SEC Fall 2019 Regulatory Agenda
In late 2019, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the spring 2019 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame has increased with 47 items as compared to 40 on the spring 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. Only one item is listed in the fall 2019 pre-rule state and that is portfolio margining harmonization. The only item that had been on the spring 2019 agenda in the pre-rule category was the harmonization of exempt offerings which moved to the proposed rule stage after the SEC published a concept release in June 2019 (see HERE).
Thirty-one items are included in the proposed rule stage, up from 22 on the spring list. Items include amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019); broker-dealer reporting, audit and notifications requirements and three amendments to Regulation NMS.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, remains on the proposed rule list. The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change. I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject. Comments and responses to the proposed rules have been voluminous and largely negative. The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system. At this point it is unclear as to the future of these much-needed changes.
Other items that first appeared on the spring agenda and have been gaining some traction and that are listed on the proposed rule stage include: (i) proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); and (ii) amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE). Both proposed rules have been controversial but should proceed to final within the planned 12 months. Also first proposed in spring and still on the proposed rule list are amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendment to MD&A were adopted in March 2019 (see HERE)
Continuing the SEC’s disclosure effectiveness initiative, the proposed rules include modernization and simplification of disclosures regarding description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE).
Earnings releases and quarterly reports were on the fall 2018 pre-rule list and then moved to long-term on the spring 2019 list. The topic is back on the proposed rule list. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements), and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list. The SEC has recently amended the rules and issued a concept release (see HERE and HERE) and appears committed to enacting much-needed updates and improvements to the rules.
Highly debated and much needed, the amendments to the accredited investor definition moved from the long-term list to the proposed rule stage. The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE). As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.
Other items moved up from long-term to proposed-rule stage include executive compensation clawback (see HERE) and clawbacks of incentive compensation at financial institutions. Clawback rules would implement Section 954 of the Dodd-Frank Act and technically require that national securities exchanges require clawback provisions as a listing qualification. Also moved up from the long-term list are amendments to Guide 5 on real estate offerings and Form S-11, Regulation Crowdfunding amendments, and Regulation A amendments.
New to the list, appearing in the proposed rule category are amendments to Form 13F filer thresholds, investment company summary shareholder report, and registration of investment advisers to rural business investment companies.
Remaining on the proposed rule list is bank holding company disclosures (proposed rules published in September 2019); filing fee processing updates (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019); use of derivatives by registered investment companies and business development companies; amendments to marketing rules under the Advisors Act; amendments to the custody rules for investment advisors; procedures for investment company act applications; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and market data distribution and market access.
Amendments to the transfer agent rules remains on the proposed rule list although it has been almost four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). SEC top brass speeches suggest that this will finally be pushed over the finish line this year (see HERE, for example).
Sixteen items are included in the final rule stage, reduced from 18 on the spring list. Financial disclosures about acquired businesses has moved to the final rule stage with amendments having been proposed in May 2019 (see HERE). The matter has been an open item for several years (see HERE).
Also included in the final rule stage are amendments to the financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE). Although still on the final rule list, the SEC adopted final amendments extending testing-the-waters provisions to non-emerging growth companies in October 2019 (see HERE)
Amendments to the definition of an accelerated filer has moved up from the proposed rule stage to final rule stage (see HERE for the proposed rule changes). Fund of fund arrangements (proposed rules were issued in December 2018), offering reform for business development companies (proposed rules published in March 2019), amendments to Title VII cross-border rules (final rules adopted in September 2019), and customer margin requirements for securities futures (proposed rules published in July 2019) have also moved up from proposed to the final rule stage.
Other items still in the final rule stage include rules related to exchange-traded funds (ETF) (for basic information on ETFs, see HERE), disclosure for unit investment trusts and offering variable insurance products, recordkeeping and reporting for security based swap dealers (new rules were adopted in September 2019), a new definition for covered clearing agency (last amended in September 2016), risk mitigation techniques (new rules were adopted on December 18, 2019), amendments to the whistleblower program, amendments to the SEC’s Rules of Practice and prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds (new rules adopted in November 2019).
Several items have dropped off the final rule list as they have now been implemented and completed, including implementation of FAST Act report recommendations (see HERE); the controversial Regulation Best Interest, which was adopted in June 2019; amendment to the single issuer exemption for broker-dealers which was adopted in June 2019; auditor independence with respect to loans or debtor-creditor relationships adopted in June 2019; amendments to the single issuer exemption for broker-dealers adopted in June 2019; amendments to the rule for nationally recognized statistical rating organizations adopted in August 2019; and amendments to the Volcker Rule which were implemented in August 2019.
Thirty-seven items are listed as long-term actions (down from 52), including many that have been sitting on the list for a long time now. Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now. Other items still on the long-term list include universal proxy (originally proposed in October 2016 – see HERE); and corporate board diversity (although nothing has been proposed, it is a hot topic); and the definitions of mortgage-related security and small-business-related security.
Also still on the long-term list (or added to the list) are numerous Dodd-Frank mandated provisions including additional proxy process amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; conflict minerals amendments (being challenged in lengthy court proceedings on constitutional First Amendment basis); and covered broker-dealer provisions under Title II of Dodd-Frank.
New to the list are asset-backed securities disclosures (last amended in 2014); mandated electronic filings; Regulation AB amendments; modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; amendments to the Family Office Rule; amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons; broker-dealer liquidity stress testing, early warning, and account transfer requirements; additional changes to exchange-traded products; recordkeeping and risk controls specific to algorithmic trading; amendments to the rules regarding the consolidated audit trail; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.
Also new to the list are a few electronic filing matters including electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports, and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and Forms ATS and ATS-R regarding the initial, quarterly, and cessation of operation reports by ATSs.
Several swap-based rules remain on the long-term list or have been added to the list including ownership limitations and governance requirements for security-based swap clearing agencies, security-based swap execution facilities, and national exchanges; end user exception to mandatory clearing of security-based swaps; registration and regulation of security based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
Also remaining on the long-term action list are Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See HERE for more information.
Other interesting items on the long-term agenda are rule changes to short sale disclosure reforms and registration of alternative trading systems. Alternative trading systems have garnered interest for their potential use for securities token trading.
« Terminating Section 15(d) Reporting; Determining Voluntary Reporting Status Nasdaq Extends Direct Listings »
Terminating Section 15(d) Reporting; Determining Voluntary Reporting Status
A public company with a class of securities registered under Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file Section 13 reports with the SEC (10-K, 10-Q and 8-K). A company becomes subject to Section 15(d) by filing a registration statement under the Securities Act of 1933, as amended (“Securities Act”) such as a Form S-1. A company registers securities under Section 12 by filing an Exchange Act registration statement such as on Form 10, Form 20-F or Form 8-A.
The Section 15(d) reporting requirements are scaled down from the Exchange Act reporting requirements for a company with a class of securities registered under Section 12. In particular, a company that is only subject to Section 15(d) need only comply with the Section 13 reporting obligations and need not comply with the federal proxy rules and third-party tender offer rules in Section 14, the officer/director and 10% shareholder reporting requirements in Section 16 or the 5% or greater shareholder reporting requirements in Sections 13(d), (g) and (f) of the Exchange Act.
This blog addresses suspending the duty to file reports under Section 15(d) and determining voluntary filer status. In a separate blog I will discuss the termination of registration under Section 12.
Suspension of Reporting Obligations
The duty to file reports under Section 15(d) can only be suspended and not terminated. To the contrary, registration under Section 12, and accordingly the requirement to file reports as a Section 12 registrant, can be terminated. However, even if a Section 12 reporting obligation is terminated, a Section 15(d) obligation remains, and even if temporarily suspended, can be resurrected when the fact basis for suspension changes.
The duty to file reports under Section 15(d) is automatically suspended: (i) If the company has a class of securities registered under Section 12 of the Exchange Act and is thus separately subject to the reporting requirements due to that registration; or (ii) on the first day of any fiscal year, other than the fiscal year in which a Securities Act registration statement became effective, in which the company has fewer than 300 record security holders.
Exchange Act Rule 15d-6 requires that a company whose duty to file reports is suspended because they have fewer than 300 shareholders as of the first day of their fiscal year-end, file a Form 15 within 30 days of the beginning of the fiscal year to inform the SEC of the suspension of the duty. SEC C&DI confirms that this notice is not a condition to the automatic suspension. In practice, very few companies actually file a Rule 15d-6 Form 15. Moreover, in practice, many companies voluntarily continue to file SEC reports even though the duty to do so has been statutorily suspended.
In addition, the duty to file reports may be voluntarily suspended, at any time, by the filing of a Form 15 upon meeting certain conditions. Exchange Act Rule 12h-3 provides that the duty to file reports under Section 15(d) is immediately suspended upon the filing of a Form 15 if the company has filed all SEC reports for the shorter of the prior three fiscal years and stub periods to date or since the company became SEC filing if the prerequisite conditions are met. If the Form 15 is subsequently withdrawn or denied, the company has 60 days to file any SEC reports not filed following the filing of the Form 15.
In addition to being current in SEC reporting at the time of filing a Form 15, in order to qualify to voluntarily suspend reporting obligations, the company must (i) have fewer than 300 shareholders of record or, if a bank holding company, have fewer than 1,200 shareholders of record; or (ii) have fewer than 500 shareholders of record and less than $10 million in assets on the last day of each of the company’s three most recent fiscal years.
A company may not voluntarily suspend Section 15(d) reporting obligations in reliance on Rule 12h-3 during a fiscal year in which a Securities Act registration statement goes effective or a company is required to file a Section 10(a)(3) prospectus update. Furthermore, a company cannot rely on the fewer than 500 shareholders and less than $10 million in assets provision if a Securities Act registration statement went effective or required a Section 10(a)(3) update in the succeeding two fiscal years. The rule specifically provides that these timing conditions do not apply for certain holding company restructures where the company has no significant assets and shares are issued pro rata. Moreover, the SEC has provided interpretative guidance with certain carve-outs to the rule.
A Section 10(a)(3) prospectus update is required to be filed to maintain the effectiveness of a Securities Act registration statement used for a continuous offering or under which securities may be offered from time to time. A Form S-3, Form S-8 and, in some instances, a Form S-1 can be used as shelf registrations that automatically forward incorporate Exchange Act reports by reference such that an annual Form 10-K acts as a post-effective amendment and Section 10(a)(3) update (for more on incorporation by reference, see HERE). If a company has an open Securities Act registration statement, it would not be able to file a Form 15 to voluntarily suspend reporting obligations unless it first filed a post-effective amendment to the registration statement to deregister any unsold shares or, if no shares had been sold, an application to withdraw the registration statement.
Analyzing the ability to file a Form 15 under Rule 12h-3 has resulted in the filing of numerous no-action letters, numerous compliance and disclosure interpretations, and the publication of SEC Staff Legal Bulletin No. 18 to provide guidance. The SEC has consistently found that a Rule 12h-3 Form 15 can be filed in a year in which a registration statement was declared effective or required to be updated under Section 10(a)(3) when all of the other conditions of Rule 12h-3 are met and where (i) a public offering is abandoned, no securities are sold under the effective registration statement and the company files a Rule 477 application to withdraw the registration statement; or (ii) the company is acquired resulting in the class of registered securities either being extinguished or held by only one record holder which is the acquiring entity. In both situations, the company has no public shareholders eliminating the purpose of requiring reporting. The SEC will not allow this concession to the rule where the company will continue to file SEC reports in any event such as voluntarily or as a result of a contractual obligation.
As an aside, when a Form 15 is filed to terminate registration under Section 12, only the duty to file reports under Section 13 is immediately terminated. The duty to file reports in accordance with the Section 14 proxy and tender offer rules, Section 16 officer/director and 10% shareholder and Section 13 5% or greater shareholder reporting does not terminate until 90 days after the filing of a Form 15. As noted above, a Section 15(d) company is not subject to those particular reporting obligations anyway.
The suspension of a duty to file reports is not a legal “termination” but rather is only a suspension. SEC Rule 12h-3 specifically provides that if a company no longer meets the legal requirements for an automatic suspension, or voluntary suspension, on the first day of its fiscal year, then the company must resume periodic reporting pursuant to Section 15(d) by filing an annual report on Form 10-K for its preceding year, not later than 120 days after the end of such fiscal year.
Determining Voluntary Filer Status
First, a company with a class of securities registered under Section 12 of the Exchange Act is never a voluntary filer. Assuming a company is not a Section 12 registrant, if the duty to file reports is automatically or voluntarily suspended and the company continues to file reports, that company is considered a voluntarily filer.
Securities Act Rule 144 sets forth certain requirements for the use of Section 4(a)(1) for the resale of securities. Rule 144 requires compliance with certain conditions, including a holding period. The length of the holding period is determined by whether the public company “has been for a period of at least 90 days immediately before the sale, subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act.” The holding period for a company that is subject to the reporting requirements is six months as opposed to one year for one that is not. A voluntary filer is not subject to the reporting requirements and therefore is subject to the longer one-year hold period. Accordingly, in order for a shareholder to calculate its required holding period under Rule 144, the shareholder (and any attorney writing a Rule 144 opinion letter) must determine whether the company is subject to the Exchange Act reporting requirements.
From a practical standpoint, there are some shortcuts for determining voluntary status. A company that files reports under Section 15(d) will have an SEC “File/Film Number” that begins with “333” (whereas a company that has a class of securities registered under Section 12 will have a number that begins with “000” or sometimes “001” or “005”). Upon quickly assessing if a company is a 15(d) filer, a practitioner should determine if a Securities Act registration statement was declared effective in the current fiscal year (not a voluntary filer) and if not, whether the company had fewer than 300 shareholders as of the first day of its current fiscal year (if less, voluntary). The latter answer generally must come from the company or the transfer agent.
If the company is not determined to be a voluntary filer based on the above, then it would only be a voluntary filer if it filed a Form 15 under Rule 12h-3. Even if a company meets the requirements and could voluntarily file a Form 15 at any time under Rule 12h-3, it would still be subject to the reporting requirements until it does so.
Determining Holder of Record
The calculation of shareholders of record for purposes of Section 15(d) and Rule 12h-3 is made in accordance with Exchange Act Rule 12g5-1. Generally each entity or custodian shareholder is counted as a single shareholder. That is, a broker, dealer, bank or nominee may be counted as a single shareholder, even if they hold shares on behalf of several different beneficial shareholders. In addition, persons that received the securities under an employee compensation plan that was exempt from U.S. registration may be excluded. Securities issued in a Regulation A, Tier 2 offering may also be excluded.
« NYSE American Board Independence Standards SEC Fall 2019 Regulatory Agenda »
NYSE American Board Independence Standards
NYSE American Company Guide Rule 803 delineates the requirements independent directors and audit committees. NYSE American Company Guide Rule 802 requires that a majority of the board of directors of a listed company be “independent.” Rule 803 requires that all members of the audit committee be independent and defines independence and Rules 804 and 805 require that all directors on the nominating and compensation committees, if a company has such committees, be independent.
Under NYSE American Company Guide Rule 803, an “independent director” means a person other than an executive officer or employee of a company. The board of directors must make an affirmative finding that a director does not have a relationship which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director for that director to qualify as independent. However, the NYSE American rules specify certain relationships that would disqualify a person from being considered independent. Stock ownership is not on the list and is not enough, without more, to preclude independence.
Company Guide Rule 803 specifies that the following people cannot be considered independent:
(i) a director who is, or at any time during the past three years was, employed by the company, provided however, interim employment of less than one year would not be a disqualifier as long as such employment had since terminated. In addition, employment by an entity that was later acquired by the company would not disqualify a director from being independent provided the former officer was not employed by the company after the acquisition;
(ii) a director who accepted or who has a family member who accepted any compensation from the company in excess of $120,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than: (a) compensation for board or board committee service; (b) compensation paid to a family member who is an employee but not an executive of the company; (c) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (d) compensation received while acting as an interim officer as long as such employment lasted for less than a year and has since terminated. Options received for services should be valued using a commonly accepted option pricing formula, such as the Black-Scholes or binomial model at the time of grant. The option value is considered a payment upon grant even if the option does not immediately vest or if there are conditions to vesting or exercise. This prohibition is meant to capture any compensation that directly benefits the director or family member and as such would include political contributions to a campaign by either. However, it is not meant to capture ordinary course business transactions such as interest on an arm’s-length loan;
(iii) a director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer;
(iv) a director who is, or has a family member who is, a partner in (other than limited partner), or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (a) payments arising solely from investments in the company’s securities; or (b) payments under non-discretionary charitable contribution matching programs;
(v) a director of the company who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or
(vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.
Reference to the “company” includes parents and subsidiaries or any other entities that the company consolidates financial statements with, including variable interest entities. “Executive officer” refers to any person covered by SEC Rule 16a-1(f) and in particular the company’s president, principal financial officer, principal accounting officer, any vice-present in charge of a principal business unit, division or function or any officer or person who performs a policymaking function, which can include officers of a parent or subsidiary.
For purposes of Rule 803, “family member” means a person’s spouse, parents, children and siblings, mothers-in-law and fathers-in-law, sons-in-law and daughters-in-law, brothers-in-law and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home. This definition differs from the – see HERE.
« SEC Proposes Amendments To The Accredited Investor Definition Terminating Section 15(d) Reporting; Determining Voluntary Reporting Status »
SEC Proposes Amendments To The Accredited Investor Definition
Four years after issuing its report on the definition of “accredited investors” in December 2015, the SEC has published a proposed rule amendment to the definition. See HERE for my blog on the SEC’s report. The amendments were anticipated following an in-depth discussion on the definition contained in the SEC’s Concept Release on Private Offerings published in July 2019 (see HERE)
As a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. In the rule amendment release the SEC cites numerous comment letters suggesting and supporting many of the proposed amendments including one from the Crowdfunding Professionals Association (CfPA), Legislative & Regulatory Affairs Division, a committee I sit on and for which I participated in the preparation of the comment letter.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify including a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC is also proposing to amend the definition of a “qualified institutional buyer” under Rule 144a of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments would also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
Background
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including rule 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows such investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2018 the estimated capital raised in rule 506 offerings was $1.7 trillion compared to $1.4 trillion in registered offerings. Of the $1.7 trillion, $1.5 trillion was raised by pooled investment funds and the balance directly by other businesses. The SEC has been talking about increasing access to this large and growing market sector for some time.
In November 2019 the topic was front and center at the Investor Advisory Committee meeting (see HERE). In my blog on the meeting, I suggested that access to private markets and private funds could be expanded by amending the definition of an “accredited investor” to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. The proposed amendments would do just that.
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
- Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
- Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
- Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
- Any entity in which all of the equity owners are accredited investors.
Proposed Amendments
The proposed amendments to the accredited investor definition would add new categories of natural persons based on professional knowledge, experience, or certifications. The proposed amendments would also add new categories of entities, including a catch-all category for any entity owning in excess of $5 million in investments. In particular, the proposed amendments would: (i) add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution; (ii) with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund; (iii) add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify; (iv) add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (v) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (vi) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The proposed amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test.
The proposed amendments to the qualified institutional buyer definition in Rule 144A would add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The proposed amendments would also add a catch-all category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
The proposed amendment would add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution. The added categories are intended to demonstrate an individual’s background and understanding in the areas of securities and investing and thus a reduced need for regulatory protection. The SEC believes that individuals with financial sophistication have the ability to balance risky investments, make risk assessments and avoid unsustainable losses.
The SEC proposes to include professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. The amendment would include a non-exclusive list of attributes the SEC would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
The SEC would issue an order designating professional certifications and designations or other credentials as qualifying for accredited investor status. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status would be posted on the SEC’s website.
The SEC also preliminarily anticipates including those that hold a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Also requiring that a list of individuals that hold the certifications be publicly available would reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC proposes to add a new category based on the person’s status as a “knowledgeable employee” of the fund. The private fund category is meant to encompass funds that rely on the exemptions found in Sections 3(c)(1) and 3(c)(7) from registration as an investment company under the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, if the knowledgeable employee does not qualified as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded. Accordingly, the SEC proposes to fill this gap and include knowledgeable employees of private funds in the amended definition of an accredited investor.
Spousal Equivalents
The SEC proposes to add a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent will be defined as a cohabitant in a relationship generally equivalent to a spouse. The rule will not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules would (i) add limited liability companies that were not formed for the specific purpose of making the investment, registered investment advisers and rural business investment companies (RBICs); (ii) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (iii) “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act, to the current list of entities that may qualify as accredited.
As mentioned above, these additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
« OTCQX Rule Changes NYSE American Board Independence Standards »
OTCQX Rule Changes
Effective December 12, 2019, the OTC Markets has implemented changes to the initial and continued quotation requirements for companies listed on the OTCQX. The amendments (i) allow certain qualifying companies to use their regular securities counsel for a letter of introduction in place of an OTCQX sponsor; (ii) establish procedures for a company effecting a change of control; (iii) enhance corporate governance requirements, refine the definition of an “independent director,” and provide for a phase in for compliance with these new provisions; (iv) require Canadian companies to utilize a transfer agent participating in the Transfer Agent Verified Shares Program by April 1, 2020, and (iv) require U.S. companies to disclose all convertible debt. The last rule changes were implemented in May, 2019 – see HERE.
Amended Rules for U.S. Companies
OTC Sponsor
An SEC reporting company with a class of securities that has been publicly traded for at least one year may submit a written application to be exempted from the requirement to select an OTCQX sponsor. A company granted this exemption must submit a letter of introduction from their outside securities counsel in lieu of such a letter from an OTC Sponsor. Prior to adopting this rule amendment, only U.S. companies moving from a national exchange or with a separate class of securities trading on a national exchange qualified for the exemption.
A letter of introduction by outside securities counsel must state: (i) the securities counsel is licensed to practice law and in good standing in the U.S. and is not subject to any disciplinary actions within the last five years; (ii) the attorney is not currently subject to any sanctions resulting from disciplinary actions; (iii) the attorney is engaged by the company as its primary disclosure counsel and has assisted in the preparation of its most recent disclosure; (iv) other areas of engagement; (v) when engaged; (vi) that the attorney has reviewed information and made inquiries to satisfy itself that the company is in compliance with Exchange Act 12g3-2(b); (vii) the company is operating and is not a shell company; (viii) company is in good standing in each jurisdiction it conducts business; (ix) all of the company’s outstanding securities have been authorized and issued in accordance with the federal and state securities laws and are fully paid and non-assessable; (x) whether the company has been delisted, removed or suspended from a Qualifying Foreign Stock Exchange; and (xi) if the company is SEC or Regulation A reporting whether it is current in its reporting obligations.
Where outside securities counsel is used as a sponsor, the duties related to a sponsor and for the company to provide information to and seek input from such sponsor extend to the outside securities counsel.
Clarification of Penny Stock Exemption Eligibility Criteria
One of the qualifications to trade on the OTCQX is that a company must be exempt from the penny stock definition under Rule 3a51-1 of the Exchange Act by meeting one of the following criteria: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application and, as of the most recent fiscal year-end, have at least one of the following: (a) net income of $500,000; (b) net tangible assets of $1,000,000; (c) revenues of $2,000,000; or (d) total assets of $5,000,000; or (ii) have net tangible assets of $2 million if the company has been in continuous operation for at least three years, or $5,000,000 if the company has been in continuous operation for less than three years, which qualification can be satisfied as of the end of a fiscal period or as a result of an interim capital raise; or (iii) have average revenue of at least $6,000,000 for the last three years. The amended rules clarify that the financial thresholds necessary to qualify for exemption must be based on audited financial reported dated within 15 months prior to the company’s application to the OTCQX.
Convertible Debt Disclosure
All OTCQX companies must now disclose all of their convertible debt arrangements and provide copies of all securities purchase or similar agreements, promissory notes, irrevocable transfer agent instruction letters and related deal documents. Generally, an SEC-reporting company files these documents as exhibits to a Form 8-K when completing the transaction, or with the subsequent Form 10-Q following the deal closure.
Change of Control
An OTCQX company must now promptly notify OTC Markets of a change of control of the company. Within 20 calendar days of the completion of the change of control, the company must submit a new OTCQX application and associated application fee. The OTCQB enacted a similar rule back in July 2017. In addition, OTC Markets may independently determine that a change of control has taken place and, in such case, will notify the company who must then complete the new application. The failure to submit the new application and fee is grounds for removal from the OTCQX.
Like the OTCQB rules, the OTCQX defines a change of control as 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.
Independent Director
The new rules have amended the definition of an independent director 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.” (for Nasdaq independence standards, see HERE).
Amended Rules for International Companies
OTC Sponsor
A company with a class of securities that has been publicly traded on a Qualified Foreign Exchange, or that has been SEC reporting for at least one year, may submit a written application to be exempted from the requirement to select an OTCQX sponsor. A company granted this exemption must submit a letter of introduction from their outside securities counsel in lieu of such a letter from an OTC sponsor. Prior to adopting this rule amendment, only international companies moving from the OTCQB to the OTCQX qualified for the exemption. Where outside securities counsel is used as a sponsor, the duties related to a sponsor and for the company to provide information to and seek input from such sponsor extend to the outside securities counsel.
The outside securities counsel sponsor letter is in substantially the same form as required for U.S. companies.
Change of Control
The same provisions as discussed above for U.S. companies also apply for international companies.
Transfer Agent Verified Shares Program
The new rules require Canadian companies to utilize a transfer agent participating in the Transfer Agent Verified Shares Program by April 1, 2020.
Clarification of Penny Stock Exemption Eligibility Criteria
The same provisions as discussed above for U.S. companies also apply for international companies.
Corporate Governance Standards
International companies that are not listed on a Qualified Foreign Stock Exchange must meet additional corporate governance standards including: (i) have at least two independent directors on its board of directors (companies listed prior to the rule change will have until January 1, 2021 to comply); (ii) have an audit committee comprised of a majority of independent directors; (iii) conduct an annual shareholders’ meeting and make annual financial reports available to its shareholders at least 15 calendar days prior to the meeting. Trusts, funds and similar entities may apply for an exemption to these new corporate governance requirements.
A company that fails to meet the requirements must notify OTC Markets immediately upon learning of the event or circumstance that cause the non-compliance and must regain compliance by the earlier of its next annual meeting or one year from the date of the non-compliance.
Application Package
The amended rules add the requirement that a company provide a current shareholder list from its transfer agent as part of its application package. In addition, OTC Markets will now require a background check authorization form as part of its application process.
Initial Disclosure
The amended rules have increased the period for which a company, that is not SEC reporting or Regulation A reporting, must post information on the OTC Website from 24 months to three years, as part of its initial disclosure obligations. All information must be posted in English.
« Division of Enforcement 2019 Annual Report SEC Proposes Amendments To The Accredited Investor Definition »
Division of Enforcement 2019 Annual Report
As my firm does not practice in the enforcement arena, it is not an area I always write about, but this year I found a few trends that are interesting. In particular, just by following published enforcement matters on the SEC’s website, I’ve noticed a large uptick in actions to suspend the trading in, or otherwise take action against, micro- and small-cap companies, especially delinquent filers. I’ve also noticed a large uptick of actions against smaller public and private companies that use misleading means to raise capital from retail investors, and the concurrent use of unlicensed broker-dealers. Of course, there have always been a significant number of actions involving cryptocurrencies. In light of my own observations, I decided to review and report on the SEC’s view of its actions.
As an aside, before discussing the report, I note that the Government Accountability Office (GAO) has raised concerns about the quality of record keeping and documentation maintained by the SEC and used to generate the enforcement report. The GAO report states, “[E]nforcement has written procedures for recording and verifying enforcement-related data (including on investigations and enforcement actions) in its central database. However, Enforcement does not have written procedures for generating its public reports (currently, the annual report), including for compiling and verifying the enforcement statistics used in the report. To produce the report, Enforcement staff told GAO that staff and officials hold meetings in which they determine which areas and accomplishments to highlight. Enforcement was not able to provide documentation demonstrating that the process it currently uses to prepare and review the report was implemented as intended.”
Keeping in mind that the report may not be completely accurate, in fiscal year 2019, the SEC brought 862 enforcement actions, including 526 stand-alone actions. These actions addressed a broad range of significant issues, including issuer disclosure/accounting violations; auditor misconduct; investment advisory issues; securities offerings; market manipulation; insider trading; and broker-dealer misconduct. Through these actions, the SEC obtained judgments and orders totaling more than $4.3 billion in disgorgement and penalties and returned approximately $1.2 billion to investors. The number of enforcement actions rose by more than 30% over the prior fiscal year with more than half of the new actions targeting investment advisers, investment companies or broker-dealers. In 2019, the two-year hiring freeze was lifted and enforcement added 22 new positions.
The Enforcement Report highlights new initiatives by the SEC, including (i) the Retail Strategy Task Force; (ii) the Cyber Unit; and (iii) the Share Class Selection Disclosure Initiative. The Retail Strategy Task Force has two primary objectives: (i) developing data-driven, analytical strategies for identifying practices in the securities markets that harm retail investors and generating enforcement matters in these areas; and (ii) collaborating with internal and external partners, such as OIEA and the Department of Justice, on retail investor advocacy and outreach. The focus on retail investors has resulted in a significant uptick in actions against investment advisors, investment companies and broker-dealers. The Share Class Selection Disclosure Initiative was directed at investment advisory firms that purchased mutual fund shares from a fee paying mutual fund when a lower- or no-cost share class of the same mutual fund was available.
Gatekeepers continued to be an enforcement focus including broker-dealers, the Options Clearing Corporation, auditors and audit firms and attorneys. The SEC also used its power under the Sarbanes-Oxley Act of 2002 to pursue actions against individuals including CEOs and CFOs, usually related to activities to manipulate reported financial results including revenue. In fiscal 2019, 69% of enforcement proceedings included actions against individuals. The SEC always seeks both monetary and non-monetary relief, especially against individuals. Settled proceedings almost always include injunctive relief prohibiting not only future violations but also officer, director bars, penny stock bars, investment restrictions and the like.
Like last year, the SEC prosecuted several cryptocurrency, digital asset and distributed ledger technology cases. The cases involved the usual unregistered sale of securities but also actions were brought related to the promotion of an ICO, touting by celebrities and operating unlicensed trading platforms. In 2019 the SEC reached settlements with three digital asset issuers that resulted in guidance for compliance and registration. The SEC report touts that these actions send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.
Cybersecurity continues to be the target of many investigations and enforcement proceedings. In addition to actions against cyber-criminals, the SEC has turned to a review of industry participants and compliance with Regulation Systems, Compliance and Integrity (see HERE), resulting in an enforcement proceeding against the Options Clearing Corporation.
The SEC has encouraged defendant cooperation and as a result, in fiscal 2019, 76% of defendants cooperated, a record high. Law enforcement and interagency coordination also plays a big role in SEC enforcement matters. The SEC regularly works with the Department of Justice, FBI and state attorney general offices where a matter goes beyond civil enforcement. In 2019, more than 400 investigations included a parallel criminal proceeding.
The whistleblower program continues to result in a significant number of enforcement proceedings. However, the SEC receives thousands of tips per year, which is much more than it can efficiently review and process. As a result, it is working on streamlining the process and accelerating the evaluation of claims to determine viable information.
In June 2017, the Supreme Court case of Kokesh v. SEC limited the SEC’s claims for disgorgement to a five-year statute of limitations. The Kokesh case had a significant impact on SEC enforcement proceedings, which often involve many years of complex fraudulent activity. The SEC estimates that Kokesh reduced disgorgement judgments by as much as $1.1 billion in filed cases.
Commissioner Hester M. Peirce’s Statement on Enforcement Report
One of the reasons I was interested in the 2019 Enforcement Report is that SEC Commissioner Hester Peirce took the time to speak about it and, as usual, her thoughts are similar to mine. Commissioner Peirce analogizes the current SEC environment with “broken windows,” reminding me of the strategy heralded in by former SEC Chair Mary Jo White back in 2013 (see HERE). However, Commissioner Peirce was not referring to the former policy, but rather her point that if the SEC had three broken windows, it “would count them and then issue press releases and reports, and journalists and academics would write all sorts of catchy articles based on those delicious statistics. But just as one cannot derive much of a pattern from the three broken windows in my lobby in 2019, one ought to be wary of drawing conclusions from our enforcement statistics.”
Commissioner Peirce’s point is that enforcement proceedings are fluid, with some taking longer than others. Publishing reports and statistics based on the ones that happen to finish during a particular period of months ends up providing arbitrary and not particularly useful information. Moreover, even breaking up cases by type is arbitrary as the factual differences in each case provide the important precedence.
Likewise, penalty amounts are not that important. She points out that low-dollar cases can provide important meaning, such as the case with the Options Clearing Corporation, which was a relatively low dollar amount but included important ongoing undertakings to address several issues. Ms. Peirce states, “[O]ur enforcement program is not a set of data points. Instead, our program consists of the judgments made by a group of hard-working, experienced, bright attorneys, accountants, economists, paralegals, data analysts, computer experts, and support staff dedicated to safeguarding the integrity of our markets.”
In that regard, Commissioner Peirce repeats a mantra she has said before, and that is that the SEC should be selective in its enforcement efforts. SEC resources are limited and not every matter opened should lead to a settlement or ligation action. The SEC should also be looking within to improve the enforcement program. Part of that process is looking for rules that need to be written, eliminated or rewritten. As an example, she points to the advertising rule banning testimonials about investment advisors. Reviews and testimonials are a basic part of consumer decision making in today’s world, and she doesn’t understand why investment advisors should be different. Commissioner Peirce succinctly states, “[R]ather than enforcing anachronistic rules, we should rewrite them and instead devote enforcement resources to the problems of today, of which, I can assure you, there are many.”
Commissioner Peirce also spends time talking about the much-needed overhaul to Rule 15c2-11 (see HERE). Micro-cap fraud is a systemic problem that results in an environment of distrust negatively impacting the legitimate capital-raising efforts by small and development-stage companies. A redo of 15c2-11 will definitely have an impact on the micro-cap space in general and certainly fraud in particular. Commissioner Peirce points out what I have been hearing from my colleagues, and that is that the comments and responses to the proposed rules have been voluminous and largely negative (I haven’t had time to read them yet). The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. Commissioner Peirce recognizes that a balance must be had that “hinders fraudsters without killing the market for micro-cap stocks.”
Another area of needed regulatory modernization deals with the regulation of transfer agents, which has remained virtually unchanged since 1977. Commissioner Peirce points to the four-year-old concept release (see HERE) and seems to be hopeful that actual proposed rule changes will be forthcoming.
Commissioner Peirce points out that the lack of regulation can be as problematic is improper regulation. An area that is badly in need of attention relates to the regulation of finders. Commissioner Peirce points out, “[I]n the absence of rulemaking, these would-be good actors are forced to discern the path from a murky mishmash of staff no-action letters and enforcement actions.” Commissioner Peirce recognizes that the current broker-dealer framework is inappropriate for finder’s working to make a few connections between investors and companies in need of capital. I’ve been very vocal about the need for a finder’s regulatory framework – see HERE.
Commissioner Peirce also thinks that the current regulatory framework for digital assets hinders innovation and growth: “The only guidance out of the SEC is a parade of enforcement actions and a set of staff guidance documents and staff no-action letters.” She supports creating a non-exclusive safe harbor period within which a token network could blossom without the full weight of the securities laws crushing it before it becomes functional.
In addition to rules, the SEC can improve enforcement by focusing more on compliance. The Office of Compliance, Inspections and Examinations can work with broker-dealers, investment advisors and market participants to improve their systems and remediate issues found during a review rather than making an enforcement referral.
Another recommendation to improve the enforcement program involves further utilizing technology. Although technology and data processing has been effective in uncovering insider trading and cherry-picking schemes, it comes at the expense of privacy. The Consolidated Audit Trail project, for example, tracks all trading activity in the equity and options markets and as such could be abused by overzealous regulators and cybercriminals. Once again, Ms. Peirce hits the nail on the head, stating, “[I] would rather have an enforcement program that respects the liberty and privacy of American investors, even if it comes at the cost of lost enforcement opportunities, than an enforcement program that has a hundred-percent success rate at catching wrongdoers.”
« Drill Down On NASDAQ Audit Committee Requirements OTCQX Rule Changes »
Drill Down On NASDAQ Audit Committee Requirements
I’ve written several times about Nasdaq listing requirements including the general listing requirements (see HERE) and the significant listing standards changes enacted in August of this year (see HERE). This blog will drill down on audit committees which are part of the corporate governance requirements for listed companies. Nasdaq Rule 5605 delineates the requirements for a Board of Directors and committees. The Nasdaq rule complies with SEC Rule 10A-3 related to audit committees for companies listed on a national securities exchange.
SEC Rule 10A-3
SEC Rule 10A-3 requires that each national securities exchange have initial listing and ongoing qualification rules requiring each listed company to have an audit committee comprised of independent directors. Although the Nasdaq rules detail its independence requirements, the SEC rule requires that at a minimum an independent director cannot directly or indirectly accept any consulting, advisory or other compensation or be affiliated with the company or any of its subsidiaries. The prohibition against compensation does not include a reasonable compensation for serving as a director.
Like the Nasdaq rules, the SEC allows for different independence standards for foreign private issuers (FPI) following their home country rules and even allows for affiliation as long as the person is not an executive officer of the FPI.
The audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for auditing and audit-related services. Furthermore, the SEC requires that an executive officer of a listed company promptly notify the national exchange if he or she becomes aware of any material non-compliance with the audit committee requirements by that listed company.
Although charter requirements are detailed in the Nasdaq rule, the SEC rule requires that the audit committee establish certaDrill Down On NASDAQ Audit Comin processes and procedures for handling complaints regarding accounting, internal financial controls and auditing matters, including for the confidential submission by employees. The SEC rule also requires that an audit committee be given the power, authority and funding to engage independent counsel and other advisors to carry out its tasks. Funding must also be provided to hire audit firms and pay administrative expenses.
The SEC allows for a phase-in for compliance when a company is completing an initial public offering. In particular, all but one director may be dependent for 90 days following the IPO and a minority of the audit committee may be dependent for one year from effectiveness of the registration statement. The SEC rule also contains general exemptions from the audit committee requirements including: (i) for consolidated subsidiaries that are listed on another exchange with similar audit committee requirements; (ii) FPI’s that follow home country rules and have a similar committee to an audit committee and satisfy certain additional conditions; and (iii) related to the listing of certain options, futures, asset-backed issuers, investment trusts, a passive trust or foreign governments. Specific disclosure is required when an exemption is being relied upon including an assessment of whether, and if so, how, such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of Rule 10A-3.
The SEC rule specifically requires that an exchange must give a listed company the opportunity to cure a defect in the audit committee requirements prior to delisting. Moreover, the SEC rule provides that if an independent director on the audit committee loses independence as a result of factors outside of their control, that person may remain on the audit committee until the next annual shareholders meeting or one year from the date of the occurrence that caused the board member to no longer be independent.
Nasdaq Rule 5605
Audit Committee Composition
One of the corporate governance related listing requirements is that a company have an audit committee consisting solely of independent directors (for more information on independence qualifications see HERE) who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements including a balance sheet, income statement and cash flow statement. The audit committee must have at least three members. One member of the audit committee must have employment experience in finance or accounting, an accounting certification or other experience that results in the individual’s financial sophistication.
None of the committee members can have participated in the preparation of the financial statements of the company or any of its current subsidiaries for the prior three years. An individual will be considered to have participated in the preparation of the company’s financial statements if the individual has played any role in compiling or reviewing those financial statements, including a supervisory role. An interim officer who signed or certified the company’s financial statements will be deemed to have participated in the preparation of the company’s financial statements and, therefore, could not serve on the audit committee for three years.
The eligibility requirements to serve on the audit committee apply to all committee members whether or not such member is afforded non-voting status or other limitations on their participation with the committee.
Nasdaq has a limited exception to the independence requirements where a director meets the independence standards in SEC Rule 10A-3 but not the more detailed requirements of Nasdaq rules, is not currently an executive officer, employee or family member of an executive officer and exceptional circumstances makes the appointment of the person in the best interests of the company and its shareholders. Specific disclosures are required when relying on this exception including the nature of the relationship that makes the person non-independent and the reasons for the board’s determination. A committee member appointed under this exception may not serve for more than two years and cannot be chair of the audit committee. Unlike the implementation of many exceptions to Nasdaq rules (such as for example the 20% rule), the limited exception for audit committee compliance for exceptional circumstances does not require Nasdaq approval.
Audit Committee Charter
Rule 5605(c) requires that each company must certify that it has adopted a formal written committee charter and that the audit committee will review and reassess the charter on an annual basis. The certification is submitted one time and a copy of the actual charter does not need to be provided to Nasdaq. However, Item 407(d)(1) of Regulation S-K requires that companies report whether a current copy of its audit committee charter is available on its website and provide the website address. If the charter is not on the website, companies should include the charter as an appendix to its proxy statement at least once every three years or in any year in which the charter has been materially amended.
The charter must specify: (i) the scope of the audit committee’s responsibilities and how it carries out those responsibilities including structure, processes and membership requirements; (ii) the audit committee’s responsibility to ensure they receive written statements from the outside auditor regarding relationships between the auditor and the company and actively taking steps for ensuring the independence of the auditor; (iii) the committee’s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company; and (iv) the specific audit committee responsibilities and authority.
Furthermore, the charter must establish procedures for the confidential, anonymous submission by employees of the listed company of concerns regarding questionable accounting or auditing matters.
Audit Committee Responsibilities and Authority
The audit committee is responsible for items delineated in SEC Rule 10A-3 and in particular related to: (i) registered public accounting firms, (ii) complaints relating to accounting, internal accounting controls or auditing matters, (iii) authority to engage advisers, and (iv) funding as determined by the audit committee.
Cure Periods
All non-compliance with audit committee requirements requires prompt notification to Nasdaq.
Consistent with SEC Rule 10A-3, if a member of the audit committee loses independent status for reasons outside the member’s reasonable control, the audit committee member may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
If noncompliance is a result of dropping below the minimum member requirements (three members), the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement – provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the vacancy, the company shall instead have 180 days from such event to regain compliance. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
Exception
If a company has a class of equity securities listed on another exchange with SEC Rule 10A-3 audit committee requirements, they may list securities of a consolidated subsidiary on Nasdaq without having a separate audit committee for that subsidiary.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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« SEC Proposed Amendments To Rule Governing Proxy Advisory Firms Division of Enforcement 2019 Annual Report »
SEC Proposed Amendments To Rule Governing Proxy Advisory Firms
As anticipated on November 5, 2019, the SEC issued two highly controversial rule proposals. The first is to amend Exchange Act rules to regulate proxy advisors. The second is to amend Securities Exchange Act Rule 14a-8 to increase the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. For a review of my blog on the Rule 14a-8 proposed amendments, see HERE. The new proposed rules are very controversial, but overdue and necessary. I am in support of both rules.
The SEC has been considering the need for rule changes related to proxy advisors for years as retail investors increasingly invest through funds and investment advisors where the asset managers rely on the advice, services and reports of proxy voting advice businesses. It is estimated that between 70% and 80% of the market value of U.S. public companies is held by institutional investors, the majority of which use proxy advisory firms to manage the decision making and logistics of voting for thousands of proposals within a concentrated period of a few months. Proxy voting advice businesses provide a variety of services including research and analysis on matters to be voted upon; general voting guidelines that clients can adopt; giving specific voting recommendations on specific matters subject to a shareholder vote; and handling the administrative process of returning proxies and casting votes. The administrative tasks are usually electronic and, at times, can involve an automated completion of a ballot based on programed voting instructions.
In 2010 the SEC issued a concept release seeking public comment on the role and legal status of proxy advisory firms within the U.S. proxy system. In 2013, the SEC held a roundtable on the use of proxy advisory firm services by institutional investors and investment advisers and in 2014, it issued a Staff Legal Bulletin (SLB 20) to provide guidance about the availability and use of exemptions from the proxy rules by proxy advisory firms. Another roundtable was held in November 2018 on the subject and in August 2019, the SEC issued new guidance clarifying that proxy advisors engage in “solicitations” within the meaning of the proxy rules.
This blog addresses the proposed rule changes related to the governance of proxy advisory firms. The proposed rules in essence codify the August 29, 2019 SEC guidance (see my blog HERE). In particular, the proposed rule changes the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provides additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amends rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.
In addition, the proposed new rules enhance the quality of the disclosures about material conflicts of interest that proxy voting advice businesses provide their clients, provide that companies and other soliciting parties be given an opportunity to review and provide feedback to identify errors in the proxy voting advice, as long as the relevant definitive proxy materials have been filed 25 days or more in advance of a meeting, and add provisions to improve how investors are informed about differing views on advice.
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The fedederal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder and apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless the follow the specific rules and procedures. Currently, under Exchange Act Rule 14a-1(l), a solicitation includes, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation.
The proposed amendments would amend Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the Rule would be amended to include “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee,“ within the definitions of “solicit” or “solicitation.”
The SEC provide for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder who does not otherwise engage in a proxy solicitation stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition and in Rule 14a-2(b) discussed below and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the proposed SEC rules (and the August guidance) specifically states that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination. On the other hand, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Currently, Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts.
Nevertheless, solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. Also, as an aside I note that the exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
The proposed amendments would revise Rule 14a-2(b)(1) and 14a-2(b)(3) such that in order to rely on the exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice, including any reports, electronic platforms or other materials; (ii) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (iii) allow companies and certain other soliciting persons to request that proxy voting advice businesses include a hyperlink or similar electronic link in their voting advice directing recipients to a written statement by the company or other soliciting person.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while at the same time working with the company on matters related to those same standards; and (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions.
The current rules do generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. In particular, the amended rules would require disclosure of: (i) any material interests, direct or indirect, of the proxy advisory firm or its affiliates in the matter or parties concerning which it is providing advice; (ii) any material transactions or relationships between the proxy advisory firm or its affiliates and the company, any other soliciting party, a shareholder proponent or in connection with the subject matter of the vote; (iii) any other information regarding the interest, transaction or relationship that is material to assessing the objectivity of the proxy voting advice; and (iv) any policies and procedures used to identify and steps taken to address material conflicts of interest.
The proposed amendments would permit proxy voting advice businesses to require companies and other soliciting persons to enter into confidentiality agreements for materials exchanged during the review and feedback period, and would allow proxy voting advice businesses to rely on the exemptions where failure to comply with the new conditions was immaterial or unintentional.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms such as ISS and Glass Lewis voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. The proposed amendments to Rule 14a2-(b) would require one standardized opportunity for timely review and feedback by companies of proxy voting advice before such advice is disseminated to clients, regardless of whether the advice is adverse to or agreeable to the company’s own position. The same opportunity must be provided to other soliciting parties only if the matter upon which they are soliciting is contested and to persons who intend to deliver their own proxy materials to voters.
The time for review depends on the timing of the definitive proxy statement compared to the meeting. If the definitive proxy statement is filed less than 45 but at least 25 calendar days before the meeting, the proxy advisory firm must provide a minimum of three business days for review and feedback. If the definitive proxy statement is filed more than 45 calendar days before the meeting, the proxy advisory firm must provide a minimum of five business days for review and feedback. If the definitive proxy statement is filed less than 25 calendar days before the meeting, the advisory firm has no obligation to provide a review and feedback period.
In addition to the review and feedback period, in order to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3), a proxy voting advice business would be required to provide companies and certain other soliciting persons with a final notice of voting advice. This final notice must be provided no later than two business days prior to delivery of same to the proxy advisory firm’s clients. This final notice gives the company or other soliciting person a chance to decide whether or not to provide a written statement and request a hyperlink to that statement be provided by the proxy advisory firm. At the end of the two-day period, the proxy advisory firm has no further notice obligations.
Inclusion of Hyperlink to Written Statement
Under proposed Rule 14a-2(b)(9)(iii), as a condition to the exemptions found in Rules 14a2(b)(1) and 14a-2(b)(3), a proxy voting advice business must, upon request, include in its proxy voting advice and in any electronic medium used to deliver the advice a hyperlink (or other analogous electronic medium) that leads to the company’s statement about the proxy advisor’s voting advice. The hyperlink must be included upon request regardless of whether the voting advice is adverse to the company’s position. The written statement itself would be considered a solicitation and therefore subject to the filing and information requirements and anti-fraud rules. Like the notice and feedback rules, the proxy advisory firm is only require to provide a hyperlink for other soliciting parties only if the matter upon which they are soliciting is contested and to persons who intend to deliver their own proxy materials to voters.
Chart of Timing
The following chart included in the SEC rule proposal is helpful:
| Action | Timing |
| Person conducts solicitation exempt under
§ 240.14a-2 or submits shareholder proposal pursuant to Exchange Act Rule 14a-8 |
N/A. Proposed rules do not apply |
| Registrant and/or soliciting person conducts non-exempt solicitation and files definitive proxy statement for shareholder meeting | N/A. Proposed rules do not dictate when the registrant and/or soliciting person files its definitive proxy statement |
| Proxy voting advice business provides the registrant and/or soliciting person with the version of the voting advice† that the business intends to deliver to its clients
[proposed Rule 14a-2(b)(9)(ii)] |
Subject to the proxy voting advice business’s discretion, so long as it provides its voting advice to the registrant and/or soliciting person and complies with the required review and feedback and final notice periods in proposed Rule 14a-2(b)(9)(ii) prior to the distribution of such advice to the business’s clients |
| Review and feedback period:
Registrant and/or soliciting person has an opportunity to review and provide feedback, if any, on the proxy voting advice business’s voting advice [proposed Rules 14a- 2(b)(9)(ii)(A)(1) and (A)(2)] |
· If definitive proxy statement is filed at least 45 calendar days before the date of the meeting, registrant and/or soliciting person has at least five business days to review and provide feedback; or
· If definitive proxy statement is filed less than 45 but at least 25 calendar days before the date of the meeting, registrant and/or soliciting person has at least three business days to review and provide feedback; or
· If definitive proxy statement is filed less than 25 calendar days before the date of the meeting, the proxy voting advice business is not required to provide its voting advice to registrant or soliciting person |
| Proxy voting advice business may revise its voting advice, as applicable | N/A. Subject to the proxy voting advice business’s discretion |
| Final notice of voting advice:
Proxy voting advice business provides a copy of its voting advice that it will deliver to its clients to allow the registrant and/or soliciting person to assess whether or not to provide a statement with its response to the advice [proposed Rules 14a-2(b)(9)(ii)(B) and 14a-2(b)(9)(iii)] |
No earlier than upon expiration of review and feedback period.
Registrant and/or soliciting person has at least two business days to provide a hyperlink (or other analogous electronic medium) with its response, if any |
| Registrant holds its shareholder meeting | N/A |
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The proposed amendments would modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose could include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The proposed rule would add to these examples the information required to be disclosed under 14a2-(b) including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. Particularly the proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter (including any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters). In its rule release, the SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does in fact meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Commissioner Statements
Chair Jay Clayton supports the proposed amendments as part of the necessary modernization of the proxy process. Chair Clayton points out that the increased disclosures will improve transparency and trust during the proxy process without adding undue burdens or delays to the process.
Commissioner Roisman also supports the proposed rule changes. He is aware that some are debating that the SEC is regulating beyond its mission and authority but firmly pushes back on that argument noting that the SEC has always regulated disclosures and fraud in the proxy solicitation process. Proxy advisors are utilized by thousands of investment advisors and institutional investors. In light of the power they hold in the voting process, disclosures on methodologies and conflicts are not only proper but imperative. Commissioner Roisman’s statement is well thought out, pointing out both sides of the arguments, and concluding that the proposed rules find a workable middle ground after much thought and effort on the SEC’s part.
Commissioner Hester Peirce supports the rule changes but points out that they are only part of the overall solution to the problems in the proxy process. Ms. Peirce points out that there is a misperception that investment advisors have a fiduciary duty to vote all of their clients proxies. As the number of retail clients investing through advisors has grown dramatically, they have naturally turned to proxy advisory firms for assistance resulting in a voting process that may or may not take into account a particular client’s views or goals. She hopes that the proposed rules encourage investment advisors and institutional investors to do more due diligence on the proxy advisory firms they use and how they are voting on their clients’ behalf.
Commissioner Jackson is not in favor of the rule change believing it weakens the relationship between investment advisors and their proxy advisor business consultant. He also believes that the new process adds burdens to an advisor that recommends against a company proposal. I simply can’t agree. Requiring proper disclosure, just as a company is required to make proper disclosure, evens the playing field and prevents small private groups from putting forth undisclosed personal interests without any transparency.
Commissioner Allison Herren Lee also disagrees with the proposed rule. Although she agrees that proxy advice should be based on the most reliable accurate information, she thinks it already is and therefore no new rules, or burdens, should be added. She also believes that there is no basis for assuming that greater issuer involvement would improve proxy voting advice.
« Nasdaq Board Independence Standards Drill Down On NASDAQ Audit Committee Requirements »
Nasdaq Board Independence Standards
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
Under Rule 5605, an “independent director” means a person other than an executive officer or employee of a company or any individual 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. In other words, the question of independence must ultimately be determined by the board of directors who must make an affirmative finding that a director is independent. However, the Nasdaq rules specify certain relationships that would disqualify a person from being considered independent. Stock ownership is not on the list and is not enough, without more, to preclude independence.
Rule 5605 specifies that the following people cannot be considered independent:
(i) a director who is, or at any time during the past three years was, employed by the company, provided however, interim employment of less than one year would not be a disqualifier as long as such employment had since terminated. In addition, employment by an entity that was later acquired by the company would not disqualify a director from being independent provided the former officer was not employed by the company after the acquisition;
(ii) a director who accepted or who has a family member who accepted any compensation from the company in excess of $120,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than: (a) compensation for board or board committee service; (b) compensation paid to a family member who is an employee but not an executive of the company; (c) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (d) compensation received while acting as an interim officer as long as such employment lasted for less than a year and has since terminated. Options received for services should be valued using a commonly accepted option pricing formula, such as the Black-Scholes or binomial model at the time of grant. The option value is considered a payment upon grant even if the option does not immediately vest or if there are conditions to vesting or exercise. This prohibition is meant to capture any compensation that directly benefits the director or family member and as such would include political contributions to a campaign by either. However, it is not meant to capture ordinary course business transactions such as interest on an arm’s-length loan;
(iii) a director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer;
(iv) a director who is, or has a family member who is, a partner in (other than limited partner), or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (a) payments arising solely from investments in the company’s securities; or (b) payments under non-discretionary charitable contribution matching programs;
(v) a director of the company who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or
(vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.
Reference to the “company” includes parents and subsidiaries or any other entities that the company consolidates financial statements with, including variable interest entities. Executive officer refers to any person covered by SEC Rule 16a-1(f) and in particular the company’s president, principal financial officer, principal accounting officer, any vice-present in charge of a principal business unit, division or function or any officer or person who performs a policymaking function, which can include officers of a parent or subsidiary.
For purposes of Rule 5605, “family member” means a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The new proposed language matches the NYSE definition.
However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change. The SEC basically thinks Nasdaq is over-correcting in its new proposed rule. Certainly it would make sense to exclude a stepchild where the parents marry after the child is an adult and no parental relationship exists, but not where the step-parent raises or is otherwise close to the stepchild. The SEC also does not necessarily believe that the term “children” excludes stepchildren, nor as noted, should it. As of publication of this blog, no further action has been taken.
« SEC Proposes To Tighten Shareholder Proposal Thresholds SEC Proposed Amendments To Rule Governing Proxy Advisory Firms »
SEC Proposes To Tighten Shareholder Proposal Thresholds
As anticipated on November 5, 2019, the SEC issued two highly controversial rule proposals. The first is to amend Exchange Act rules to regulate proxy advisors. The second is to amend Securities Exchange Act Rule 14a-8(b) to increase the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954. Together the new rules would represent significant changes to the proxy disclosure and solicitation process and shareholder rights to include matters on a company’s proxy statement. Not surprisingly, given the debate surrounding this topic, each of the SEC Commissioners issued statements on the proposed rule changes.
I am in support of both rules. This blog addresses the proposed rule changes related to shareholder proposals. Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years. The rules have not been amended in decades and during that time, shareholder activism has shifted. Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets. The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements. I note that a 2018 study found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.
Background – Current Rule 14a-8
The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.
All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.
Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors, and is accordingly a source of much contention. Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that if meet substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.
State laws in general allow a shareholder to attend a meeting in person and, at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process. By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost, to themselves. It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.
The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so. Procedurally to qualify to submit a proposal, a shareholder must:
- Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
- If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
- If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
- Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
- Clearly state the proposal and course of action that the shareholder desires the company to follow;
- Submit no more than one proposal for a particular annual meeting;
- Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
- Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
- If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
- The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.
A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.
Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC. If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.
As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion. Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.
As a refresher, substantive grounds for exclusion include:
- The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
- The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
- The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
- The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
- The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
- The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
- The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
- The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
- The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
- The proposal seeks to remove an existing director whose term is not completed;
- The proposal questions the competence, business judgment or character of one or more director nominees;
- The company has already substantially implemented the requested action;
- The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
- The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
- The proposal seeks to require the payment of a dividend; or
- The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.
Proposed Rule Change
The need for a change in the rules has become increasingly apparent in recent years. As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and as such is susceptible to abuse. In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules. Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals. The SEC also conducted a Proxy Process Roundtable and invited public comments and input.
The proposed rule changes address eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal. The proposed amendments would amend the proposal eligibility requirements in Rule 14a-8(b) to:
(i) update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;
(ii) require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal;
(iii) require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal, and provide contact information as well as business days and specific times that the shareholder is available to discuss the proposal with the company.
The proposed amendments would amend the “one proposal” requirements in Rule 14a-8(c) to:
(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.
Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.” The proposed amendments would amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to:
(i) increase the current resubmission thresholds of 3%, 6% and 10% for matters voted on once, twice or three or more times in the last five years, respectively, of shareholder support a proposal must receive to be eligible for future submission to thresholds of 5%, 15% and 25%; and
(ii) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote.
Commissioner Statements on the Proposed Rule Changes
Chair Jay Clayton supports the proposed amendments as part of the necessary modernization of the proxy process. He specifically believes that the requirement for shareholders to engage and meet with management on a proposal will have a significant beneficial impact on company-shareholder communications and the proxy process. Focusing on the resubmission changes, Chair Clayton states, “if after three attempts at a proposal within a 5 year period, 75% of your fellow shareholders still do not support your proposal, you should take a time out.”
Commissioner Roisman also supports the proposed rule changes discussing how long it has been since the last amendments and the significant changes in the markets and technology since that time. The SEC has an obligation to revisit rules regularly to ensure they remain appropriate in the current dynamic. He points out that this is especially true when the market participants are loudly proclaiming that the rules are not working, as in the case of the proxy process and shareholder submission and resubmission eligibility criteria.
Commissioner Hester Peirce supports the rule changes and is eloquent and clever in her statement, as usual. Cutting to the chase, the question in Rule 14a-8 is: “[W]hen should one shareholder be able to force other shareholders to pay for including the proponent shareholder’s proposal in the company’s proxy materials?” Continuing: “[T]he proposed changes would help to weed out proposals whose proponents do not have a real interest in the company and proposals for which other shareholders do not share the proponent’s enthusiasm.” The current proposals are fair, ensuring that shareholders with a real economic stake can submit proposal and resubmit those proposals where other shareholder interest increases.
Not surprisingly, Commissioner Jackson is not in support of the changes beginning his statement by characterizing the proposed rule changes as limiting public company investors’ ability to hold corporate insiders accountable. He agrees that the rules need to be updated and revisited but does not approve of proposals made.
Commissioner Allison Lee sides with Commissioner Jackson in seeing the proposed rules as suppressing shareholder rights. Commissioner Lee is specifically concerned about small shareholders being deterred from submitting proposals related to ESG matters including climate risk disclosures.
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