquidity for users could include a secondary trading market. In that case, the team would be required to utilize a trading platform that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection. Although I find this requirement perplexing, Commissioner Peirce believes it will help facilitate the distribution of the tokens such that they can flow back to a utility use on the network.
As mentioned, the safe harbor would not include the anti-fraud provisions of the securities laws. In addition, the safe harbor would be subject to the bad actor rules, such that it could not be used if any member of a team fell within the bad actor provisions (see HERE). The safe harbor would pre-empt state securities laws, but as with other pre-emptions, it would not include the state anti-fraud provisions.
The safe-harbor would be retroactive in that it would apply to tokens previously issued in registered or exempt offerings to allow for the free use of the token to build the network, and secondary sales.
Conclusion
Although as Commissioner Peirce notes, it has to start somewhere, it is a given in the industry that the proposal as written will not likely gain traction. It is simply too anti-regulation for any regulator’s and perhaps even industry participant’s liking. However, it does lay the framework to open the conversation and start towards a workable solution. Certainly, the current plan to let tokens registered as securities, be used as utilities, until we say otherwise, is not any better. The industry needs a workable solution, and I am glad an SEC Commissioner is taking a step forward.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.
For FinCEN’s most recent guidance related to cryptocurrency, see HERE.
For a discussion on the enforceability of smart contracts, see HERE.
For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.
For a review of the SEC, FinCEN and CFTC joint statement on digital assets, see HERE.
« SEC Proposes Additional Disclosures For Resource Extraction Companies SEC Small Business Advocate Releases First Annual Report »
SEC Proposes Additional Disclosures For Resource Extraction Companies
In December 2019, the SEC proposed rules that would require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals. The proposed rules have an interesting history. In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court. In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress. However, the statutory mandate in the Dodd-Frank Act requiring the SEC to adopt these rules requiring the disclosure remains in place and as such, the SEC is now taking its third pass at it.
The proposed rules would require domestic and foreign resource extraction companies to file a Form SD on an annual basis that includes information about payments related to the commercial development of oil, natural gas, or minerals that are made to a foreign government or the U.S. federal government.
Proposed Rule
The Dodd-Frank Act added Section 13(q) to the Securities Exchange Act of 1934 (“Exchange Act”) directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.
As noted above, the first two passes at the rules by the SEC were rejected. The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects. In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors. The rules were also thought to exceed the SEC authority.
The proposed rules make many significant changes to the rejected 2016 rules. In particular, the proposed rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) review the definition of “not de minimis” at both the project and individual payment threshold such that disclosure of a payment that equals or exceeds $150,000 would be required when the total project payments equal or exceed $750,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made at a level below the major subnational government level; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.
The proposed rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q). Under the proposed rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F. Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered. Moreover, smaller reporting companies and emerging growth companies are exempted.
The proposed rules would define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity. The proposed definition of “commercial development” would capture only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The proposed definition of “commercial development” would capture only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.
Likewise, the definitions of “extraction” and “processing” are narrowly defined and would not include downstream activities such as refining or smelting. “Export” would be defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource. Companies that provide transportation services, without an ownership interest in the resource, would not be covered.
Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits. The proposed rules would define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure. Furthermore, an anti-evasion provision will be included such that the rules would require disclosure with respect to an activity or payment that, although not within the categories included in the proposed rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).
A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place. As proposed, a resource extraction issuer would have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral. The disclosure would be at the broad level without the need to drill down further on the type of resource. The second prong would require a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining. Again, additional details would not be required. The third prong would require an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.
Under the proposed rules, a “foreign government” would be defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” would include a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government. On the other hand, “federal government” refers to the government of the U.S. and would not include subnational governments such as states or municipalities.
The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate. Under the proposed rules, Form SD would expressly state that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited. The report will cover the company’s fiscal year and will need to be filed no later than nine months following the fiscal year-end. The Form SD must include XBRL tagging.
As noted above, the proposed rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts. In addition, the rules contain a targeted exemption for payment related to exploratory activities. Under this proposed targeted exemption, companies would not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year. The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.
Finally, the proposed rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO. When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year. Similarly, companies that complete an IPO would not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.
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OTCQB And OTC Pink Rule Changes
In December 2019 the OTC Markets updated its Pink Disclosure Guidelines and Attorney Letter Agreement and Guidelines. The Pink disclosure guidelines and attorney letter apply to companies that elect to report directly to OTC Markets pursuant to its Alternative Reporting Standard. Furthermore, in January 2020 OTC Markets amended the OTCQB standards related to the disclosure of convertible debt and notification procedures for companies undergoing a change in control. The OTCQB also updated its criteria for determining independence of directors, and added additional transfer agent requirements for Canadian Companies.
The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. Companies trading on the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets have the option of reporting directly to OTC Markets under its Alternative Reporting Standards. The Alternative Reporting Standards are somewhat more robust for the OTCQB and OTCQX in that they require audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor in the same format as would be included in SEC registration statements and reports.
As an aside, companies that report to the SEC under Regulation A and foreign companies that qualify for the SEC reporting exemption under Exchange Act Rule 12g3-2(b) may also qualify for the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets if they otherwise meet the listing qualifications. For more information on OTCQB and OTCQX listing requirements, see HERE and HERE.
OTCQB Amendments
Effective February 22, 2020, the OTCQB Standards, Version 8, will go into effect. Some of the rule changes were previously adopted and others have been added to or modified. In particular, the new Version 8 includes:
Debt Securities, Including Promissory and Convertible Notes – Companies will be required to provide prompt disclosure of the issuance of any promissory notes, convertible notes, convertible debentures, or any other debt instruments that may be converted into a class of the company’s equity securities. Such disclosure must include copies of the securities purchase agreement(s) or similar agreement(s) setting forth the terms of such arrangement, any related promissory notes or similar evidence of indebtedness, and any irrevocable transfer agent instructions. Companies must make such disclosure either through the SEC’s EDGAR system or the OTC Disclosure & News Service, as applicable. Effective December 12, 2019, OTC Markets made a similar rule change for OTCQX listed companies.
OTCQB Certifications – Companies will be required to list and describe any outstanding promissory notes, convertible notes, convertible debentures, or any other debt instruments that may be converted into a class of the issuer’s equity securities when completing OTCQB certifications. OTC Market has been vocal about concerns with convertible instruments and, in particular, the potential for extreme dilution to existing shareholders and stock promotion campaigns by certain convertible investors. For more on OTC Markets stock promotion guidelines and policies, see HERE. As I have written about many times, there are quality investors and others that are not quality in the micro-cap space. The use of convertible instruments as a method to invest in public companies is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. The requirement to disclose these investments, and the investment documents, is a smart change for OTC Markets, adding a level of transparency to the marketplace as a whole.
Change of Control – The new rule release reiterates the requirements related to a change of control. In particular, effective July 31, 2017, OTC Markets amended the OTCQB rules to set standards related to the processing and reporting of change in control events (see HERE). Subsequently, effective April 16, 2019, OTC Markets updated the definition of a “change of control” to include any events resulting in:
(i) Any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) becoming the “beneficial owner” (as defined in Rule 13d-3 of the Exchange Act), directly or indirectly, of securities of the company representing fifty percent (50%) or more of the total voting power represented by the company’s then outstanding voting securities;
(ii) The consummation of the sale or disposition by the company of all or substantially all of the company’s assets;
(iii) A change in the composition of the board occurring within a two (2)-year period, as a result of which fewer than a majority of the directors are directors immediately prior to such change; or
(iv) The consummation of a merger or consolidation of the company with any other corporation, other than a merger or consolidation which would result in the voting securities of the company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity or its parent) at least fifty percent (50%) of the total voting power represented by the voting securities of the company or such surviving entity or its parent outstanding immediately after such merger or consolidation.
Under the change of control rule, a company is responsible for notifying OTC Markets upon the completion of a transaction resulting in a change of control and must submit a new OTCQB application and application fee ($2,500) within 20 calendar days. OTC Markets will review the notice and application and may request additional information. The failure to respond or fully comply with such requests may result in removal from the OTCQB. Furthermore, immediately following a change in control event, a company is required to file a new OTCQB certification and updated company profile page. Regardless of notification, OTC Markets may also make a discretionary determination that a change of control event has occurred.
The newest rule release clarifies that the failure to submit the new application and documentation within the 20 days is grounds for the suspension or removal from the OTCQB at OTC Markets’ sole and absolute discretion.
Independent Directors – The new rules amend the definition of an independent director to conform to the earlier amendment in the OTCQX rules. The definition of an independent director has been updated to mean “a person other than an executive officer or employee of the company or any other person having a relationship which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent: (A) a director who is, or at any time during the past three years was, employed by the company; (B) a director who accepted or has a family member who accepted any compensation from the company in excess of $120,000 during any fiscal year within the three years preceding the determination of independence, other than compensation for board or board committee service; compensation paid to a family member who is an employee (other than an executive officer) of the company; or benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (C) a director who is the family member of a person who is, or at any time during the past three years was, employed by the company as an executive officer.”
Canadian Companies – Canadian companies must retain a transfer agent that participates in the Transfer Agent Verified Shares Program as of April 1, 2020 (rule change was adopted December 12, 2019).
Pink Disclosure Guidelines Amendments
OTC Markets updated the Pink Disclosure Guidelines in anticipation of changes to the SEC’s Rule 15c2-11 (see HERE). The Pink Disclosure Guidelines are designed to track the information requirements in Rule 15c2-11. The amended rules have updated the Pink Disclosure Guidelines to require:
(i) Corporate History – the name of the company and predecessors since inception (previously a company only had to provide prior names for the last five years);
(ii) Debt Securities, Including Promissory and Convertible Notes – a company must now disclose all outstanding convertible, promissory or similar debt instruments as of the period end date of the report (previously only had to disclose such obligations issued in the previous two fiscal years);
(iii) Financial Statements – must now include a statement of changes in shareholders’ equity. In addition, all financial statements for a particular period must be uploaded in one document.
(iv) Officers, Directors, and Control Persons – the rules have been amended to clarify that all 5%-or-greater shareholders of any class of outstanding securities must be disclosed; and
(v) Verified Profile – a company must verify the company profile through OTCIQ to qualify for Pink Current or Limited Information.
Attorney letters are required for a company to qualify for OTC Pink Current Information if that company does not submit audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor. In order to submit an attorney letter on behalf of a company, the attorney must submit an Attorney Letter Agreement to OTC Markets and be approved by OTC Markets. The rules related to an attorney letter agreement have been updated to allow for submittal of the agreement through Docusign.
Furthermore, the attorney letter agreement has updated required disclosures that must be included in a company’s attorney letter related to regulatory proceedings. In particular, an attorney letter submitted on behalf of a company must state that the attorney is permitted to practice before the SEC (i.e., has not been prohibited from such practice) and whether the attorney is currently or has in the past five years been the subject of any investigation, hearing or proceeding by the SEC, CFTC, FINRA or any federal, state or foreign regulatory agency, including a description of any investigation, hearing or proceeding.
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SEC Proposes Amendments To MD&A Disclosures
Continuing its disclosure effectiveness initiative, on January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information. Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles based approach to disclosure requirements. In addition, the proposed rule changes are intended to reduce repetition and disclosure of information that is not material.
On the same day the SEC issued an Interpretive Release on MD&A. A week earlier the SEC issued three new compliance and disclosure interpretations on the subject.
Among the proposed changes, the new rule would add a new Item 303(a) to state the principal objectives of MD&A, replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements, add a requirement to discuss critical accounting estimates and add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter. On the same day as the proposed rule release, the SEC issued guidance on the disclosure of key performance metrics in MD&A.
SEC Chairs Jay Clayton and Commissioners Allison Herren Lee and Hester Peirce issued statements on the changes. Allison Herren Lee again expressed her disappointment that the SEC is not requiring additional environment- and climate-related disclosures. Chair Clayton touched on the subject, noting that the issues are complex, changing and multi-national and investor and company capital allocation decisions that are influenced by climate and environmental factors are forward-looking and likewise complex. Furthermore, disclosure requirements are generally historical in nature with limited forward-looking statement requirements, for the obvious reason that the future is impossible to predict. With that said, all companies are required to disclose material risks, expenditures and factors that affect their business, including climate change and environmental issues where relevant.
Climate and environmental disclosures are an evolving topic. The SEC continues to review and study the issue but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics. It is this exact concern Commissioner Hester Peirce spoke about in her statement noting, “[T]hanks in part to an elite crowd pledging loudly to spend virtuously other people’s money, the concept of materiality is at risk of degradation.” With that said, Commissioner Peirce supports the proposed rule changes as written, and is pleased they do not go further into environmental, social and governance (ESG) matters. For more on ESG in general, see HERE.
Proposed New Rules
The proposed new rules would completely eliminate Item 301 – Selected Financial Data; Item 302 – Supplementary Financial Information; and Item 303(a)(5) requiring tabular disclosure of contractual obligations. The proposed rules will also (i) add a new Item 303(a) to state the principal objectives of MD&A; (ii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (vi) add a requirement to discuss critical accounting estimates, and (vii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new rules also apply to foreign private issuers (FPIs). Finally, the proposed amendments would make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.
Elimination of Item 301 – Selected Financial Data
Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years. Smaller reporting companies (SRCs) are not required to provide this information and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.
When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL. Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends. Accordingly, Item 301 is not useful and the SEC proposed to eliminate it.
Elimination of Item 302 – Supplementary Financial Information
Item 302 requires selected disclosures of quarterly results and variances in operating results. SRCs and FPIs are not required to provide the information (note FPIs are not required to report quarterly results or file quarterly reports at all). Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).
In addition to the same reasons for eliminating Item 301, including duplication, the SEC has been considering the costs and benefits of requiring quarterly financial information at all.
Elimination of Item 303(a)(5) – Contractual Obligations Table
Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format. There is no materiality threshold for the disclosure. The SEC proposes to eliminate the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy.
Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
Currently MD&A is broken down into 4 parts. Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations. Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information. Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures. Item 303(d) provides scaled back disclosure accommodations for SRCs. The proposed rules would substantially change this structure.
The new Item 303 will (i) add a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods; (ii) eliminate unnecessary cross-references, clarify and remove outdated and duplicative language; (iii) update capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) update the results of operations disclosure to require a discussion of the reasons underlying material changes in nets sales or revenues; (vi) eliminate the requirement to discuss the impact of inflation; (vii) replace the specific requirement to disclose off balance sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) add a requirement to discuss critical accounting estimates, and (ix) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The proposed new Item 303(a) instruction paragraph will be revised to set forth the principal objectives of MD&A. The instructions will codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.” Also, the instructions will emphasize providing disclosure on:
(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;
(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and
(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.
Interpretive Release
On January 30, 2020, the SEC issued an interpretive release providing guidance on key performance indicators and metrics in MD&A. Current Item 303(a) requires disclosure of information not specifically referenced in the item that the company believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations. The item also requires discussion and analysis of other statistical data that, in the company’s judgment, enhances a reader’s understanding of MD&A.
Keeping in line with the SEC’s efforts to streamline disclosures to those that are specifically material to each company, the SEC has stated that companies should identify and address those key variables and other qualitative and quantitative factors that are peculiar to and necessary for an understanding and evaluation of the individual company. The interpretive guidance reminds companies to consider whether the information they are disclosing is GAAP or non-GAAP (and thus requires compliance with Regulation G or Item 10 of Regulation S-K – see HERE).
In addition, the company should consider what additional information may be necessary to provide adequate context for an investor to understand the metric presented. The SEC expects that the following information will be provided regarding a metric: (i) a clear definition of the metric and how it was calculated; (ii) a statement indicating the reasons why the metric provides useful information to investors; and (iii) a statement indicating how management uses the metric in managing or monitoring the business. Changes in the method of calculating the metric from one year to another must also be disclosed including the reasons for and impact of the change.
New C&DI
On January 24, 2020, the SEC issued three new C&DI on MD&A disclosures. The new C&DI clarifies the ability to incorporate prior financial years’ MD&A by reference from a previous SEC filing. In particular, the instructions to Item 303 allow a company to incorporate an MD&A discussion from a prior report for financial statements that are more than two years old. The C&DI clarifies that to properly incorporate by reference specific language must be provided together with a hyperlink to the incorporated information. For more on incorporation by reference, see HERE.
Furthermore, if incorporation by reference is not used for discussion of a third year of financial statements, the company must assess whether the discussion is relevant and necessary for a proper disclosure of its financial condition. No discussion can be omitted that is material to an understanding of results of operations.
The third new C&DI illustrates how incorporation by reference can be used in a Section 10(a)(3) prospectus update to a registration statement that allows forward incorporation by reference. In particular, if a year of MD&A is omitted from a Form 10-K, that year will not be deemed included in the updated registration statement unless it is specifically incorporated by reference from a prior year’s filing.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
On August 8, 2019, the SEC proposed changes to disclosures related to business descriptions, legal proceedings and risk factors under Regulation S-K. See my blog HERE.
In May 2019 the SEC proposed amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. This was a follow-on to the September 2015 request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates listed further below.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE, and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018 the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Taking into account responses to portions of that request for comment, in the summer of 2018, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
In early December 2015, the FAST Act was passed into law. The FAST Act required the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.
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Nasdaq Extends Direct Listings
The Nasdaq Stock Market currently has three tiers of listed companies: (1) The Nasdaq Global Select Market, (2) The Nasdaq Global Market, and (3) The Nasdaq Capital Market. Each tier has increasingly higher listing standards, with the Nasdaq Global Select Market having the highest initial listing standards and the Nasdaq Capital Markets being the entry-level tier for most micro- and small-cap issuers. For a review of the Nasdaq Capital Market listing requirements, see HERE as supplemented and amended HERE.
On December 3, 2019, the SEC approved amendments to the Nasdaq rules related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market. As previously reported, on February 15, 2019, Nasdaq amended its direct listing process rules for listing on the Market Global Select Market (see HERE).
Interestingly, around the same time as the approval of the Nasdaq rule changes, the SEC rejected amendments proposed by the NYSE big board which would have allowed a company to issue new shares and directly raise capital in conjunction with a direct listing process. In other words, the NYSE proposed an IPO without an underwriter. Although it was not clear as to all of the aspects of the proposal that prompted the rejection, in late December the NYSE made some adjustments to the proposed rule change and resubmitted it to the SEC. The most significant adjustment would be to allow listings with a capital raise of $100 million, down from $250 million in the first proposal. To qualify for the direct listing, the total value of shares, including those previously outstanding and those sold in the direct listing process, would need to be $250 million or higher. As of the date of this blog, no SEC action has been taken on the latest proposal.
Direct Listings in General
In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A company would also not necessarily need a banker in the resale direct listing process. A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC. For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.
Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering. One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees. For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.
The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Oftentimes a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.
Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering. For more on Rule 506, see HERE.
Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk. For more on the accredited investor definition including the SEC’s recent proposed amendments, see HERE.
The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.
Like many tech companies, Spotify’s share price has been erratic, but as of the date of this blog is slightly higher than its initial listing price on the NYSE. However, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option. An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.
A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).
Direct Listing on NASDAQ
A company seeking to list securities on Nasdaq must meet minimum listing requirements, including specified financial, liquidity and corporate governance criteria. Nasdaq listing Rules IM-5405-1 and IM-5505-1 set forth the direct listing requirements for the Nasdaq’s Global Market and Capital Market respectively. The Rules describe how the Exchange will calculate compliance with the initial listing standards related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
Like it previously did for the Global Select Market, Nasdaq is now providing a methodology for companies which have not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing and which wish to list their securities to allow existing shareholders to sell their shares.
Direct Listings are subject to all initial listing requirements applicable to equity securities and, subject to applicable exemptions, the corporate governance requirements set forth in the Rule 5600 Series. In addition to setting forth the method for determining initial listing requirements based on the price of a security, including the bid price, market capitalization and market value of publicly held shares, the new rules require that a listing can only be completed upon effectiveness of a registration statement that solely registers securities for resale by existing shareholders (i.e., no new shares may be registered).
The rule changes will also clarify that an IPO Cross can be used for the initial pricing of such securities. An IPO Cross is a methodology for the initiation of trading of a security where there has been no underlying IPO. To allow for the IPO cross initial trading, a broker-dealer must serve in the role of financial advisor to perform the functions that an underwriter would perform in an IPO to initiate trading.
Under the amended rules, Nasdaq will determine a security’s price based on (i) a third party tender offer for cash; (ii) a sale between unaffiliated third parties; (iii) equity sales by the company; (iv) an independent valuation meeting specific standards; or (v) a valuation as determined by a private placement market. Both IM 54-5-1 and IM-5505-1 are identical on their substantive provisions for direct listing valuations. In order to be considered evidence of valuation under (i) – (iii), the transactions must be completed within the prior six months and be substantial in size representing sales of at least 20% of the market value of unrestricted publicly held shares requirement.
In addition, any affiliate involvement in the transactions must be less than 5% per affiliate or 10% total, must have been suggested or required by a non-affiliate, and the affiliate must not have participated in negotiations.
Any valuation used for this purpose must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. The valuation must be of a recent date as of the time of the approval of the company for listing and the evaluator must have considered, among other factors, the annual financial statements required to be included in the registration statement, along with financial statements for any completed fiscal quarters subsequent to the end of the last year of audited financials included in the registration statement. Nasdaq will consider any market factors or factors particular to the listing applicant that would cause concern that the value of the company had diminished since the date of the valuation and will continue to monitor the company and the appropriateness of relying on the valuation up to the time of listing. Nasdaq may withdraw its approval of the listing at any time prior to the listing date if it believes that the valuation no longer accurately reflects the company’s likely market value.
(f) A valuation agent shall not be considered independent if:
(1) At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days.
(2) The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, “investment banking services” includes, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, Popes (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting.
(3) The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.
For a security that has had sustained recent trading in a private placement market prior to listing, Nasdaq will determine a company’s price, market value of listed securities and market value of unrestricted publicly held shares based on the lesser of: (i) the value calculable based on the valuation calculated in accordance with the standards listed above and (ii) the value calculable based on the most recent trading price in a private placement market.
For purposes of the rule, a private placement market is one that is operated by a national securities exchange or a registered broker-dealer. Nasdaq will examine the trading price trends for the stock in the private placement market over a period of several months prior to listing and will only rely on a private placement market price if it is consistent with a sustained history over that several-month period evidencing a market value in excess of Nasdaq’s market value requirement.
For a security that has not had sustained recent trading in a private placement market for a period of several months prior to listing, Nasdaq will determine that such company has met the market value of publicly held shares requirement if the company has a valuation, as calculated via the above methods, in excess of 200% of the otherwise applicable requirement. For example, to list on the Nasdaq Global Market the valuation (if not gleaned from a private placement market) will need to be at least $8 per share. Likewise, each of the liquidity calculations will need to exceed 200% of the regular listing requirement.
Furthermore, if Nasdaq determines that the valuation evidence required by IM 5405-1 and IM-5505-1 is not reliable, Nasdaq will require evidence, including a review of all facts and circumstances, that the various valuation and pricing requirements exceed 250% of the listing standards. The rule release reminds companies that Nasdaq has broad discretion over the listing process and may deny an application, even if the technical requirements are met, if it believes such denial is necessary to protect investors and the public interest. I suspect that Nasdaq will carefully review any applications for a direct listing.
Foreign Exchange Listings
Where a company is transferring from, or seeking to dual list on, Nasdaq from a foreign exchange where there is a broad, liquid market in the securities, Nasdaq will consider the value based on the recent trading price in the foreign market.
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