Securities Attorney Laura Anthony, Author at Reverse-Merger.com

SEC Investor Advisory Committee Meeting

Posted by Securities Attorney Laura Anthony | November 19, 2019 Tags: SEC Investor Advisory Committee Meeting

On November 7, 2019, the SEC Investor Advisory Committee held a meeting on the topics of (i) whether investors use environmental, social and governance (ESG) data in making investment and capital allocation decisions; and (ii) the SEC’s recent concept release on harmonization of securities offering exemptions. For more on ESG matters, see HERE and for my blog on the SEC’s concept release on exempt offerings, see HERE. Both SEC Chair Jay Clayton and Commissioner Allison Herren Lee made remarks before the committee. As always, it is helpful in navigating our complex securities laws and regulatory priorities to stay informed on matters involving SEC decision makers and policy setters.

The Investor Advisory Committee was created by the Dodd-Frank Act to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace. The Dodd-Frank Act authorizes the committee to submit findings and recommendations for review and consideration by the SEC. Since its formation, the committee has made over 20 recommendations to the SEC on a wide range of pertinent topics.

Several panelists during the meeting expressed concern over the lack of information on private offerings, other than the fact that with the information the SEC does have, it is known that private offerings outpace public markets. Information is generally learned from Form D filings, but not all private offering issuers file a Form D. Moreover, there is no reliable or centralized resource as to how private offerings perform. As a result, panelists at the meeting do not believe that exemptions should be expanded. For example, one law professor stated that there is little evidence that retail investors would have better returns if allowed to invest in private securities. The negative opinions were strong.

However, there is another side, and not surprisingly I am a proponent of increasing private offering availability for retail investors. Absolutely there is no evidence that overall returns would increase and possibly they would not. Private offerings, especially in start-ups, are among the riskiest of all investments. Nonetheless, when they do perform, they also provide the highest returns. Also importantly, it is this start-up culture that fuels the American economy, creates new jobs, supports technological and scientific advancement that is increasingly left to private sectors, and keeps America competitive in the global economy.

There are ways to increase access to private markets without letting fraudsters run amuck with grandma’s retirement account. The definition of an “accredited investor” can be amended to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. Increased access to professionally managed funds that invest in private markets is another option.

Also, access to private markets can be increased, and investor protections increased through the regulation of private market finders. I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the new FINRA Securities Industry Essentials Exam (see HERE) for finders that are otherwise exempt from the full broker-dealer registration requirements.

Form D’s can also become mandatory in order to preserve the federal exemption being relied upon which will add to the information that the SEC has on private offerings, though not their success. However, I can’t think of any methodology for the SEC to gather information on the success of private offerings, that wouldn’t be overly burdensome and cumbersome on both the issuing companies and the government regulators. Furthermore, this information will provide little beneficial additional knowledge. It is known that most start-ups fail, that 9 out of 10 businesses fail within the first 10 years, that if you invested $1,000 in Amazon in 1997 it would be worth $1,362,000 as of September 4, 2018 and the numbers are similar for Netflix, Twitter, Google and many others.

Inaction is the same as action, it has a result. I agree with Chair Clayton that access to private markets needs to be expanded and that the lack of data on the results of private investments is not a good enough reason to do nothing.

Remarks by Chair Jay Clayton

Prior to the meeting, SEC Chair Jay Clayton delivered prepared remarks on the meeting topics and provided a list of areas of focus he would like to see the committee address. Consistent with prior statements, Chair Clayton stresses that ESG means many different things to different investors and different companies, even in the same sector. He is concerned about requiring disclosures of immaterial information or information that is not designed to assist in investment decisions. Chair Clayton suggests focusing on the committee members and panelist use ESG data including whether the use of such data designed to improve investment performance over a particular term, to screen certain activities, companies or industries to address a particular objective or policy, or a combination of these goals.

Chair Clayton also made suggestions for areas that the committee should consider reviewing and making recommendations on. The topics suggested include:

(i) Self-directed individual retirement accounts (IRAs) including whether retail investors have enough protections;

(ii) Teachers and military service members including additional initiatives the SEC can take to protect these investor groups;

(iii) Minority and non-English-speaking communities including whether there are regulatory barriers discouraging access to investment services or leading to higher prices or inferior financial product choices;

(iv) Retail access to investment opportunities including opening access to private investments that currently or traditionally have only been available to institutional investors. In this regard, Chair Clayton would like to consider changes to fund regulations to align the interests of retail investors with fund managers (a regulation best interests for fund managers?);

(v) Retail investor protections in an increasingly global world including a study of the differences in the securities laws and investor protections between the U.S. and abroad. In this regard, Chair Clayton specifically pointed out that he does not believe that U.S. investors have proper assurances, based on regulatory regimes, that non-U.S. companies actually meet reported ESG standards. Similarly he points out concerns with audit quality in some foreign countries (see HERE for information on the SEC’s cautionary statement regarding audit quality in China);

(vi) LIBOR transition including how the SEC can help market participants address and respond to the risks of the transition away from LIBOR;

(vii) Index construction including whether retail investors and their advisors understand indices from a technical perspective and market exposure perspective and whether the SEC should increase required disclosures for indices; and

(viii) Credit rating agencies including the level of influence they have in the marketplace and whether their disclosures are sufficient.

Remarks by Commissioner Allison Herren Lee

Commissioner Allison Herren Lee is the newest member of the SEC commission. Like the market as a whole, Commissioner Lee is focused on ESG matters. The last time the SEC issued guidance on climate-related disclosure was in 2010 and since that time, scientific knowledge of climate change and its risks has increased significantly. Climate change risks are very real and could impact everything from the physical location of equipment to human resources to the value of assets…

« SEC Solicits Input To Improve Markets For Thinly Traded Securities SEC Proposes To Tighten Shareholder Proposal Thresholds »

SEC Solicits Input To Improve Markets For Thinly Traded Securities

Posted by Securities Attorney Laura Anthony | November 12, 2019 Tags: SEC, SEC Solicits Input To Improve Markets For Thinly Traded Securities

On October 17, 2019, the SEC made a statement inviting stock exchanges and market participants to submit “innovative proposals designed to improve the secondary market structure for exchange listed equity securities that trade in lower volumes, commonly referred to as ‘thinly traded securities.’” On the same day the SEC issued a staff background paper on the subject. The SEC is not asking for input on how a company can better promote its stock and gain investor awareness, but rather how the capital market system, including trading rules and regulations, can be amended or improved to benefit thinly traded securities.

The staff background paper cites many statistics on the number of thinly traded securities, which they define as trading less than 100,000 shares daily. It also refers to the U.S. Department of the Treasury report entitled “A Financial System That Creates Economic Opportunities; Capital Markets” – see HERE for a summary of the report. As a result of this report, the SEC began looking at changes to Regulation NMS and unlisted trading privileges, both of which they continue to review and are now seeking public input on.

Regulation NMS

The SEC points out that thinly traded securities drive up transaction costs, and can make an exit of security holdings challenging and increase a company’s cost of capital. In its statement the SEC talks about potentially suspending unlisted trading privileges on multiple exchanges for thinly traded securities and overhauling Regulation NMS, including by providing exemptions from the rules. The SEC has raised these ideas previously, HERE).

Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.

Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations, and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.

Institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.

Unlisted Trading Privileges

One idea to improve liquidity is to restrict or even terminate unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC-traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.

Market Maker Incentives

In a recent roundtable, a suggestion was made to provide market makers with incentives to trade and make markets in thinly traded securities. Increased incentives to be in, and stay in, the markets for these securities could encourage market makers to quote more frequently and in greater size, which in turn could lead to narrower spreads and increased displayed order interest.

Intraday Auctions

Another possible strategy to help with thinly traded securities is to have periodic intraday auctions as a means of concentrating liquidity in thinly traded securities at times other than solely at the market open and market close. This strategy may assist market participants in finding counterparties for trades, especially larger block trades.

Non-Automated Markets

The idea around a non-automated market is that buyers and sellers could negotiate directly and communicate with each other to determine trade prices and order size. To me this seems to result in a sort of private market for thinly traded securities that could result in abuse and an unfair advantage for market participants with knowledge and contacts over Main Street investors.

General Information for Proposals

The SEC statement also includes general instructions and suggestions for submittals. The SEC invites exchanges to proceed with submittals for suspension or termination of unlisted trading privileges under Section 12(f) of the Exchange Act and for exemptive relief from Regulation NMS under current Exchange Act rules. Submittals and suggestions should include an analysis of broader market impacts. Proposals should also cite relevant statutory authority and requirements.

Since “thinly traded securities” is not statutorily defined, proposals should include a definition, whether based on average daily trading volume, number of trades, share volume, or dollar volume, combined with additional factors such as market capitalization, number of shareholders, or public float. Proposals should include an explanation of how the thresholds were set, including any relevant data and analysis and transitioning into and out of the definition. Proposals should include all parameters of a requested rule change, including exemptions, whether companies can opt in or out and the mechanics of implementation.

The Author

« The SEC, FinCEN And CFTC Issue A Joint Statement On Digital Assets SEC Investor Advisory Committee Meeting »

The SEC, FinCEN And CFTC Issue A Joint Statement On Digital Assets

Posted by Securities Attorney Laura Anthony | November 5, 2019 Tags: The SEC FinCEN And CFTC Issue A Joint Statement On Digital Assets

On October 11, 2019 the SEC, FinCEN and CFTC issued a joint statement on activities involving digital assets. Various agencies have been consistently working together, with overlapping jurisdiction, on matters involving digital assets and distributed ledger technology. Earlier, in August, the SEC and FINRA issued a joint statement on the custody of digital assets, including as it relates to broker-dealers and investment advisors (see HERE).

The purpose of the joint statement is to remind persons engaged in activities involving digital assets of their anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA). AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC. The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs).

For purposes of the joint statement, “digital assets” include securities, commodities, and security- or commodity-based instruments such as futures or swaps. The agencies point out that industry participants may use different terminology or assign different meanings to standard terminology. As such, in determining whether an asset is a “digital asset” the agencies will look to the facts and circumstances, including its economic reality and use, whether intended, organically developed or repurposed. As I’ve discussed in other blogs, the same analysis is used to determine whether an entity is a financial institution, including a BSA.

Furthermore, the nature of the activities of a person or institution determine what, if any, licenses are needed and regulations that must be complied with. Some activities would require registration under the Commodity Exchange Act (CEA) and others may require registration as a broker-dealer under the Securities Exchange Act of 1934 (“Exchange Act”). Although the joint statement only included three agencies, others also oversee digital assets and industry participants. For example, the AML/CFT activities of a futures commission merchant will be overseen by the CFTC, FinCEN, and the National Futures Association (NFA); those of an MSB will be overseen by FinCEN; and those of a broker-dealer in securities will be overseen by the SEC, FinCEN and FINRA.

The CFTC added a specific statement that once an entity, such as an introducing broker or futures commission merchant, is licensed or required to be licensed under the CEA, all of their activities would require proper AML/CFT processes and procedures, not just those involving commodities.

FinCEN added a statement discussing its role as the administrator and lead regulator under the BSA. FinCEN has supervisory and enforcement authority over U.S. financial institutions to ensure the effectiveness of the AML/CFT regime. In general, entities that are subject to the BSA must: (i) register with FinCEN as a money services business (MSB) or with another agency such as the CFTC or the SEC; (ii) prepare a written AML compliance program that is designed to mitigate risks, including AML risks, and to ensure compliance with all BSA requirements including the filing of suspicious activity reports (SAR) and currency transaction reports; (iii) keep records for certain types of transactions at specific thresholds; and (iv) obtain customer identification information sufficient to comply with the AML program and recordkeeping requirements. In its statement, FinCEN referenced the guidance it issued in May 2019 and encouraged entities to carefully review the guidance to determine if they qualify as a MSB. For a review of the guidance, see HERE.

Like the other agencies, the SEC added a statement. The SEC’s additional statement reminds SEC registered broker-dealers and mutual funds that they are considered financial institutions for purposes of the BSA. A “broker-dealer” is defined in rules implementing the BSA as a person that is registered or required to register as a broker or dealer under the Securities Exchange Act, and a “mutual fund” is defined as an investment company that is an “open-end company” and that is registered or required to register under the Investment Company Act of 1940. Both broker-dealers and mutual funds must enact and comply with AML/CFT policies and procedures for all activities, including as related to digital assets.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.

For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.

For information on the SEC’s FinTech hub, see HERE.

For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.

For FinCEN’s most recent guidance related to cryptocurrency, see HERE.

For a discussion on the enforceability of smart contracts, see HERE.

For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.

« Incorporation By Reference SEC Solicits Input To Improve Markets For Thinly Traded Securities »

Incorporation By Reference

Posted by Securities Attorney Laura Anthony | October 29, 2019

During lulls in the very active rule changes and blog-worthy news coming from the SEC and related regulators, it is great to step back and write about basics that affect SEC attorneys and market participants on a daily basis. In the realm of securities laws, the concept of “incorporation by reference” is simple enough – information from another document, registration statement or filing is included in a current document, registration statement or filing by referring to the other without repeating its contents. Similarly, “forward incorporation by reference” means that a document is automatically updated with information contained in a future SEC filing.

Although the concepts are relatively straight forward, their application is complex with differing rules for different classes of companies (such as an emerging growth company, smaller reporting company, or well-known seasoned issuer) and different filings such as a registration statement filed under the Securities Act of 1933 (“Securities Act”) or a periodic report filed under the Securities Exchange Act of 1934 (“Exchange Act”). Although rule changes to Regulation S-K enacted in March of this year (see HERE) revised several rules and forms to help simplify the incorporation-by-reference puzzle and facilitated access to incorporated documents by requiring hyperlinks, the provisions are still complicated and spread among a variety of rules and forms. This blog unwinds and summarizes the various rules and eligibility criteria to benefit from incorporation by reference. I’ve also included a chart for quick reference at the end of the blog.

As an aside, incorporation by reference can also include referencing disclosures in another part of the same registration statement or report to avoid repetition. The ability to incorporate by reference in the same document is universal to all reports and classes of companies and is encouraged by the SEC.

Securities Act Rule 411

Securities Act Rule 411 is a part of Regulation C governing registration statements and prospectus requirements. Rule 411 generally prohibits incorporation by reference in a prospectus unless the particular form being used specifically allows it. However, as discussed below, most forms of registration statements specifically allow it in some instances. In any financial statements, incorporating by reference, or cross-referencing to, information outside of the financial statements is not permitted unless otherwise specifically permitted or required by SEC rules or by GAAP or IFRS rules. Hyperlinks must be included to any information that is incorporated by reference.

Rule 411 further provides that incorporation by reference is allowed in parts of a registration statement that do not include the prospectus. Exhibits may be filed by incorporation by reference to any other exhibit in a SEC filing, whether filed by the same company or a different company, but a hyperlink must be included to that exhibit.

Rule 411 also contains a general statement that incorporation by reference may not be used in any case where such incorporation would render the disclosure incomplete, unclear, or confusing. For example, unless expressly permitted or required, disclosure must not be incorporated by reference from a second document if that second document incorporates information by reference to a third document.

Rule 411 does not mention forward incorporation by reference.

Exchange Act Rule 12b-23

Rule 12b-23 governs incorporation by reference for Exchange Act registration statements and periodic reports. Where Rule 411 prohibits incorporation by reference unless expressly allowed in a form, Rule 12b-23 allows incorporation by reference unless expressly prohibited in the rule or a particular form.

The remainder of Rule 12b-23 is substantially the same as Rule 411, including related to financial statements, exhibits, hyperlinks and general requirements related to unclear or confusing references.

Exhibits

Incorporation by reference to exhibits has been allowed by all issuers since the enactment of the Securities Act and Exchange Act. Subject to the requirements of Rules 411 and 12b-23, any exhibits required to be filed pursuant to Item 601 of Regulation S-K (the Exhibits Rule), all exhibits may be filed by incorporation by reference. On March 1, 2017, the SEC passed final rule amendments to Item 601 to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

Although it would seem common sense, Item 601 also specifically provides that an exhibit filed by incorporation by reference, must not have thereafter been materially amended or changed. In other words, when filing an exhibit today by using incorporation by reference, make sure the referenced exhibit is up to date.

Form S-1

The rules related to the ability to use incorporation by reference and forward incorporation by reference in a Form S-1 are confusing. The eligibility requirements to use incorporation by reference in a Form S-1 include:

The company must be subject to the reporting requirements of the Exchange Act (not a voluntary filer);
The company must have filed all reports and other materials required by the Exchange Act during the prior 12 months (or such shorter period that such company was reporting);
The company must have filed an annual report for its most recently completed fiscal year;
The company may not currently be, and during the past 3 years neither the company nor any of its predecessors were, (i) a blank check company; (ii) a shell company other than a business combination shell company (SPAC), or (iii) have offered a penny stock;
The company cannot be registering an offering for a business combination transaction; and
The company must make its reports filed under the Exchange Act that are incorporated by reference, available on its website, and include a disclosure of such availability and that it will provide such document upon request.

If a company elects to incorporate by reference, it must include specific language regarding the incorporation by reference and forward incorporation by reference.

The FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies that meet the eligibility requirements to use historical incorporation by reference. In what was probably unintended in the drafting, the FAST Act changes only included smaller reporting companies and not emerging growth companies. Prior to the FAST Act, forward incorporation by reference was only available for companies that use Form S-3 or F-3. The FAST Act change has created an anomaly whereby a smaller reporting company can utilize forward incorporation by reference but other classes of company, including emerging growth companies and large accelerated filers, cannot.

The SEC is aware of the continuing confusing distinction between the obligations of smaller reporting companies vs. emerging growth companies and has included forward incorporation by reference on Form S-1 on its long-term action list (see HERE). Unfortunately, this topic is not new to the long-term list.

Form S-3

Form S-3 allows for both incorporation by reference and forward incorporation by reference for all companies that are eligible to use the form. In particular, a company’s latest annual report on Form 10-K and all other reports filed pursuant to the Exchange Act following the latest annual report are specifically incorporated by reference into a Form S-3. Furthermore, all documents filed under the Exchange Act following the filing of the Form S-3 are incorporated by reference and the future annual reports on Form 10-K act as a prospectus update requiring a review of continued eligibility to use the Form S-3.

Companies filing the Form S-3 are required to include specific language regarding the incorporation by reference and forward incorporation by reference and must agree to provide copies of any documents incorporated by reference upon request.

For more on Form S-3, including eligibility requirements, see HERE.

Form S-4

Form S-4 allows for both incorporation by reference and forward incorporation by reference for all companies that are eligible to use Form S-3 with substantially the same requirements as Form S-3.

Form S-8

A Form S-8 registration statement can be used by issuers to register securities to be offered to employees and certain consultants underwritten employee benefit plans. For more on a Form S-8, see HERE and HERE. A Form S-8 registration statement is popular with all public companies, but particularly with small public companies as it becomes effective immediately upon filing and allows for incorporation by reference, both of which benefits are not always available to smaller public companies.

A Form S-8 allows for incorporation by reference of both previously filed Exchange Act reports and Securities Act registration statements in the Form. As a Form S-8 is effective upon filing, any requests for confidential treatment of the incorporated document must be fully resolved prior to the filing of the Form S-8. For more on confidential treatment requests, see HERE.

Likewise, a Form S-8 is updated by forward incorporation by reference to future filed Exchange Act reports for all companies, including smaller reporting companies. A Form S-8 even goes one step further and allows certain documents that are required to be delivered to an employee as part of an employee incentive plan, to be incorporated by reference into a Form S-8 and not be filed with the SEC at all.

Form 10-K Incorporation by Reference to Proxy Statement

A company may elect to omit Part III information from its Form 10-K and incorporate this information by reference from its proxy statement if the proxy statement is filed within 120 days after the end of the fiscal year. In such case, the company must provide a statement to that effect in the Form 10-K under each item under Part III. If the company is then unable to file its proxy statement by the 120th day, it must amend its Form 10-K, and file a Form 10-K/A by the 120th day after the end of its fiscal year to include all of the Part III information that was previously omitted.

Part III information includes: (i) information related to directors, executive officers and corporate governance; (ii) executive compensation; (iii) security ownership of certain beneficial owners and management and related stockholder matters; (iv) certain relationships and related transactions and director independence; and (v) principal accountant fees and services.

Furthermore, if a company prepares an annual report to shareholders separate from its Form 10-K, it may incorporate some or all of the Part I and Part II information required to be in Form 10-K by reference from its annual report as long as the annual report is filed as an exhibit to the Form 10-K.

Quick Reference Chart

I created the below quick reference chart.

Form/Filing	Incorporation by Reference	Forward Incorporation by Reference

Exhibits in Exchange Act Reports and Securities Act Registration Statements	Allowed by all issuers – requires the use of hyperlinks to all exhibits listed on the exhibit list	N/A

S-1	Allowed by issuers that meet certain eligibility requirements, including that during the past 3 years, neither the company nor any of its predecessors were (i) a blank check company; (ii) a shell company other than a business combination shell company (SPAC), or (iii) have offered a penny stock.	Only allowed by smaller reporting companies that meet the eligibility requirements for use of historical incorporation by reference.

S-3	Allowed by all issuers	Allowed by all issuers

S-8	Allowed by all issuers	Allowed by all issuers

S-4	Allowed for issuers that are eligible to use Form S-3	Allowed for issuers that are eligible to use Form S-3

Financial Statements	Not allowed to information outside of the financial statements unless specifically permitted by an SEC rule or GAAP or IFRS rule.	Not allowed

Form 10-K	Can incorporate Part I and II information into an annual report that is filed as an Exhibit	Can incorporate Part III information into a proxy statement that is filed after the 10-K

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.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

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law·cast

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Lawcast is derived from the term podcast and specifically refers to a series of news segments that explain the technical aspects of corporate finance and securities law. The accepted interpretation of lawcast is most commonly used when referring to LawCast.com, the securities law network. Example: “LawCast expounds on NASDAQ listing requirements.”

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« SEC Testifies At House Financial Services Committee Hearing The SEC, FinCEN And CFTC Issue A Joint Statement On Digital Assets »

SEC Testifies At House Financial Services Committee Hearing

Posted by Securities Attorney Laura Anthony | October 22, 2019

On September 24, 2019, all five SEC commissioners gave testimony to, and were questioned by, members of the U.S. House of Representatives Committee on Financial Services. Commissioner Robert J. Jackson, Jr. also gave an opening statement at the Committee hearing.

Commissioner Jackson’s Opening Statement

Commissioner Jackson’s short opening statement was consistent with his prior public views, consisting of a list of three areas in which he believes legislation should intervene to prevent corporate insiders from spending shareholder money to advance their own interests over those of investors.

His first recommendation is to shorten the current four-day 8-K filing requirement in which a company must notify the public of certain material events. For an overview of 8-K filing categories, including the categories that require an advance filing (Regulation FD) or lesser time period than the standard four days, see HERE. Commissioner Jackson states that there is “evidence that corporate insiders often trade during the ‘gap’ between key business events and when our rules require that event to be revealed to the public.” Trading on material insider information is illegal. Although I think a company could file an 8-K in a shorter period of time, persons that are engaging in illegal activity are not likely to stop; they would just have less time to do so.

His second recommendation is to limit stock buyback programs. Commissioner Jackson has been vocal in his disdain for stock buyback programs, including in a speech last year and a separate letter to Senator Van Hollen this spring. Commissioner Jackson believes that when a company engages in a stock buyback program, it is, more often than not, company insiders that are selling back to the company. He also believes that a company’s performance declines after a stock buyback program.

I don’t have enough information to argue against Commissioner Jackson’s views on this, but I do know that insiders, especially in smaller-cap companies, are often compensated in stock, which stock is very hard to liquidate. In addition to regulatory hurdles, including Section 16 limits on short-swing profits, Rule 144 controls on share rules including drip rules, insider-trading rules and a few open-trading windows, there are the optics and negative market impact resulting from an insider selling. Add to that the challenges with supporting a stock price in the face of selling pressure, and I think that for a smaller public company with cash reserves, a stock buyback program that an insider happens to participate in can benefit the company as a whole. The insiders of smaller public companies do not make millions of dollars in compensation like their large-cap counterparts might. Some liquidity can be a big motivator for hard work. However, with that said, I am a staunch believer in full disclosure, and as such if insiders are selling into a stock buyback company, of course they should be filing their Form 4’s in a timely manner.

Jackson’s third recommendation is to require public companies to disclose direct and indirect political expenditures. Jackson believes that money is often filtered to political parties, candidates or other political causes through third parties furthering the personal political interests of executives and insiders. Again, I do not have enough information to effectively address this belief; however, this could turn into a rabbit hole. I can see requiring a company to disclose a direct contribution on behalf of a particular political candidate if the amount is material, but what is or isn’t political could be amorphous. For example, would it be a political expenditure if an executive chooses one vendor over another because he/she supports the political beliefs of that vendor? Moreover, companies may have valid business reasons for supporting candidates in a particular jurisdiction, such as where they have operations and an employee base. If the amount is not material, such a disclosure may be confusing without providing any additional investor protection or useful information.

Testimony

Below is a summary of the written testimony on behalf of all five Commissioners. In addition, the House Committee spent several hours questioning each of the Commissioners.

The SEC begins its testimony with a brief summary of their purpose and responsibilities. As is often repeated, the SEC’s mission is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. The SEC has almost 4,400 employees in Washington over 11 regional offices and oversees (i) approximately $96 trillion in securities trading annually on U.S. equity markets; (ii) the disclosures of approximately 4,300 exchange-listed public companies with an approximate aggregate market capitalization of $33 trillion; and (iii) the activities of over 26,000 registered entities and registrants including, among others, investment advisers, broker-dealers, transfer agents, securities exchanges, clearing agencies, mutual funds and exchange-traded funds (ETFs), who employ over one million people in the United States. The SEC also has oversight of self-regulatory organizations (SROs) such as the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB) and the Public Company Accounting Oversight Board (PCAOB).

Strategic Plan

The SEC then talked about its Strategic Plan for 2018-2022 (see HERE) and the progress that has been made on the plan. The first goal in the plan is focusing on the interests of long-term Main Street investors, a group the SEC mentions in almost all public communications since the first publication of the Plan. In furtherance of this goal, the SEC holds town hall meetings and outreach tours, and uses digital tools and other outreach methods. The testimony cited several specific examples of town hall meetings.

The second goal of the Strategic Plan is recognizing significant developments, including technological developments, and trends in evolving capital markets and adjusting efforts to ensure the effective allocation of resources. The creation of the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) (see HERE) was in furtherance of this goal. FinHub is intended to serve as a public resource for fintech-related issues at the SEC, including matters dealing with distributed ledger technology (DLT), automated investment advice, digital marketplace financing and artificial intelligence/machine learning.

The third goal of the Strategic Plan is to elevate the SEC’s performance by enhancing analytical capabilities and human-capital development. The SEC did not site any specific performance parameters related to this goal.

Fiscal Year 2019 Initiatives

The SEC testimony then turns to its 2019 initiatives starting with enforcement proceedings. In FY 2018, the Commission brought 821 enforcement actions and obtained judgments and orders for $3.945 billion in penalties and disgorgement, while returning $794 million to harmed investors and awarding nearly $50 million in payments to whistleblowers. The actions have covered many topics including investment management, securities offerings, issuer reporting and accounting, market manipulation, insider trading, broker-dealer activities, cyber-related conduct and the Foreign Corrupt Practices Act, among many others.

In the enforcement arena the SEC has created (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. I notice that the SEC files multiple actions, almost daily, taking actions against defendants involved in fraud and other misconduct affecting retail investors.

In September 2017, the SEC created a specialized Cyber Unit within enforcement to combat cyber-related threats to investors focusing on potential violations involving distributed ledger technology (blockchain), digital assets, cyber-intrusions and hacking to obtain material, non-public information. The Cyber Unit has resulted in many actions for fraudulent or unregistered initial coin offerings (ICOs) and works closely with the SEC’s FinHub to monitor this area. In addition to an enforcement focus, the SEC has been focused on digital asset and distributed ledger technology in general, including their impact on capital markets and company disclosures.

Another area of 2019 initiatives has been monitory and addressing market developments and risks, including the potential impact of Brexit on U.S. capital markets and company disclosures related to Brexit risks. The SEC also has been focused on the transition away from LIBOR as a benchmark for short-term interest rates and the financial market risks that the transition may present. Earlier this year, Chairman Clayton created a new position, the Senior Policy Advisor for Market and Activities-Based Risk, to manage and coordinate a cross-disciplinary SEC staff committee that is responsible for identifying, monitoring and responding to market risks, including activities-based risks. Additionally, the SEC plays an active role and contributes to various domestic and international organizations that focus on market and systemic risks.

Cybersecurity risks at the SEC itself have also taken a front row. The topic of cybersecurity and improved technology in general was covered in depth in the testimony. After the SEC EDGAR system was hacked, the agency has dedicated resources to improving systems. For more on the hacking and cybersecurity issues in general, see HERE and HERE. The SEC has also reduced the collection of personal information such as Social Security numbers and dates of birth as unnecessary in light of the risks. A new Chief Data Officer will be put in place to ensure that the SEC only collects data it needs to fulfill its duties and that it can effectively manage and secure.

Regulatory and Policy Agenda

The SEC Commissioners highlighted some of the regulatory actions of the last year including the proposed amendments to the “accelerated filer” and “large accelerated filer” definitions (see HERE); adding test-the-waters for all companies (see HERE); proposed amendments to 15c2-11 (see HERE and the expansion of Regulation A for reporting companies (see HERE), among others. The SEC also highlighted its efforts to improve exempt offerings and private markets, including the concept release published this summer (see HERE).

Committee Questions

As mentioned, the House Committee spent several hours questioning the SEC in what turned out to be a fairly expected bipartisan manner. The democratic Committee members criticized the SEC for not doing a great job as “Wall Street’s Cop” and expressing a need for additional regulations, including those related to ESG matters (see HERE). The Republicans were more complimentary and urged further efforts in improving capital formation…

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SEC Adopts New Rule To Expand Testing The Waters For All Companies

Posted by Securities Attorney Laura Anthony | October 15, 2019 Tags: SEC Adopts New Rule To Expand Testing The Waters For All Companies

The SEC has adopted final rules allowing all issuers to test the waters prior to the effectiveness of a registration statement in a public offering. The final rules are largely the same as proposed. The rule change is designed to encourage more companies to go public. Although it will help in this regard, a much larger expansion of testing the waters, allowing unlimited testing the waters (subject to anti-fraud of course) for all registered offerings under $50 million, would go far to improve the floundering small cap IPO market.

Prior to the rule change, only emerging growth companies (“EGCs”) (or companies engaging in a Regulation A offering) could test the waters in advance of a public offering of securities. The proposal implements a new Securities Act Rule 163B.

Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. The public offering process is divided into three periods: (1) the pre-filing period, (2) the waiting or pre-effective period, and (3) the post-effective period. Communications made by the company during any of these three periods may, depending on the mode and content, result in violations of Section 5 of the Securities Act of 1933 (the “Securities Act”). Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.”

All forms of communication could create “gun-jumping” issues (e.g., press releases, interviews, and use of social media). “Gun jumping” refers to written or oral offers of securities made before the filing of the registration statement and written offers made after the filing of the registration statement other than by means of a prospectus that meet the requirements of Section 10 of the Securities Act, a free writing prospectus or a communication falling within one of the several safe harbors from the gun-jumping provisions.

In April 2012, the JOBS Act established a new process and disclosures for public offerings by a new class of companies – i.e., emerging growth companies (“EGCs.”) An EGC is defined as a company with total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. In particular, Section 5(d) of the Securities Act of 1933 (“Securities Act”) allows EGCs to test the waters by engaging in communications with certain qualified investors. The SEC has now created new Securities Act Rule 163B allowing all companies intending to file, or who have filed, a registration statement.

Permitting companies to test the waters is intended to provide increased flexibility to such issuers with respect to their communications about contemplated registered securities offerings, as well as a cost-effective means for evaluating market interest before incurring the costs associated with such an offering. Since the enactment of the JOBS Act, 87% of all IPOs have been by EGCs, leaving non-EGC companies at a disadvantage where specific rules favor EGC status.

The current rule change is consistent with other SEC actions to extend benefits afforded to EGCs to other issuers.

Section 5(d) of the Securities Act – Testing the Waters; New Rule 163B

Section 5(d) of the Securities Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”) in order to gauge their interest in a proposed offering, whether prior to or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus. Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.

Prior to the new rule, “well-known seasoned issuers,” or WKSIs, could engage in similar test-the-waters communications, but smaller reporting companies that do not otherwise qualify as an EGC could not.

An EGC may utilize the test-the-waters provision with respect to any registered offerings that it conducts while qualifying for EGC status. Test-the-waters communications can be oral or written. An EGC may also engage in test-the-waters communications with QIBs and institutional accredited investors in connection with exchange offers and mergers. When doing so, an EGC would still be required to make filings under Sections 13 and 14 of the Exchange Act for pre-commencement tender offer communications and proxy soliciting materials in connection with a business combination transaction.

There are no form or content restrictions on these communications, and there is no requirement to file written communications with the SEC. During the first year or two following enactment of the JOBS Act, the SEC staff regularly asked to see any written test-the-waters materials during the course of the registration statement review process, but eventually these requests ceased. The SEC staff maintains the right to ask to review test-the-waters, or any, communications made by a company during the S-1 review process.

The new rules expand the test-the-waters provisions currently available to EGCs, to all companies. In particular, Securities Act Rule 163B permits any issuer, including investment companies, or any person authorized to act on its behalf, to engage in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or IAIs, either prior to or following the filing of a registration statement, to determine whether such investors might have an interest in a contemplated registered securities offering. The rule is a non-exclusive, and an issuer can rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate related to a contemplated securities offering.

The rule does not require a filing with the SEC or any particular legend on the communications. Like other communications during a registration process, the test-the-waters communications must be consistent with, and cannot conflict with, the information in a related registration statement. The communications are considered “offers” and accordingly anti-fraud provisions, such as Section 12(a)(2) and 10(b), still apply to such communications.

Companies that are subject to Regulation FD will need to be cognizant of whether any information in a test-the-waters communication would trigger a disclosure obligation under Regulation FD and make the required disclosure accordingly. As a reminder, Regulation FD requires that companies take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Regulation FD requires the filing of a Form 8-K immediately prior to or simultaneously with the issuance of the information. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day.

Thoughts on the Rule

The SEC believes that by allowing more test-the-waters communications, companies will be encouraged to participate in public markets which, in turn, promotes more investment opportunities for more investors and improves transparency and resiliency in the marketplace. Furthermore, added communication can enhance the ability of issuers to conduct successful offerings and lower the cost of capital. I agree, but it is not enough. Although the rule change is certainly welcome, I would advocate for a rule amendment that not only expands test-the-waters communications for all issuers but that broadens the category of potential investor that could be the subject of such communications, to include all accredited investors, and for offerings under $50 million, to include all investors analogous to Regulation A.

In its proposal release, the SEC noted that the 2015 modernization of Regulation A, which allows companies to test the waters with all potential investors, without restriction as to the type of investors, has helped modernize the Securities Act communication rules. I have trouble understanding why the SEC is comfortable with the unfettered Regulation A test-the-waters communications, but is limiting offerings registered under the Securities Act to qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”). Certainly the potential total investor loss is limited in a Regulation A offering (with the high end maxing out at $50 million for a Tier 2 offering) and Regulation A communications require specified disclaimers and filing with the SEC, but I still find it to be a disconnect.

In the final rule release, on several occasions, the SEC points out that QIBs and IAIs are sophisticated and do not need the protections of the Securities Act. I believe that the current change is in line with a conservative “incremental change” approach. A next-step middle ground could be to require any test-the-waters communications that are made available to potential investors that are not QIBs or IAIs to contain a specified legend and be filed with the SEC. That way, a company embarking on an offering could decide if it wants to take on the filing liability under Section 11 of the Securities Act or limit its test-the-waters communications to QIBs and IAIs.

Ultimately, I would like to see unlimited test the waters for any offering that is $50 Million or under, or whatever the Regulation A upper limit is at that time, if increased. An S-1 or other registered offering under the Securities Act has more robust disclosures than a Form 1-A and requires additional follow on disclosure obligations under the Exchange Act. The small cap IPO market, once active, is practically non-existent in today’s world and without it, our economy and Main Street investors will suffer. As a result of multiple factors including the devastating blow of large cap IPO failures like WeWork, Pelaton and Uber together with our shifting capital markets and the regulatory burdens for trading in lower priced securities small cap investment banking houses have no outlet for small cap IPO’s.

I firmly believe that if unlimited test the waters communications were allowed in a regular S-1 IPO, it would encourage bankers to work with small cap companies and help invigorate the market place. Although Regulation A is great, and a I am big advocate and fan, a Regulation A offering does not operate the same as a registered offering on the back-end such as closing through a clearing firm (T+2) or utilizing greenshoe overallotment options with market support. By limiting open test the waters for offerings up to $50 million, a small cap company could have the same benefits of a Regulation A offering with the additional investor protections associated with a standard registered IPO.

The Author

Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

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« SEC Proposes Amendments To 15c2-11 SEC Testifies At House Financial Services Committee Hearing »

SEC Proposes Amendments To 15c2-11

Posted by Securities Attorney Laura Anthony | October 8, 2019 Tags: SEC Proposes Amendments To 15c2-11

As anticipated, on September 26, 2019, the SEC published proposed amendments to Securities Exchange Act (“Exchange Act”) Rule 15c2-11. The purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities. The SEC release also includes a concept release regarding information repositories and a possible regulatory structure for such entities. The SEC believes the proposed amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors.

The proposed rules entail a complete overhaul of the rule and its exceptions are complicated and, if enacted, will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system. I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks.

Background

Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent micro-cap fraud. The last substantive amendment was in 1991. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through.

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. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA.

The specific information required to be maintained by the broker-dealer is delineated in Exchange Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv). In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.

The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.

The SEC’s proposed rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies. However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity). Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company.

The proposed rules: (i) require that information about the company and the security be current and publicly available; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; and (iv) streamline the rule and eliminate obsolete provisions.

The proposed rule release adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.

Proposed Amendments

Current Public Information Requirements

The proposed rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed. In addition, the amendment will restructure and renumber paragraphs and subparagraphs.

The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the proposed rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.

The information that needs to be reviewed depends on the category of company and in particular (i) a company subject to the Exchange Act reporting requirements; (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer and (v) all others (catch-all category).

Regardless of the category of company, the broker-dealer, and OTC Markets if they are doing the review, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.

Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the only broker-dealer that actively submits Form 211 applications does complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. If the execution of the new rule matches its language, it will benefit the process greatly and possibly encourage more broker-dealers to offer OTC Markets’ quotations.

Information will be deemed publicly available if it is on the EDGAR database or posted on the OTC Markets (or other qualified IDQS), a national securities association (i.e., FINRA), or the company’s or a registered broker-dealer’s website. The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.

Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule will have a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.

The proposed rule will add specifics as to the date of financial statements. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.

The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify additional company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors. In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.

The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security.

Piggyback and Unsolicited Quote Exception Changes

There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception. The proposed rule will amend the piggyback exception to: (i) require that information be current and publicly available; (ii) limit the piggyback exception to priced bid and ask (two-way) quotations; (iii) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (iv) eliminate the piggyback exception for shell companies; and (v) revise the frequency of quotation requirement. To reduce some of the added burdens of the rule change, the SEC would allow a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of an exception have been met.

As discussed above, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme. The SEC proposes to only allow reliance on the piggyback exception when current public information is available. I think this will have a significant impact on micro-cap fraud.

The elimination of the piggyback exception for shell companies will likewise have a huge effect on the microcap space and instances of micro-cap fraud. The SEC intends this amendment to prevent shell companies from maintaining a quoted market. A broker-dealer will be prohibited from relying on the piggyback exception to publish or submit a quotation for a security of a company that meets the definition of a shell company. The proposed amendments will include a definition of a shell company which is the same as the definition in Rule 144: “any issuer, other than a business combination related shell company as defined in Rule 405 of Regulation C, or an asset-backed issuer, as defined in Item 1101(b) of Regulation AB, that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.”

The SEC notes that there are perfectly legal and valid reverse-merger transactions. My firm has worked on many reverse-merger transactions over the years. Obviously if passed, this rule change will have a significant effect on the reverse-merger market. I think the rule change sounds good on paper, and that a business engaged in a going public transaction should not bulk at either a Super 8-K or a 15c2-11 process. I do have concerns about the process and FINRA’s lengthy merit review of Form 211 filings, but perhaps these rule changes would give FINRA more confidence in its broker-dealer members and OTC Markets when they perform the review, making the process less arduous once submitted to FINRA.

A company would not be considered a shell simply because it is a start-up or has limited operating history. However, the onus will be on the broker-dealer to remain vigilant regarding whether they may rely on the piggyback exception if the company becomes a shell or falls into shell status. To help reduce the obvious burden on broker-dealers imposed by this proposed rule change, the rules will allow a broker-dealer to rely on a publicly available determination by a qualified IDQS (OTC Markets) or a national securities association (FINRA) that the securities are eligible for the piggyback exception. When up and running, I would hope that OTC Markets would add “piggyback qualified” or not, to each company’s quote page. I would hope the same for FINRA but do not foresee that occurring.

The SEC’s proposed rule only requires that companies that fall within the “catch-all” category have current public information for reliance on the piggyback exemption, since other categories of issuers have current public information by definition and thus adding the requirement to those categories would be redundant.

The requirement limiting the piggyback exception for the first 60 calendar days after a trading suspension will not likely have a market impact. A trading suspension over 5 days currently results in the loss of the piggyback exception and requirement to file a new Form 211. In practice, the SEC issues ten-day trading suspensions on OTC securities, and there is no broker-dealer willing to file a new 15c2-11 within 60 days thereafter in any event. In fact, in reality, it is a rarity for a company to regain an active Form 211 after a trading suspension. Perhaps that will change with implementation of the new rules.

The proposal would eliminate the 12-day requirement in the piggyback exception. Currently if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may rely on the piggyback exception. As proposed, for a broker-dealer to rely on the piggyback exception, the quoted OTC security would need to be the subject of two-way priced quotations within the previous 30 calendar days, with no more than four business days in succession without a quotation.

The existing rule excepts from the information review requirement the publication or submission of quotations by a broker-dealer where the quotations represent unsolicited customer orders. Under the proposed rule, a broker-dealer would need to determine that there is current publicly available information. If no current available information exists, the unsolicited quotation exception is not available for company insiders including officers, directors and 10%-or-greater shareholders.

The proposed rule requires that documentation be maintained that supports a broker-dealer’s reliance on any exception to the rule, including reliance on third-party determinations that an exception applies.

Lower Risk Securities; New Exceptions

The proposed rule amendments also add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception (see discussion under current information above); and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met.

The proposed rule provides an exception for companies that are well capitalized and whose securities are actively traded. In order to rely on this exception, the OTC security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”). The company must also have current public information to rely on the exception.

The ADTV test requires that the security have a worldwide ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation. To satisfy the proposed ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade).

The asset test requires that the company have at least $50 million in total assets and unaffiliated stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end. This would cover both domestic and foreign issuers.

The proposal would add an exception to the rule to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This proposal may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.

This exception requires that the broker-dealer have the 211 current information in its possession and has a reasonable basis for believing the information is accurate and the sources of information are reliable. Since FINRA issues a ticker symbol, this new exception will still require the filing of a Form 211 (or new form generated by FINRA to facilitate the exception). Whether the process for an exception review is quicker or less arduous will remain to be seen.

The proposed rule will also add a provision excepting broker-dealers from the 211 information review requirement where a qualified IDQS (OTC Markets) complies with the information review requirements and the broker-dealer relies on that review. The broker-dealer would need to publish a quotation within 3 business days after the qualified IDQS makes its determination of compliance publicly available. The proposed exception, however, would not be available if the issuer of the security to be quoted is a shell company, or 30 calendar days after a broker-dealer first publishes or submits such quotation, on OTC Markets, in reliance on this exception.

Once OTC Markets has complied with the rule’s information review requirement and made a publicly available determination that the requirements have been met, any broker-dealer could quote the security in the 30-day window. If the stock becomes frequently quoted during that 30-day window, the piggyback exception could then become available for continued quotation; otherwise, a new review or exception would need to be complied with. This is a win for OTC Markets, which included this as one of its suggestions in its comment letter to the SEC on the subject in January of 2018.

The SEC amendments also propose to allow a broker-dealer to rely on a determination by a qualified IDQS (OTC Markets) or national securities association (FINRA) that an exception to the rule is available as long as the broker-dealer determines that current public information is available or that they rely on OTC Markets’ or FINRA’s determination that such information is available. To facilitate a broker-dealer’s reliance, OTC Markets or FINRA must represent in a publicly available determination that it has reasonably designed written policies and procedures to determine whether information is current and publicly available, and that the conditions of an exception are met.

The proposed amendments require that the broker-dealer, OTC Markets and FINRA keep records regarding the basis of its reliance on, or determination of availability of, any exception to the rule.

Miscellaneous Amendments to Streamline

The SEC has also proposed numerous miscellaneous changes to streamline the rule and eliminate obsolete provisions. The miscellaneous changes include: (i) allowing a broker-dealer to provide an investor that requests company information with instructions on how to obtain the information electronically through publicly available information; (ii) updated definitions; and (iii) the elimination of historical provisions that are no longer applicable or relevant.

Conclusion

I’m happy that the SEC is reviewing the 211 process and attempting to improve the system, especially allowing the OTC Markets itself to conduct a review, submit a Form 211 directly to FINRA and determine the availability of an exception; however, I would like to see additional changes. In particular, the proposing release did not address the prohibition on broker-dealers, or now, OTC Markets, charging a fee for reviewing current information, confirming the existence of an exemption and otherwise meeting the requirements of Rule 15c2-11. The process of reviewing the information is time-consuming and the FINRA review process is arduous. Although not in the rule, FINRA in effect conducts a merit review of the information that is submitted with the Form 211 application and routinely drills down into due diligence by asking the basis for a reasonable belief that the information is accurate and from a reliable source. Most brokerage firms are unwilling to go through the internal time and expense to submit a Form 211 application. In fact, in reality, there is really only one that does so consistently. I believe the SEC needs to allow broker-dealers and OTC Markets to be reimbursed for the expense associated with the rule’s compliance.

« A Drill Down On Rule 506 Of Regulation D SEC Adopts New Rule To Expand Testing The Waters For All Companies »

A Drill Down On Rule 506 Of Regulation D

Posted by Securities Attorney Laura Anthony | October 1, 2019 Tags: A Drill Down On Rule 506 Of Regulation D, Rule 506 Of Regulation D

On June 18, 2019, the SEC issued a 211-page concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework. The concept release seeks input on whether changes should be made to improve the consistency, accessibility, and effectiveness of the SEC’s exemptions for both companies and investors, including identifying potential overlap or gaps within the framework. See HERE for my blog on the release. As the topic of private exemptions becomes front and center, it is a good time to blog about the most commonly used of those exemptions, Rule 506.

Ever since the National Securities Markets Improvement Act of 1996 (“NSMIA”) amended Section 18 of the Securities Act to pre-empt state blue sky review of specified securities and offerings including offerings made in reliance on Rule 506 of Regulation D under the Securities Act of 1933 (“Securities Act), the vast majority of private capital raises are completed relying on Rule 506. For more information on the NSMIA, see HERE and HERE.

Introduction

As I have repeated many times, all sales of securities must either be registered in accordance with the Securities Act or have an available exemption from registration. Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering, from the Act’s registration requirements. The Supreme Court case of SEC v. Ralston Purina Co. and its progeny Doran v. Petroleum Management Corp. and Hill York Corp. v. American Int’l Franchises, Inc. together with Securities Act Release No. 4552 set out the criteria for determining whether an offering is public or private and therefore the availability of Section 4(a)(2). In order to qualify as a private placement, the persons to whom the offer is made must be sophisticated and able to fend for themselves without the protection of the Securities Act and must be given access to the type of information normally provided in a prospectus.

Furthermore, all facts and circumstances must be considered including the relationship between the offerees and the issuer, and the nature, scope, size, type, and manner of the offering. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Purchasers receive restricted securities which can only be resold in accordance with a registration exemption. Regulation D itself does not provide for any resale exemptions and is only available for the issuance and sale of securities by the issuer. Historically a private offering always prohibited general solicitation or advertising.

Rule 506 is “safe harbor” promulgated under Section 4(a)(2). That is, if all of the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with. An issuer can rely directly on Section 4(a)(2) without regard to Rule 506; however, Section 4(a)(2) alone does not pre-empt state law and thus requires blue sky compliance.

Effective September 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors, provided however that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.

At the same time, the SEC imposed bad actor disclosure and disqualification provisions to the rules. The bad actor provision disqualifies the use of Rule 506 as a result of certain convictions, cease and desist orders, suspensions and bars (“disqualifying events”) that occur on or after September 23, 2013, and adds disclosure obligation in Rule 506(e) for disqualifying events that occurred prior to September 23, 2013 (see HERE).

Offerings under both Rule 506(b) and 506(c) must satisfy the conditions of Rule 501 (definitions), 502(a) (integration), 502(d) (limitations on resale), and 506(d) (bad actor disqualifications). In addition, offerings under Rule 506(b) must satisfy the conditions of Rule 502(b) (type of information to be furnished) and 502(c) (limitation on the manner of offering). The offerings are also subject to the anti-fraud provisions of the federal securities laws. Furthermore, Rule 503 requires the filing of a Form D for all Rule 506 offerings, though an SEC C&DI has found that the failure to make such filing does not result in a loss of the offering exemption.

Rules Applicable to Both Rule 506(b) and 506(c) Offerings

Offerings under both Rule 506(b) and 506(c) must satisfy the conditions of Rule 501 (definitions), 502(a) (integration), 502(d) (limitations on resale), and 506(d) (bad actor disqualifications).

Rule 501 – Definitions

Rule 501 contains definitions application to all Regulation D offerings. The definitions most important to Rule 506 offerings include:

Accredited Investor – see HERE for a summary of the definition of an accredited investor and the SEC concept release on same.
Affiliate – An affiliate of, or person affiliated with, a specified person shall mean a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified.
Purchaser representative. Purchaser representative shall mean any person who satisfies all of the following conditions or who the issuer reasonably believes satisfies all of the following conditions: (i) Is not an affiliate, director, officer or other employee of the company, or beneficial owner of 10% or more of the equity interest in the company, except where the purchaser is: (a) A relative of the purchaser representative by blood, marriage or adoption and not more remote than a first cousin; (b) A trust or estate in which the purchaser representative and any persons related to him collectively have more than 50% of the beneficial interest or of which the purchaser representative serves as trustee, executor, or in any similar capacity; or (c) A corporation or other organization of which the purchaser representative and any persons related to him collectively are the beneficial owners of more than 50%of the equity securities (excluding directors’ qualifying shares) or equity interests; (ii) Has such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment; (iii) Is acknowledged by the purchaser in writing, during the course of the transaction, to be his purchaser representative in connection with evaluating the merits and risks of the prospective investment; and (iv) Discloses to the purchaser in writing a reasonable time prior to the sale of securities to that purchaser any material relationship between himself or his affiliates and the issuer or its affiliates that then exists, that is mutually understood to be contemplated, or that has existed at any time during the previous two years, and any compensation received or to be received as a result of such relationship.

Rule 502(a) – Integration

All sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. Offers and sales that are made more than six months before the start of a Regulation D offering or are made more than six months after completion of a Regulation D offering will not be considered part of that Regulation D offering, so long as during those six month periods there are no offers or sales of securities by or for the issuer that are of the same or a similar class as those offered or sold under Regulation D, other than those offers or sales of securities under an employee benefit plan.

Unless there is a specific safe harbor or rule exemption, such as the six-month rule, the following five factors should be considered in making an integration analysis: (i) whether the sales are part of a single plan of financing; (ii) whether the sales involve issuance of the same class of securities; (iii) whether the sales have been made at or about the same time; (iv) whether the same type of consideration is being received; and (v) whether the sales are made for the same general purpose.

Rule 502(d) – Limitations on Resale

Securities issued in a Rule 506 offering are “restricted” and as such may only be resold if registered with the SEC or there is an available exemption from registration. The company relying on the Rule 506 exemption must exercise reasonable care to ensure that the purchasers of the securities are not underwriters planning to engage in a distribution of the securities. To satisfy their reasonable care requirement, a company can (i) make reasonable inquiry to determine if the purchaser is acquiring the securities for their own use or for other persons; (ii) require written disclosure to each purchaser prior to the sale that the securities have not been registered and, therefore, cannot be resold unless they are registered under the Securities Act or an exemption from registration is available; and (iii) place a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Securities Act and setting forth or referring to the restrictions on transferability and sale of the securities. In addition, the issuer in a Rule 506(b) offering is required to disclose the resale limitations to any non-accredited investors.

In an effort to keep this blog focused on company obligations, I will not get into the available exemptions but for those interested in learning more, see HERE; HERE; and HERE.

Rule 506(d) – Bad Actor Disqualifications

Rule 506 provides that disqualifying events committed by a list of specified “covered persons” affiliated with the issuer or the offering would result in disqualification from using Rule 506 or require disclosure to investors prior to their purchasing securities. It is a company’s obligation to determine whether it or any of the covered persons discussed below fall within the bad actor rules. In particular, covered persons include:

The issuer and any predecessor of the issuer or affiliated issuer;

Any director, general partner or managing member of the issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);

Any beneficial owner of 20% or more of the outstanding equity securities of the issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting);

Investment managers of Issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering; general partners and managing members of such investment managers; the directors and executive officers of such general partners; and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);

Any promoter connected with the Issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);

Any person who has been or will be paid, either directly or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and

Any director, officer, general partner, or managing member of any such compensated solicitor.

Disqualifying events include:

Criminal convictions (felony or misdemeanor) within the last five years in the case of Issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

Final orders issued by a state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, or the National Credit Union Administration that, at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;

Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203€ or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;

Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;

Suspension or expulsion from membership in, or suspension or bar from association with, a member of an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;

Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and

U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.

The rule includes an exception from disqualification for offerings in which the company establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a covered person. Moreover, the SEC can grant a waiver of disqualification if it determined that the issuer has shown good cause that disqualification is not necessary under the circumstances. For more on the bad actor rules, see HERE.

Filing Requirements/State Blue Sky Laws

Rule 503 requires the filing of a Form D for all Rule 506 offerings within 15 days of the first sale of securities. However, an SEC C&DI has found that the failure to make such filing does not result in a loss of the offering exemption.

As long as an offering meets the requirements of Rule 506, NSMIA pre-empts state law such that the company is not required to register or qualify the offering with state securities regulators. The offering does, however, remains subject to state law enforcement and anti-fraud authority. States may also require notice filings and the payment of a filing fee. See links to my blogs on NSMIA and state blue sky laws at the beginning of this blog.

Rule 506(b)

Companies conducting an offering under Rule 506(b) can sell securities to an unlimited number of accredited investors with no limit on the amount of money that can be raised from each investor or in total. In addition to complying with all the criteria and conditions applicable to both 506(b) and 506(c) offerings, an offering under Rule 506(b): (i) prohibits general solicitation or advertising to market the offering; (ii) limits the number of unaccredited investor purchasers to no more than 35 and such investors must, either alone or with a purchaser representative, have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment; and (iii) requires the delivery of specified disclosures where even one unaccredited investor is included.

General Solicitation and Advertising

The Rules do not define “general solicitation” or “advertising” but do provide some examples, such as advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. Offering information posted on an unrestricted website or social media would also be considered a general solicitation.

A company may offer and sell securities to persons with whom it, or anyone acting on its behalf, has a pre-existing substantial relationship, without being deemed to have engaged in general solicitation or advertising. A “pre-existing” relationship is one that the company, or someone acting on the company’s behalf such as through a broker-dealer or investment adviser, has formed with the prospective investor prior to the commencement of the offering. The existence of a pre-existing relationship depends on facts and circumstances.

The absence of a pre-existing relationship does not automatically make a communication a general solicitation or advertisement under Regulation D. For example, a company may solicit prospective investors they are introduced to who are members of an informal, personal network of individuals or investors, such as angel investor groups. As a rule of thumb, if all members of the group or network are sophisticated and experienced in the type of investment being offered, members can be solicited without triggering the solicitation and advertisement rules under Regulation D. Moreover, the higher the number of persons without financial experience, sophistication, or prior personal or business relationships with the company that are solicited, the greater the chance that it will be deemed a general solicitation of the offering.

For a discussion on what constitutes a general solicitation including SEC guidance on the topic, see my blog HERE.

Disclosure Requirements

If a company plans to offer or sell securities to unaccredited investors in a 506(b) offering, it must provide the disclosures required by Rule 502(b). Although the rules only require that information be furnished to unaccredited investors, in light of the anti-fraud provisions, in practice, when a company puts together a disclosure package, it should be provided to all investors. Moreover, if any information is provided to accredited investors, even if not technically required by the disclosure obligations, it must also be provided to unaccredited investors. Like disclosures in SEC filings, only material information should be provided.

All information must be provided prior to the sale of securities. Specific disclosure must be made regarding resale limitations and other restrictions on transferability. The company must also make available to each purchaser at a reasonable time prior to his purchase of securities the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the company possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of information furnished under the rules.

If a company is subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), its SEC reports, including all reports, schedules and filings up to the date of the offering, will satisfy any information requirements. Foreign private issuers eligible to use Form 20-F can provide the information that would be required in that form. For business combinations and exchange offers, the information required by Form S-4 would satisfy the disclosure requirements.

The exhibits that would normally be filed with the SEC need not be included in the offering package, but they must be made available to an investor upon request, and the exhibits must be identified and described in the disclosure document.

If a company is not subject to the Exchange Act reporting requirements, it needs to provide:

Non-Financial Information – If the company is eligible to use Regulation A, the same kind of information as would be required in Part II of Form 1-A or if the company is not eligible to use Regulation A, the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the company would be entitled to use.

Part II of Form 1-A is similar to the prospectus in a registration statement. Part II requires disclosure of basic information about the company and the offering; material risks; dilution; plan of distribution; use of proceeds; description of the business operations; description of physical properties; discussion of financial condition and results of operations (MD&A); identification of and disclosure about directors, executives and key employees; executive compensation; beneficial security ownership information; related party transactions; description of offered securities; and two years of financial information.

The required information in Part II of Form 1-A is scaled down from the requirements in Regulation S-K applicable to Form S-1. Companies can complete Part II by either following the Form 1-A disclosure format or by including the information required by Part I of Form S-1 or Form S-11 as applicable. Part I of a registration statement requires the same categories and types of information but with more robust disclosures.

Financial Information – The financial statement requirements depend on the amount of the offering. All financial statements must be prepared in accordance with U.S. GAAP. For offerings up to $2,000,000, the same financial statements that are required of a smaller reporting company (Article 8 of Regulation S-X) are required except that only the balance sheet, which must be dated within 120 days of starting the offering, must be audited. Generally this means two years of financial statements (or from inception) and quarterly periods to date.

For offerings up to $7,500,000, the same financial statements that are required of a smaller reporting company (Article 8 of Regulation S-X) are required. This would include two years of audited financial statements (or from inception) and reviewed quarterly financial statements to date. However, if the company cannot obtain audited financial statements without unreasonable effort or expense, then only the company’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

For offerings over $7,500,000, the full financial statements that would be required in a registration statement must be included. For a smaller reporting company, this would be the same financial statements as for offerings over $2,000,000 but below $7,500,000. As with other categories, if the company cannot obtain audited financial statements without unreasonable effort or expense, then only the company’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

Rule 506(c)

Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and this adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Companies conducting an offering under Rule 506(c) can sell securities to an unlimited number of accredited investors with no limit on the amount of money that can be raised from each investor or in total. I’ve written many times about Rule 506(c) including as the SEC came out with a fairly steady flow of guidance in the months after its first adoption. See this blog, which contains links to prior blogs on the subject HERE.

Accredited Investor Verification

Rule 506(c) provides a principles-based method for verification of accredited investor status as long as the steps are reasonable, as well as a non-exclusive list of verification methods. Whether the steps taken are reasonable would be an objective determination, based on the particular facts and circumstances of each transaction. Among the factors that companies should consider under the facts-and-circumstances analysis are:

The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker-dealer registered with the SEC, verification could be a simple check on the FINRA website. The harder status to verify is a natural person claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements.
The amount and type of information that the company has about the purchaser. Clearly, the more information, the better. The SEC lists the obvious (W-2; tax returns; letters from a bank or broker-dealer). Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.
Nature and terms of the offering, such as type of solicitation and minimum investment requirements. For example, is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former. The greater the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.

After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.

Examples of the type of information that companies can review and rely upon include:

(i) Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages);

(ii) Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and

(iii) Third-party accredited investor verification service providers.

Moreover, non-exclusive methods of verification include:

Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.

Related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property. The SEC has provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. However, if the evidence is at all questionable, further inquiry should be made.

Although the review of tax returns filed in a foreign country does not qualify under the verification safe harbors in the rule, a company could rely on foreign tax returns if the laws of that jurisdiction provide penalties similar to the laws of the IRS for making a false statement.

In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors. In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.

The Author

Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.

Listen to our podcast on iTunes Podcast channel.

law·cast

Noun

« Environmental, Social And Governance– The World Of ESG SEC Proposes Amendments To 15c2-11 »

Environmental, Social And Governance– The World Of ESG

Posted by Securities Attorney Laura Anthony | September 24, 2019 Tags: Environmental, Social And Governance– The World Of ESG

Over the past few years, the term “Environmental, Social and Governance” or “ESG” has been both first used and brought into daily use by capital market participants. Multiple publications have been written on the subject, Nasdaq has published an ESG Reporting Guide, the House Financial Services Committee has debated multiple bills that would require various ESG disclosures and the SEC top brass is vocal, and divided, on the subject. SEC Chair Jay Clayton and Commissioner Hester M. Peirce both believe that ESG matters are too abstract and undefined to result in meaningful disclosure while Commissioners Robert J. Jackson Jr. and Allison Herren Lee just issued a joint statement expressing disappointment in the recently proposed changes to Regulation S-K (see HERE) for omitting the topic of climate risk.

It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider. It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).

What is “Environmental, Social and Governance” or “ESG”

In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America. However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.

As noted by Commissioner Peirce in a recent speech, the G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.

However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information is much more nebulous. Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors. A number of self-identified ESG experts have developed and many groups produce ESG ratings. The ratings are not standardized, allowing the ESG expert or rating organization to further their own agenda, which may be a paid effort or based on personal preferences. The analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.

It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters. Unfortunately, this is resulting in increased internal expenses without increased benefit. Some rating organizations send out surveys requiring a company to respond or risk receiving a bad review. Senior counsel for The Travelers Cos., Inc., reported at a recent Investor Advisory Committee meeting that her company had received 55 survey and data verification requests from ESG rating organizations in the last year. It took 30 employees and 44.8 work days to respond to just one of these surveys.

When a rating organization uses public information, such as sustainability reports, the results can be arbitrary as there is no clear standard. For instance, a “practice” may be rated differently than a “policy” such that a company doing more for the environment than another company may receive a lower rating as a result of terminology. For example, one rating organization gave Tesla a lower ESG rating than other car companies because it did not believe Tesla’s ESG disclosures to be sufficient, and not because of a review of its actual environmental impact.

Another issue is purported ESG financial advisors and money managers. As ESG is not standardized, as Hester Peirce states, “A statement that you are an ESG manager may not require much to back it up. It may be enough to buy an ESG scorecard, hire a proxy advisor, or invest according to an index that incorporates an ESG filter.”

ESG Disclosure Requirements

As mentioned above, both SEC Chair Jay Clayton and Commissioner Hester M. Peirce believe that ESG matters are too abstract and undefined to result in meaningful disclosure. In a recent interview, Chair Clayton justified his position noting that if a matter, whether falling under an ESG category or not, would impact a company’s financial position and is material to that company and its investors, it should be disclosed. However, because the categories under ESG are so broad and so diverse, it is not appropriate to try and impose regulatory disclosure obligations. Chair Clayton states, “[M]y view is that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies. Such a step would be inconsistent with our mandate, would be a departure from our long-standing commitment to a materiality-based disclosure regime, and could effectively substitute the SEC’s judgment for the company’s judgment on operational matters.”

Nevertheless, there are some current and potential ESG disclosure requirements. The Nasdaq stock market has published an ESG Reporting Guide, which is discussed below. As touched on above, countless memorandums and publications have been written on ESG matters including what in particular and how they should be reported (with countless differing opinions). The recent proposed changes to Regulation S-K added the topic of human capital as a disclosure item including any human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy). In making this proposal, the SEC noted that human capital matters fall within an ESG disclosure.

Non-U.S. countries have also been beating the ESG drum with Europe requiring increased disclosures and the International Organization of Securities Commissions or “IOSCO,” without the participation of the SEC, issued a statement “setting out the importance of considering the inclusion of environmental, social, and governance matters when disclosing information material to investors’ decisions.”

Nasdaq ESG Reporting Guide

Nasdaq has had a corporate sustainability program in place for six years and has a decidedly positive viewpoint on ESG seeing these factors as beneficial to investors, “but also for public companies trying to increase operational efficiency, decrease resource dependency, and attract a new generation of empowered workers.” Nasdaq continues with “E[]ffective management of sustainability issues helps Nasdaq (and our listed companies) better understand operational performance, address resource inefficiencies, and forecast enterprise risk. In addition, there is a growing body of academic and analytic evidence suggesting that ESG excellence correlates with other benefits, such as lower costs of capital, reduced shareholder turnover, and enhanced talent recruitment and retention. With a renewed market emphasis on long-term value creation, we also believe that ESG is an effective and mutually beneficial communication channel between public companies and the investment community.” Clearly Nasdaq and Commissioner Peirce have differing views on the subject.

With that said, the Nasdaq ESG Reporting Guide is merely a recommendation for the record keeping and reporting of material information on ESG matters. In determining materiality, Nasdaq suggests that companies consider impacts to external stakeholders and ecosystems in addition to those directly affecting the company. Nasdaq does not impose financial or legal reporting requirements beyond that required by Regulations S-K and S-X. Many companies choose to report ESG matters in separate ESG reports made available to investors on their website, rather than in formal reports to the SEC.

The Nasdaq guide focuses on economic principles and specific data, rather than moral or ethical arguments. The ESG topics that Nasdaq address include:

Environmental – (i) GHG Emissions (i.e., greenhouse gas emissions); (ii) emissions intensity; (iii) energy usage; (iv) energy intensity; (v) energy mix; (vi) water usage; (vii) environmental operations; (viii) climate oversight/board; (ix) climate oversight/management; and (x) climate risk mitigation.
Social – (i) CEO pay ratio; (ii) gender pay ratio; (iii) employee turnover; (iv) gender diversity; (v) temporary worker ratio; (vi) non-discrimination; (vii) injury rate; (viii) global health and safety; (ix) child and forced labor; and (x) human rights.
Corporate Governance – (i) board diversity; (ii) board independence; (iii) incentivized pay; (iv) collective bargaining; (v) supplier code of conduct; (vi) ethics and anti-corruption; (vii) data privacy; (viii) ESG reporting; (ix) disclosure practices; and (x) external assurance.

For each topic, Nasdaq provides an explanation as to why such a measurement is important and a formula for completing the measurement or setting a policy addressing the topic.

« SEC Issues Guidance On Proxy Advisory Firms A Drill Down On Rule 506 Of Regulation D »

SEC Issues Guidance On Proxy Advisory Firms

Posted by Securities Attorney Laura Anthony | September 17, 2019 Tags: SEC Issues Guidance On Proxy Advisory Firms

On August 29, 2019, the SEC issued anticipated guidance related to the application of the proxy rules to proxy advisory firms. Market participants have been very vocal over the years regarding the need for SEC intervention and guidance to rein in the astonishing power proxy advisor firms have over shareholder votes, and therefore public companies in general. The new SEC interpretation clarifies that advice provided by proxy advisory firms generally constitutes a “solicitation” under the proxy rules including the necessity to comply with such rules and the related anti-fraud provisions. On the same day, the SEC issued guidance on the proxy voting responsibilities of investment advisors, including when they use proxy advisory firms. This blog focuses on the guidance directly related to proxy advisory firms.

The SEC has been considering the role of proxy advisors for years. In 2010 it 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. Although the current guidance is a good step in providing clarification, the SEC is also considering rule amendments directly related to proxy advisory firms.

The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. 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. Under the SEC’s interpretation, proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation.

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. However, 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.

Rule 14a-1(l) – Solicitations

Exchange Act Section 14(a)9 applies to any solicitation for a proxy with respect to any security registered Section 12 and authorizes the SEC to establish rules and regulations governing such solicitations. As mentioned above, Exchange Act Rule 14a-1(I) defines a solicitation for purposes of compliance with the federal proxy rules. In particular, the terms “solicit” and “solicitation” include: (i) any request for a proxy whether or not accompanied by or included in a form of proxy; (ii) any request to execute or not to execute, or to revoke, a proxy; or (iii) the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.

The terms do not apply, however, to: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder; (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.

The new SEC guidance, which is in Q & A format, indicates that solicitations by proxy advisors are reasonably calculated to “result in the procurement, withholding or revocation of a proxy” and, as such, fall within the definition of a solicitation. Finding that proxy advisor solicitations are covered by the rules is consistent with the SEC’s interpretations over the years that the definition is meant to be very broad. The SEC has also consistently stated that the federal proxy rules apply to any person seeking to influence the voting of proxies, regardless of whether the person himself/herself is seeking authorization to act as a proxy. To me it is clear that proxy advisor communications related to a particular vote are clearly solicitations as they both describe the specific proposals and make a voting recommendation.

Proxy advisors can exert a great deal of influence. Many investment advisers retain and pay a fee to proxy advisory firms to provide detailed analyses of various issues, including advice regarding how the investment adviser should vote on the proposals at the registrant’s upcoming meeting. Further proxy advisory firms recommend particular investment advisors based, at least in part, on that investment advisor’s voting history and criteria.

The courts have likewise interpreted the definition of a solicitation expansively. For example, courts have held that a report provided by a broker-dealer to shareholders of the target company in a contested merger constituted a solicitation because it advised the shareholders that one bidder’s offer was “far more attractive” than the other and therefore was a communication reasonably calculated to affect the shareholders’ voting decisions. Similarly, a letter from a shareholder to other shareholders in connection with an annual meeting asking them not to sign any proxies for the company was found to be a solicitation.

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 new SEC 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, I note that 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 filing requirements

Although a proxy advisory firm may be engaged in solicitations, they may be exempt from the information and filing requirements of the federal proxy rules under Rule 14a-2(b). 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.” A proxy advisory firm does not seek to vote on behalf of those they solicit or advise.

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.

Rule 14a2-(b)(2) provides an exemption from the information and filing requirements of the federal proxy rules when the number of persons being solicited is under 10. This would rarely, if ever, apply to a proxy advisory firm. Rule 14a2-(b)(3) provides an exemption from the information and filing requirements for financial advisors who provide voting advice to their clients subject to certain disclosures such as related party relationships and subject to certain conditions such as the lack of special commissions or compensation for furnishing the voting advice.

Rule 14a2-(b)(4) provides an exemption for certain limited partnership roll-up transactions. Rule 14a2-(b)(5) exempts broker-dealer research reports. Subject to certain timing limitations, Rule 14a2-(b)(6) provides an exemption for “any solicitation by or on behalf of any person who does not seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a shareholder 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 in an electronic shareholder forum.” Finally, subject to certain conditions, Rule 14a2-(b)(7) provides an exemption for shareholders in connection with the formation of a nominating shareholder group.

Rule 14a-9 – Anti-fraud provisions

The SEC guidance affirms that solicitations that are exempt from the federal proxy rules’ information and filing requirements remain subject to 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 or omits to state any material fact necessary in order to make the statements therein not false or misleading.

Rule 14a-9 also extends to opinions, reasons, recommendations, or beliefs that are disclosed as part of a solicitation. To protect from Rule 14a-9 concerns, opinions and recommendations should disclose underlying facts, assumptions and limitations. The SEC guidance gives specific examples of information that proxy advisory firms should consider providing in respect to their recommendations, including:

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) where the omission of such information would render the voting advice materially false or misleading;
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 if such differences are material and the failure to disclose the differences would render the voting advice false or misleading; and
disclosure about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of those conflicts.

The Author

Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.

Listen to our podcast on iTunes Podcast channel.

law·cast

Noun

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