NYSE American Compliance Guidance MEMO
In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies. The annual letter updates companies on any rule changes from the year and reminds companies of items the NYSE deems important enough to warrant such a reminder.
The only new item in this year’s letter relates to advance notice of stock dividends and distributions. Effective February 1, 2018, the NYSE requires listed companies to provide ten minutes’ advance notice to the exchange of any announcement with respect to a dividend or stock distribution, whether the announcement is during or outside exchange traded hours. This change is consistent with other NYSE and Nasdaq rules which generally require notifications of announcements, including press releases, that could impact trading, at least 10 minutes prior to such notification.
The NYSE letter also provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news. Part 4 of the Company Guide requires listed companies to promptly release to the public any news or information which might reasonably be expected to materially affect the market for its securities. Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FDcompliant method. Furthermore, for news being released between 7:00 a.m. and 4:00 p.m. Eastern time, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email. As noted above, where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement.
The NYSE includes examples of material news such as earnings, mergers/acquisitions, executive changes, redemptions/conversions, securities offerings and pricings related to these offerings, major product launches, regulatory rulings, new patent approvals and dividend or major repurchase announcements. Once notified, NYSE Marketwatch will determine if a temporary trading halt should be effected to allow the market time to fully absorb the news. Also, if the news is being released between 7:00 a.m. and 9:25 a.m., the company can request a temporary trading halt.
Furthermore, the requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference. In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.
Similarly, NYSE believes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination.
The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information. It is widely believed that insider trading rules are in need of an overhaul. Generally, insider trading refers to buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. For more information, see HERE.
The compliance letter also addresses the following matters:
Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 704 of the Company Guide, which requires that a company hold an annual meeting during each fiscal year.
Record Date Notification – Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date. Record dates should be set for business days.
Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security. The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards.
Annual Report Website Posting Requirement – Section 610(a) of the Company Guide requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC.
Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements. The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC.
Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants). No additional securities can be issued until the NYSE authorizes the LAS. Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date. Authorization takes approximately 2 weeks.
Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners. The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed. The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.
NYSE American Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions. The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.
Shareholder Approval and Voting Rights Requirements – Sections 711 through 713 of the Company Guide outline the Exchange’s shareholder approval requirements including the 20% rules. Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).
Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.
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S-3 Eligibility
The ability to use an S-3 registration statement is significant for exchange traded companies. An S-3 allows forward incorporation by reference and can be used for a shelf registration among other benefits. S-3 eligibility is comprised of both registrant or company requirements and transaction requirements. In this blog I will discuss the general company and transaction requirements for a Form S-3. In a separate blog I will drill down on shelf offerings.
Registrant Requirements
Companies that meet the following requirements are eligible to use a Form S-3 for a transaction that meets one of the transaction requirements:
(1) The company must be organized under the laws of the United States and must have its principal business operations in the United States or its territories;
(2) The company has a class of securities registered pursuant to either Section 12(b) or 12(g) of the Securities Exchange Act of 1934 (“Exchange Act”) or is required to file reports pursuant to Section 15(d) of the Exchange Act;
(3) The company (i) has been required to file Exchange Act reports and has filed all such Exchange Act reports for a period of 12 months; and (ii) has timely filed all Exchange Act reports required by Sections 13(a), 15(d) and Section 14(a) and 14(c) materials for a period of 12 calendar months, except for reports under Item 1.01 (entry into a material definitive agreement), 1.02 (termination of a material definitive agreement), 1.04 (mine safety – reporting shutdowns and patterns of violations), 2.03 (creation of a direct financial obligation or an obligation under an off-balance sheet arrangement), 2.04 (triggering events that accelerate or increase a direct financial obligation or off-balance sheet obligation), 2.05 (costs associated with exit or disposal activities), 2.06 (material impairments), 4.02(a) (non-reliance on previously issued financial statements or related audit report where the company makes the non-reliance determination) or 5.02(e) (compensatory arrangements with certain officers) of Form 8-K.
This eligibility rule specifically refers to reports required to be “filed” under the Exchange Act. Certain Items in a Form 8-K may be “furnished” and not “filed,” including disclosures pursuant to Items 2.02 (results of operations and financial conditions) and 7.01 (Regulation FD disclosure) and accordingly, the failure to timely file an 8-K under these Items will not affect Form S-3 eligibility. For more information on Form 8-K filing requirements, see HERE. If a company files for an extension of a Form 10-Q or 10-K on Form 12b-25 and files its report within the extension time frame, that report will be deemed timely filed.
Eligibility requires that a company have been required to file reports under the Exchange Act and as such, the voluntary filing of reports generally does not count. However, in the Lamar Advertising Co. no-action letter issued in 2009, the SEC set out nine factors that, if satisfied, would allow a voluntary filer to use form S-3. In short, the company must have been required to file Exchange Act reports because of an effective Securities Act registration statement, at some point thereafter become a voluntary filer as they had less than 300 shareholders, did not file a Form 15, had a contractual obligation to file reports and continued to do so, and then again became required to file reports either because of a newly filed Securities Act or Exchange Act registration statement. A company can request relief from the timeliness requirement; however, such relief is only granted in very limited circumstances;
(4) Since the filing of its last Exchange Act report, neither the company nor any of its subsidiaries has: (i) failed to pay a dividend or sinking fund installment or a cumulative dividend on preferred stock; or (ii) defaulted on any installment on indebtedness for borrowed money or on any rental on a long-term lease if the default is material to the financial position of the company or its subsidiaries on a consolidated basis. Furthermore, regardless of the fact that a disqualifying default is either cured or waived after it occurs, the form may not be used between the date of the default and the audit at the end of the fiscal year in which such material default occurred. However, if a prospective default never occurs because the lenders have waived payment in advance of the due date, the form may still be used;
(5) A foreign company that meets all of the other eligibility requirements and files regular U.S. Exchange Act reports;
(6) A company will not lose eligibility if it is a successor registrant as long as the succession was for the purpose of changing state of domicile or creating a holding company structure and the assets and liabilities of the successor are substantially the same as the predecessor;
(7) If a company is subject to the electronic filing requirements of Rule 101 of Regulation S-T, which all reporting companies are, it must have made all required electronic filings and posted on its website all XBRL data files within the prior 12 months. I note, however, that effective September 17, 2018, the SEC no longer requires that companies post XBRL data on their websites. See HERE.
Transaction Requirements
Primary Offerings – Instruction 1.B.1
Form S-3 can be used for primary offerings of a company whose market value of voting and non-voting common equity held by non-affiliates is $75 million or more, including for the sale and issuance of new securities or for the resale of already issued and outstanding securities held by third parties (indirect primary or resale), including offerings by subsidiaries and standby underwriters in connection with the call or redemption of warrants or a class of convertible securities. Common equity is defined as “any class of common stock or an equivalent interest, including but not limited to a unit of beneficial interest in a trust or a limited partnership interest.” Only outstanding common equity is used in the calculation and not convertible securities or common equity underlying convertible securities.
An affiliate of a Company is a person that “controls, or is controlled by, or is under common control with, such issuer.” The SEC defines “control” as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.” Determining affiliate status is a facts and circumstances determination, and the SEC has indicated many times that it will not provide guidance on affiliate status. Clearly, executive officers and directors are affiliates. However, whether stockholders that do not otherwise have board representation are affiliates or not can be a troublesome analysis. A beneficial owner of 10% or more of the voting securities of a company is presumed to be a control person/affiliate. Further, 5% stockholders are required to disclose in a Schedule 13D or 13G filed with the SEC whether their shares are held for the purposes of influencing or changing control. Companies should review their known beneficial owners and consider all factors relating to affiliate status, including but not limited to: (i) distribution of voting shares among all stockholders; (ii) impact of possible resale; (iii) relationship between the stockholder and management; (iv) influence as a stockholder; and (v) voting agreements.
For purposes of determining the value threshold, market value is computed by using the last sale price or the average of the bid and asked prices as of a date within 60 days prior to the date of filing. The number of shares held by non-affiliates is usually determined as of the date of filing but can be any day within the 60-day look-back period. It is not necessary to calculate the number of shares held by non-affiliates for the same day on which the average price of the stock is determined. For example, the number of shares outstanding on the date of filing might be used, together with the average price of stock for any day within the 60-day period.
A company must meet this eligibility requirement each time it files an update to the registration statement. Accordingly, if the market value drops between updates, a company would need to switch to an S-1 (or other form it is qualified to use) when filing an update. Furthermore, as Form S-3 incorporates Exchange Act reports by reference, the filing of a Form 10-K is the equivalent to filing a post-effective amendment. This means that if the company is not eligible to use Form S-3 at the time of filing its 10-K, it would be required to file a post-effective amendment on whatever other form would be available at the time. However, a company can use the same Form S-3 (as updated and amended through subsequent Exchange Act reports or post effective amendments) to switch between a baby shelf and full shelf based on the fluctuating market value of voting and non-voting common equity held by non-affiliates.
Prior to the recent change in the definition of a smaller reporting company (SRC) (see HERE), the threshold for use of a Form S-3 for a full shelf offering was the same as that for an SRC. That is, prior to June 2018, SRCs did not qualify to use Form S-3 for primary offerings except for under the baby shelf rule. Following the amended definition of an SRC, companies that qualify as an SRC and to use Form S-3 (i.e., with a public float in excess of $75 million but under $250 million) will be able to take advantage of the SRC scaled disclosures in their shelf offerings.
Unlike the baby shelf rule, companies eligible to use Form S-3 for a primary offering are not required to have a class of equity registered on a national exchange. In other words, a company whose market value of voting and non-voting common equity held by non-affiliates is $75 million or more and that trades on the over the counter market, would be eligible to use Form S-3 assuming it met the other eligibility requirements (such as the timely filing of all Exchange Act reports).
A company that qualifies to use Form S-3 for primary offerings under Instruction 1.B.1 may use that form to register the offer and sale of both an immediately convertible security and the underlying security. The fact that subsequent conversions may occur at a time when the company does not meet the transaction requirement for conversions described below, would not affect the initial registration of the offer of the underlying securities. If it becomes necessary to update the registration statement, the company may accomplish the update by incorporation by reference or post-effective amendment only if it meets the conditions for the use of the form at that time.
A Form S-3 cannot be used for exchange offers or other business combination transactions. Although securities registered on Form S-3 cannot be sold in exchange for other securities, the consideration is not strictly limited to cash. Form S-3 would be available, for example, for transactions in which the consideration for the securities consists of promissory notes or services performed for the issuer by the recipient of the securities.
Other Limited Primary Offerings (the “Baby Shelf Rule”) – Instruction 1.B.6
For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, Instruction 1.B.6(a) limits the amount that the company can offer to up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.” The baby shelf rule is only available to companies that have at least one class of securities listed on a national exchange.
To calculate the non-affiliate float for purposes of S-3 eligibility, a company may use the last sale price or the average of the bid and asked prices on any date within the last 60 days. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold relying on the baby shelf rule in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases. Moreover, if the aggregate market value of voting and non-voting common stock held by non-affiliates equals or exceeds $75 million after the effective date of the S-3, the one-third limit will not apply to additional sales and instead the registration statement will be considered filed under the full shelf registration provisions.
In making the calculation where derivative securities had been sold, the company should multiply the aggregate market value of the underlying equity by the maximum number of common shares that the derivative securities can be converted into. The market value of the underlying common equity can be determined using the same per share price used to determine the market value of the non-affiliate float. If the derivative securities have been converted or exercised, the aggregate market value of the underlying equity shall be calculated by multiplying the actual number of shares into which the securities were converted or received upon exercise, by the market price of the shares on the date of conversion or exercise.
To rely on this instruction to conduct an offering, the company cannot be a shell company and must not have been a shell company for at least 12 calendar months prior to utilizing Form S-3. In addition, if the company has been a shell company at any time previously, it must have filed current Form 10 information with the SEC at least 12 calendar months previously reflecting its status as an entity that is not a shell company.
On November 2, 2016, the SEC issued a C&DI clarifying the calculation of the one-third limitation under the baby shelf rule. In particular, some companies were effecting an S-3 shelf takedown with an investor while simultaneously completing a private placement with the same investor and registering the private placement securities via a new resale S-3 filing. Although the shelf takedown was a primary direct issuance from the company and the resale registration filed on behalf of the selling shareholder, the combined effect was the use of S-3 for an amount of securities in excess of the $75 million limitation.
This workaround had become somewhat commonplace until the SEC issued the new C&DI on November 2, 2016 clarifying that this will no longer be allowed. The C&DI provides in total:
Question: An issuer with less than $75 million in public float is eligible to use Form S-3 for a primary offering in reliance on Instruction I.B.6, which permits it to sell no more than one-third of its public float within a 12-month period. May it sell securities to the same investor(s), with a portion coming from a takedown from its shelf registration statement for which it is relying on Instruction I.B.6 and a portion coming from a separate private placement that it concurrently registers for resale on a separate Form S-3 in reliance on Instruction I.B.3, if the aggregate number of shares sold exceeds the Instruction I.B.6 limitation that would be available to the issuer at that time?
Answer: No. Because we believe that this offering structure evades the offering size limitations of Instruction I.B.6, the securities registered for resale on Form S-3 should be counted against the issuer’s available capacity under Instruction I.B.6. Accordingly, an issuer may not rely on Instruction I.B.3 to register the resale of the balance of the securities on Form S-3 unless it has sufficient capacity under Instruction I.B.6 to issue that amount of securities at the time of filing the resale registration statement. If it does not, it would need to either register the resale on Form S-1 or wait until it has sufficient capacity under that instruction to register the resale on Form S-3.
Although the SEC has made it clear that the private placement and shelf takedown shares will both count towards the $75 million baby shelf limit, a company can still conduct concurrent shelf takedowns and private placements with the same investor. In such case, the investor can either hold the private placement shares for the applicable Rule 144 holding period, or the shares can be registered for resale on Form S-1.
Primary Offerings of Non-Convertible Securities Other than Common Equity – Instruction 1.B.2
Form S-3 can be used for the primary offering of non-convertible securities other than common equity (such as debt or preferred stock), to be offered by cash, if the company (i) has issued at least $1 billion in non-convertible securities in registered primary offerings over the prior three years; or (ii) has outstanding at least $750 million of non-convertible securities, issued in primary offerings for cash; or (iii) is a wholly owned subsidiary of a well-known seasoned issuer; or (iv) is a majority owned operating partnership of a real estate investment trust that qualifies as a well-known seasoned issuer.
Secondary Offerings – Instruction 1.B.3
A Form S-3 can be used to register the resale of outstanding securities held by a shareholder as long as the company meets the registrant qualifications and already has securities of the same class listed and registered on a national securities exchange or quoted on the automated quotation system of a national securities association. The OTC Markets does not qualify as an automated quotation system for purposes of this eligibility requirement. When registered warrants, the warrants themselves do not have to be trading on the national exchange as long as the underlying common stock is listed.
Instruction 1.B.3 is not the exclusive way to use Form S-3 for secondary offerings. That is, if a company meets the eligibility requirement for a primary offering under Instruction 1.B.1 (i.e., market value of voting and non-voting common equity held by non-affiliates is $75 million or more), it can use Form S-3 to register a secondary offering under that provision, regardless of whether it has a class of securities registered on a national exchange.
Earnout shares to be issued in connection with a consummated merger may be registered on Form S-3, even though the shares have not been earned and are not outstanding at the time the registration statement. Likewise, securities to be issued in an exchange relying on Section 3(a)(9) of the Securities Act may be registered for resale on Form S-3 even though the exchange has not yet been completed.
A Form S-3 may be used under Instruction 1.B.3 to register the resale of securities to be issued upon the conversion of a convertible security such as a convertible note or preferred stock prior to the actual conversion. However, the company may not register an indeterminate number of shares. Accordingly, if the conversion formula is floating such as a discount to market price, the company must make a good-faith estimate of the maximum number of shares that it may issue on conversion to determine the number of shares to register for resale. If the number of registered shares is less than the actual number issued, the company would need to file a new registration statement to register the additional shares. Furthermore, if the number of shares to be registered is in excess of thirty percent (30%) of the outstanding public float at the time of registration, it will be considered an indirect primary offering and a company may only use Form S-3 if it qualifies to use the form for a primary offering under Instruction 1.B.1.
Instruction 1.B.3 may not be relied on for the “resale” of securities held by a parent or subsidiary as a parent or subsidiary is generally considered an alter ego of the company itself. That is, a resale in that case would be considered a primary offering and the company would have to rely on Instruction 1.B.1 to use Form S-3. However, there are circumstances where affiliates may make offerings that are deemed to be genuine secondaries.
Rights Offerings, Dividend or Interest Reinvestment Plans, and Conversions of Warrants and Options – Instruction 1.B.4
Form S-3 is available for securities to be offered (i) upon the exercise of outstanding rights granted by the issuer of the securities to be offered, if such rights are granted on a pro rata basis to all existing security holders of the class of securities to which the rights attach, (ii) under a dividend or interest reinvestment plan, or (iii) upon the conversion of outstanding convertible securities or the exercise of outstanding warrants or options issued by the issuer of the securities to be offered, or by an affiliate of the issuer. To utilize Form S-3 for one of these transactions, the company must have, within the prior 12 calendar months, sent an annual report complying with Rule 14a-3(b) to all record holders of the rights, all participants in the plan or all record holders of the convertible securities. Similarly, the company must have, within the prior 12 calendar months, provided certain information about management, management compensation, securities ownership and corporate governance under Regulation S-K.
Asset-backed Securities – Instruction 1.B.5
Form S-3 is not available to register offerings of asset-backed securities.
Equity Line Transactions
Depending on the amount of securities to be issued in an equity line transaction, a company that meets the eligibility requirements could use a Form S-3 to register the put shares as a primary indirect offering (Instruction 1.B.1), a baby shelf offering (Instruction 1.B.6) or a secondary offering (Instruction 1.B.4).
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SEC Cautionary Statement on Audits of Public Companies Operating in China
Eight years following the crash of the Chinese reverse merger boom and a slew of SEC enforcement proceedings, the SEC is once again concerned with the financial reporting by U.S. listed companies with operations based in China. In December 2018, the SEC issued a cautionary public statement from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III entitled “Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally – Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China.”
Just reading the title reminded me of the boom in China-based reverse mergers around 2009-2010 followed by the trading halts or delistings of at least 50 companies in 2011 and 2012. In the summer of 2010, the SEC launched an initiative to determine whether certain companies with foreign operations—including those that were the product of reverse mergers—were accurately reporting their financial results, and to assess the quality of the audits being done by their auditors. By June 2011, the SEC was strongly warning investors of the risks posed by reverse mergers in general, and Chinese deals in particular, singling out six Chinese issuers.
Numerous SEC enforcement actions and civil lawsuits were filed claiming fraud and misrepresentations in SEC filings including financial reports. Partially as a result of the crisis, in late 2011 both the NYSE and Nasdaq amended their listing requirements to add a seasoning requirement following a reverse merger. The seasoning rules prohibit a company that has completed a reverse merger with a public shell from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange, for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, the rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report.
In addition, the seasoning rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes an exception for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.
In addition to the specific additional listing requirements contained in the new rule, the Exchange may “in its discretion impose more stringent requirements than those set forth above if the Exchange believes it is warranted in the case of a particular reverse merger company based on, among other things, an inactive trading market in the reverse merger company’s securities, the existence of a low number of publicly held shares that are not subject to transfer restrictions, if the reverse merger company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or if the reverse merger company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the reverse merger company’s independent auditor and has not yet implemented an appropriate corrective action plan.”
Slowly since that time, Chinese companies have again started to access U.S. capital markets via both reverse mergers and direct IPO’s. However, clearly the issues and concerns raised by the SEC in 2011 have not all been resolved.
SEC Public Statement
The SEC’s recent cautionary public statement was issued jointly from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III. The statement’s opening sentence sets the tone for the rest of the content, and in particular, “[A]s we are nearing the end of the fiscal year for many reporting companies, it is important to remember that complete, accurate financial statements and credible audits are things we—investors, issuers, and regulators worldwide—all care about.”
The statement continues with a recognition of the global nature of both capital markets and companies, with U.S.- and non-U.S.-based companies seeking access to the U.S. capital markets and the fundraising and liquidity they bring. The statement points out that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017. Capital access and liquidity are made possible by the assurance that companies that list and trade on U.S. markets provide high-quality and reliable financial information and that U.S. rules, regulations, and regulatory oversight apply. When the listed company operates outside the U.S., regulators must operate in multiple jurisdictions to be able to access audit-related information and otherwise effectuate their responsibilities over any company trading in the U.S. markets.
A multinational company must comply with financial reporting obligations in many of the countries in which it operates and its auditors must be able to operate on a worldwide basis. The multi-jurisdictional aspect is sometimes challenging in that information necessary for regulatory oversight does not always flow back to the U.S. as it should. Barriers to the information flow include data protection, privacy, confidentiality, bank secrecy, state secrecy, or national security laws. The U.S. has been working with foreign jurisdictions to address these laws and barriers where a company subjects itself to U.S. regulatory oversight by listing on U.S. securities exchanges and accessing U.S. capital markets. For example, the SEC is one of over 120 signatories to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding, which provides for enforcement consultation and cooperation, and the exchange of information. Moreover, the SEC has over 75 formal cooperative arraignments with foreign regulators, the PCAOB has conducted inspections of registered accounting firms in over 50 foreign countries, and the PCAOB has cooperative arrangements with 23 foreign regulators.
Unfortunately, China is not one of these cooperative arrangements, and the PCAOB has been facing issues being able to inspect auditing firms in China, as well as Hong Kong where the audit client has operations in mainland China. Based on reports to the PCAOB from audit firms up to March 31, 2018, there were 213 listed companies in China and 11 in Belgium for which the PCAOB and SEC have not been able to inspect audit records despite ongoing and significant efforts. From March 31 to the date of the SEC’s public statement, some of those companies changed their listing or trading status, dropping the number down to 178 companies.
The SEC is and remains the principal regulator of the world’s largest securities markets and, as such, must often deal with cross-border issues. The SEC sees its mission as administering and enforcing requirements for reliable financial reporting globally in light of the global nature of the economy and the many companies that operate worldwide. The SEC furthers this mission by communicating and cooperating with regulators in other countries and by participating in international organizations such as IOSCO (the International Organization of Securities Commissions) and The Monitoring Group, which engages in the monitoring of international accounting, auditing, and ethics standards.
The SEC also oversees the PCAOB which, in turn, is the principal U.S. regulator that oversees the audits of public companies and SEC-registered brokers and dealers. The PCAOB is required by U.S. law to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports or that play a substantial role in their preparation. As noted above, the PCAOB has inspected audit firms in 50 different foreign countries. The PCAOB also often works in cooperation with foreign regulators and their audit inspection authorities.
However, despite the cooperative arrangements, there are legal impediments blocking the free flow of information from some countries. In particular, blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws sometimes complicate or outright restrict the sharing of information with U.S. regulators. Some of these laws prohibit foreign-domiciled companies from responding directly to SEC requests for information and documents or doing so, in whole or in part, only after protracted delays in obtaining authorization. Other laws can prevent the SEC from being able to conduct any type of examination, either on-site or by correspondence. Accordingly, securities regulators around the world seek agreements with one another for access to business books and records or auditor documentation. Likewise, some countries prohibit the PCAOB from inspecting audit firms within their borders, even if the auditor is PCAOB-registered. In that case, the PCAOB usually enters into cooperative arrangements with local regulators that allows them to jointly inspect a firm.
However, the SEC is generally not satisfied with their ability to inspect, investigate and enforce the U.S. securities laws in China. Despite the significant value of China-based companies trading in U.S. markets, Chinese law requires that the business books and records related to transactions and events occurring within China be kept and maintained there. China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. Also, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers. As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers. The SEC and PCAOB are engaging in ongoing discussions with Chinese officials and regulators but have not made satisfactory progress.
The SEC believes that if a company wants to access U.S. securities markets, the SEC needs to be able to directly supervise these entities and the auditors that audit their books and records. Any audit firm that registers with the PCAOB is legally obligated to cooperate and provide documents and testimony, if requested, in connection with inspections and investigations regardless of their locations. If the SEC and/or PCAOB cannot access a company or its auditor, they will seek sanctions and other remedial measures. To help keep investors informed of these issues, the PCAOB publishes a list of companies and auditors for which they have not been able to conduct inspections or obtain sufficient information.
The SEC continues to try and negotiate with Chinese authorities to improve relations and allow the SEC and PCAOB to have timely access to information necessary to conduct investigations or inspections but has not been successful to date. Many China-based companies and companies with significant operations in China want to access U.S. securities markets, but the inability of U.S. regulators to properly access records is causing the SEC concern about the risk to investors. Even if an audit is conducted correctly and financial reports are accurate, there is a greater risk to investors if the SEC cannot do its job and inspect the records. Of course, there is also the very real risk of fraud, which could emanate from a large company (for example, Enron or WorldCom) and have a broad market impact. The SEC is considering remedial measures, which could include requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances.
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Updated Disclosures for Mining Companies
In the 4th quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescind Industry Guide 7 and consolidate the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K.
The final amendments require companies with mining operations to disclose information concerning their mineral resources and mineral reserves. Disclosures on mineral resource estimates were previously only allowed in limited circumstances. The rule amendments provide for a two-year transition period with compliance beginning in the first fiscal year on or after January 1, 2021.
Summary of the Final Rules
In amending the disclosure rules for mining companies, the SEC considered that many companies are already subject to one or more of the s and that by aligning the SEC reporting requirements to these rules, the compliance burden and costs for these companies could be reduced while still providing the necessary investor protections.
Under the final rules, a company with material mining operations must disclose specific information related to its mineral resources and mineral reserves on one or more of its properties. The rules define “mineral reserve” to include diluting materials and allowances for losses that may occur when the material is mined or extracted. The rules also amend the definition of “mineral resource” to exclude geothermal energy. Consistent with CRIRSCO standards, a company must disclose exploration results, mineral resources, or mineral reserves in SEC filings based on information and supporting documentation prepared by a mining expert referred to as a “qualified person.”
A company must obtain a dated and signed technical report summary from the qualified person related to mineral resources and reserves determined to be on each material property. The report must be signed either directly by the qualified person or the firm that employs them. Moreover, multiple qualified persons may take part in preparing the final technical report summary. The qualified person may conduct either a pre-feasibility or final feasibility study to support a determination of mineral reserves even in high-risk situations. The report must be filed as an exhibit to the company’s SEC report when first disclosed and subsequent changes or amendments to the report must also be filed as exhibits. A technical report on exploration results may also be voluntarily filed as an exhibit.
The final rules require the qualified person to use a price for each commodity that provides a reasonable basis for establishing estimates of mineral resources or reserves. The price may be either historical or forward-looking, but the report must disclose and explain the reasons for using the selected price, including any material underlying assumptions. Similarly, instead of requiring a specific point of reference, the qualified person may choose any point of reference subject to disclosure and explanations. The technical report summary may disclose mineral resources as mineral reserves as long as it also discloses mineral resources excluding mineral reserves.
A qualified person is not subject to expert liability under Section 11 of the Securities Act of 1933 (“Securities Act”) for information and factors that are outside that person’s expertise, even if discussed in the technical report.
Although the proposed rule amendment provided for quantitative presumptions as to when mineral resources or reserves will be deemed material, the final rule did not include this provision, instead allowing management to rely on a principles-based approach in determining materiality. Likewise, management can determine when a change in previously reported estimates of mineral resources or reserves is material. Also, the proposed rule would have required a table with certain information on a company’s top 20 properties, but the final rule instead also uses a principles-based approach, again leaving it to the company to determine material disclosures of its properties and mining operations.
Materiality relating to mineral resources and reserves has been modified to consistently rely on a principles-based approach. A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required. The SEC has shown a trend towards this principles-based approach for determining materiality for purposes of disclosure in its recent reviews and amendments to Regulation S-K and Regulation S-X (see, for example, HERE and HERE). Practitioners, including the American Bar Association (“ABA”), have advocated for principles-based disclosure over quantitative or bright line tests (see HERE) believing that a quantitative guideline results in lengthy, and often immaterial, information. Congressional lawmakers have also supported this approach requiring the SEC to conduct a study on shifting even more disclosure requirements to principles based, as part of the FAST Act (see HERE).
The number of summaries and tables that are currently required has been reduced from seven to two and the company may now choose to make its disclosures using either tables or a narrative format. A company is permitted to voluntarily disclose exploration targets in its SEC reports as long as they are accompanied by certain specified cautionary and explanatory statements. Disclosure of exploration activity and results is mandatory once the company determines the information is material to investors. Also, the qualified person may include inferred resources in their economic analysis as long as certain conditions are met.
A company may now use historical estimates of mineral resources or reserves in SEC filings pertaining to mergers, acquisitions, or business combinations if they are unable to update the estimate prior to the completion of the relevant transaction, provided that the company discloses the source and date of the estimate, and does not treat the estimate as a current estimate.
Finally, the amended rules allow a company holding a royalty or similar interest to omit any information required under the summary and individual property disclosure provisions to which it lacks access and which it cannot obtain without incurring an unreasonable burden or expense.
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An IPO Without The SEC
On January 23, 2019, biotechnology company Gossamer Bio, Inc., filed an amended S-1 pricing its $230 million initial public offering, taking advantage of a rarely used SEC Rule that will allow the S-1 to go effective, and the IPO to be completed, 20 days from filing, without action by the SEC. Since the government shutdown, several companies have opted to proceed with the effectiveness of a registration statement for a follow-on offering without SEC review or approval, but this marks the first full IPO, and certainly the first of any significant size. The Gossamer IPO is being underwritten by Bank of America Merrill Lynch, SVB Leerink, Barclays and Evercore ISI. On January 24, 2019, Nasdaq issued five FAQ addressing their position on listing companies utilizing Section 8(a). Although the SEC has recommenced full operations as of today, there has non-the-less been a transformation in the methods used to access capital markets, and the use of 8(a) is just another small step in a new direction.
Section 8(a) of the Securities Act
Section 8(a) of the Securities Act of 1933 (“Securities Act”) provides for the effectiveness of registration statements and amendments. In particular, the statute provides that a registration statement shall automatically go effective on the 20th day after its filing or such earlier date as the SEC may determine. Section 8(b) gives the SEC the power to issue a stop order to prevent a registration statement from going effective in accordance under Section 8(a) if the registration statement is “on its face incomplete or inaccurate in any material respect.”
In practice, companies avoid the Section 8(a) effectiveness by adding language to their registration statements known as the “delaying amendment.” The typical language for a delaying amendment is similar to the following:
The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.
… and with that provision, Section 8(a) is avoided. A company then goes through a comment, review and amendment process with the SEC which ultimately results in the SEC informing the company that it has cleared comments. A company then files a letter with the SEC, relying on another rule (Rule 461) requesting that the registration statement become effective. Technically the request is that the SEC accelerate the effectiveness of the registration statement so that a company does not have to file a final amendment removing the “delaying amendment” language and adding Section 8(a) language and then waiting 20 days for the registration statement to go effective.
The reasons that Section 8(a) is not used in practice are twofold. The first is that a company and its attorneys, auditors and underwriters believe that there is too much risk of litigation associated with forgoing SEC review. If the registration statement disclosures are later shown to have shortcomings, the unusual lack of SEC review adds fuel to the plaintiff’s lawyer’s claims. However, the SEC does not conduct a merit review, but rather just reviews to determine if the disclosures comply with the rules and regulations. Not only does the SEC not pass on whether a deal is good or bad, but making a statement to the contrary is a criminal offense and Item 501 of Regulation S-K specifically requires a disclaimer on the subject with suggested language, to wit:
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.
It seems that if a company has competent counsel and the underwriter has competent counsel, they can together review the disclosures to determine if they are accurate and complete. Moreover, the fact is that if the stock price goes way down, the company is likely to face an investor lawsuit anyway, regardless of what the SEC reviews or doesn’t review. Besides, risk factors are designed to warn investors of potential issues, and Gossamer did so with its newest SEC filing adding the following risk factor:
As a result of the shutdown of the federal government, we have determined to rely on Section 8(a) of the Securities Act to cause the registration statement of which this prospectus forms a part to become effective automatically. Our reliance on Section 8(a) could result in a number of adverse consequences, including the potential for a need for us to file a post-effective amendment and distribute an updated prospectus to investors, or a stop order issued preventing use of the registration statement, and a corresponding substantial stock price decline, litigation, reputational harm or other negative results.
The registration statement of which this prospectus forms a part is expected to become automatically effective by operation of Section 8(a) of the Securities Act on the 20th calendar day after the most recent amendment of the registration statement filed with the SEC, in lieu of the SEC declaring the registration statement effective following the completion of its review. Although our reliance on Section 8(a) does not relieve us and other parties from the responsibility for the adequacy and accuracy of the disclosure set forth in the registration statement and for ensuring that the registration statement complies with applicable requirements, use of Section 8(a) poses a risk that, after the date of this prospectus, we may be required to file a post-effective amendment to the registration statement and distribute an updated prospectus to investors, or otherwise abandon this offering, if changes to the information in this prospectus are required, or if a stop order under Section 8(d) of the Securities Act prevents continued use of the registration statement. These or similar events could cause the trading price of our common stock to decline substantially, result in securities class action or other litigation, and subject us to significant monetary damages, reputational harm and other negative results.
The second is that the S-1, which will go effective after 20 days, must be totally complete, including pricing information. In a traditional IPO or follow-on offering, the company does not file the final amendment with pricing information until the day it goes effective. This allows a company to judge the market at the moment of sale to choose the best price, which is especially important in a firm commitment underwritten deal where the underwriter buys all the company’s registered stock in the IPO and immediately resells it to customers and syndicated broker-dealers. A company also may get feedback during its roadshow, which typically occurs in the 10-15 days prior to effectiveness that affects pricing decisions.
Interestingly, Gossamer has decided to ignore these market factors and let the world know its believed value up front. I’m actually not surprised at all. This is just another way that capital markets are shifting. There has been a recent rise in different methods of going public including direct public listings without an IPO (see HERE).
Nasdaq FAQ
On January 24, 2019, Nasdaq issued five FAQ addressing the listing of new companies during the government shutdown and the impact on already listed companies. Nasdaq will list companies that had cleared comments, but whose registration statement had not yet been declared effective at the time of the shutdown. Likewise if a company has substantially cleared comments, Nasdaq is willing to proceed with the listing under certain circumstances. In particular, the company will have had to clearly address the outstanding comments and Nasdaq will require a representation from the company’s counsel and auditor that they believe all disclosure and accounting comments have been fully addressed. Nasdaq will not list a company that has not yet received SEC comments or that first filed for its IPO during the shutdown. Gossamer announced that it has applied for the Nasdaq Global Select Market and so it will likely amend its S-1 to allow SEC review.
Nasdaq will also allow certain up-listings from the OTC Markets to proceed as long as the company satisfies the listing requirement. In particular, if the company only needs to file a registration statement under the Securities Exchange Act of 1934 (“Exchange Act”), such as a Form 10 or Form 8-A, Nasdaq will allow it to continue. Keep in mind a registration statement under the Exchange Act does not involve the offer or sale of any securities. However, if the up-listing involves an offering and the filing of a registration statement under the Securities Act, Nasdaq will review the application the same as a new IPO. That is, if the company has already cleared or substantially cleared comments, they may continue, if not, they will need to complete the SEC review process.
If a company is already listed on Nasdaq, they may proceed with a follow-on offering without SEC review.
Although the SEC is again operational, they will be backlogged, so presumably Nasdaq is still willing to proceed with certain companies without SEC action. Companies that have already filed a registration statement without the delaying amendment and with the appropriate Section 8(a) amendment will likely proceed. For those that had one or two unsubstantial comments left, they will need to assess which route will be the quickest, wait for the SEC to review the final comments or file a new fully completed registration using Section 8(a). Of course, Nasdaq may issue updated FAQ altering their position on accepting these applications.
Continued Shifting Capital Markets
The rise of decentralized platforms and imminent change in how the capital markets function as a whole and the role of intermediaries in the process has opened the market’s view to relying less on the SEC’s input in their disclosures. tZero is scheduled to launch its security token platform this week, introducing a new way in which securities, or fractional ownership interests in a company, can be bought and sold. tZero is starting with launching its own securities tokens on the platform but will soon open up to third-party companies and reportedly already has applications from over 60 companies. tZero may be the first to launch, but it will not be the only and soon we will have independent markets competing with Nasdaq and the NYSE. Moreover, the securities token markets will have sectors for private company markets and public company markets, blurring the current private equity silo with public trading.
Much more significantly, though, is that this is the first step in a retooling and complete change in how the clearing and settlement of securities functions (for more on the current clearing and settlement, see HERE and HERE). The new blockchain technology will allow for instantaneous clearing and settlement, a big change from the current t+2 and sometimes t+3 settlement of today (thus the name tZero). Notably, blockchain eliminates the need for a trusted intermediary, thus opening up the question as to the future role of DTC and its custodial arm, Cede & Co.
No regulator, the SEC or FINRA included, is ready for a complete disruption of the capital markets system, but they have been thinking about it for a while. FINRA published a report on the implications of blockchain for the securities industry back in January 2017 (see HERE). Furthermore, the SEC has reportedly told tZero, and presumably others following in their lead, that they will allow incremental changes in the market system.
This is a small concession considering that they will have no choice as the proverbial train has left the station. tZero is launching a joint venture with Boston Options Exchange, which is one of 12 SEC-listed security exchanges which together comprise the National Market System network. The joint venture seeks to launch a marketplace able to deal in both public securities and digital tokens. Nasdaq Financial Framework, a software company owned by the exchange, just closed a $20 million Series B funding round into Symbiont which is working to “give Nasdaq the ability to originate a financial instrument and the smart contract to custody it on a blockchain, to allow trading to occur with their matching engine, to allow surveillance to occur across the network using Nasdaq technology and then to perform settlement on a blockchain.”
Meanwhile, the SEC is clearly not against forgoing the comment and review process and relying on Section 8(a). As it was shutting down, the SEC posted an FAQ on its website reminding companies that they can proceed to rely on Section 8(a) to effectuate their registration statements, and even providing the exact language that needs to be included in order to accomplish this. In particular: “This registration statement shall hereafter become effective in accordance with the provisions of Section 8(a) of the Securities Act of 1933.” Even with the re-opening of the SEC, CorpFin will be exponentially backlogged compared to the time it was shutdown. It will be interesting to see how the SEC handles the workload – perhaps in addition to simply foregoing comments on many filings, the SEC will continue to support the use of 8(a) on others, especially follow-on offerings completed for a company that has had a full review in the last few years.
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The Treasury Department Report To The President On FinTech And Innovation
This summer, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Nonbank Financials, Fintech and Innovation” (the “Treasury Report”). The Treasury Report was issued in response to an executive order dated February 3, 2017 which has resulted in a series of such reports. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports. For a summary of the Treasury Department Report on Capital Markets, see HERE.
The Core Principles identified in the executive order are:
- Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
- Prevent taxpayer-funded bailouts;
- Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
- Enable American companies to be competitive with foreign firms in domestic and foreign markets;
- Advance American interests in international financial regulatory negotiations and meetings;
- Make regulation efficient, effective, and appropriately tailored; and
- Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.
This blog will summarize key portions of the 222-page report; however, for those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken down by category.
Interestingly, the Treasury Report opts not to provide any detailed coverage on blockchain, distributed ledger technologies or digital assets, instead finding that topic to be significant enough to warrant stand-alone treatment. The Treasury Department is party of an interagency working group of the Financial Stability Oversight Council focused on this new area of technology and capital resources.
Non-bank Financials, Fintech, and Innovation
A non-bank financial firm provides financial services, including extending credit; providing investment advice; executive retail investment transactions; processing payments; facilitating back-end check processing; enabling card issuance, processing, and network activities; and providing customer-facing digital payments software. As such, non-bank financial firms play an important role in the U.S. economy.
During the financial crisis, the government wrote far-reaching laws that mandated the adoption of hundreds of new regulations, many of which either limited certain services by banks or made them unprofitable. As a result, the financial service sector grew rapidly. Importantly, capital is available for companies in the financial services and fintech sectors. The financing of financial services firms has reached in excess of $22 billion globally, and such firms now make up more than 36% of all U.S. personal loans, up from less than 1% in 2010.
In addition, at the same time, the rapid development of financial technology enabled financial services firms to improve operational efficiencies and lower regulatory compliance costs. The Treasury Report succinctly notes, “[S]ince the financial crisis, there has been a proliferation in technological capabilities and processes at increasing levels of cost effectiveness and speed. The use of data, the speed of communication, the proliferation of mobile devices and applications, and the expansion of information flow all have broken down barriers to entry for a wide range of startups and other technology-based firms that are now competing or partnering with traditional providers in nearly every aspect of the financial services industry.”
There are abundant examples of significant changes in the world economy. Digital advice platforms make financial planning and wealth management tools available to all households regardless of income level. Technology provides options for the unbanked and underbanked population through mobile-based applications. Consumer and mortgage lending are all available online in a shorter process than ever before. Payment processors allow for quick and easy transactions between businesses and consumers and person-to-person among friends sharing a bill. Cloud computing, machine learning, artificial intelligence, blockchain and distributed ledger technologies are likewise revolutionizing the financial service sectors.
Issues and Recommendations
The Treasury Report groups its recommendations into four categories: (i) adapting regulatory approaches to changes in the aggregation, sharing and use of consumer financial data and support competitive technologies; (ii) aligning the regulatory framework to eliminate regulatory fragmentation and support new business models; (iii) updating activity-specific regulations, especially those that are outdated by technological advances; and (iv) advocating an approach that supports responsible experimentation in the financial sector and helps America be competitive internationally.
Specific recommendations include:
Consumer Financial Data
The Treasury Report recommendations focus on improving consumers’ access to data and its use by third parties to support better delivery of services. In particular, there are numerous regulations and regulatory uncertainties that act as impediments for financial service companies and data aggregators desiring to establish data sharing agreements. The Treasury Report also recommends that Congress enact a federal data security and breach notification law to protect consumer financial data and ensures that consumers are notified of breaches in a timely manner.
Eliminating Regulatory Fragmentation and Supporting New Business Models
Treasury makes numerous recommendations for removing regulatory burdens and fragmentation and for new regulations that will support cloud technologies, machine learning, and artificial intelligence into financial services. Treasury also recommends a more unified state law system, including the drafting of model laws and unifying licensing processes across states. Treasury supports Vision 2020, an effort by the Conference of State Bank Supervisors that includes establishing a Fintech Industry Advisory Panel to help improve state regulation, harmonizing multi-state supervisory processes, and redesigning the Nationwide Multistate Licensing System.
Further at the federal level, Treasury encourages the development of a special-purpose national bank charter for non-bank financial service providers. Interestingly, on the same day as the release of the Treasury Report, the Office of the Comptroller of the Currency announced that it would begin accepting applications for special-purpose national bank charters from financial technology companies that don’t take deposits. As of the date of this blog, no such charters have yet been issued. Moreover, the Conference of State Bank Supervisors (CSBS) has filed a federal lawsuit claiming the program is illegal.
The Treasury Report also encourages banking regulators to clarify guidance regarding bank partnerships with non-bank financial firms, encouraging such partnerships, especially those that promote innovation. Furthermore, Treasury makes recommendations regarding changes to permissible activities, including bank activities related to acquiring or investing in non-bank platforms.
Updating Activity-specific Regulations
Specific areas with recommendations for regulatory reform include:
- Marketplace lending – The Treasury Report recommends eliminating constraints on relationships between non-bank and bank lenders, codifying the “valid when made” doctrine and the role of the bank as the “true lender” of loans it makes.
- Mortgage Lending and Servicing – Non-bank financial firms now originate approximately half of all new mortgages. Regulatory changes should encourage broad primary market participation and the adoption of technological developments, shorten origination timelines, facilitate efficient loss mitigation and generally help deliver a more reliable, lower-cost mortgage product.
- Student Lending and Servicing – The federal student loan program represents more than 90% of outstanding student loans and is managed by a network of non-banks for servicing and collection. The Treasury Report recommends that the U.S. Department of Education establish minimum effective servicing standards and the increased use of technology for communication with borrowers, monitoring and management.
- Short-Term, Small Dollar Lending – Treasury recommends that the Bureau of Consumer Financial Protection rescind its Payday Rule as state regulations are adequate. The goal is to encourage access to short-term, small-dollar installment lending by both non-bank and bank financial institutions.
- Debt Collection – Treasury recommends that the Bureau establish minimum effective federal standards for third-party debt collectors, including standards for the information that must be transferred with the debt for purposes of third-party collection or sale.
- New Credit Models and Data – Regulators should provide regulatory clarity for the use of new data and modeling approaches that are generally recognized as providing predictive value.
- Credit Bureaus – Credit bureaus are not routinely monitored for the privacy provisions and data security requirements under the federal Gramm-Leach-Bliley Act and as such, the Treasury Report recommends that processes be put into place for such monitoring. Treasury also recommends that Congress amend the Credit Repair Organizations Act to exclude national credit bureaus and national credit scorers in order to allow these entities to provide credit education and counseling services to consumers to prospectively improve their credit scores.
- IRS Income Verification – The Internal Revenue Service (IRS) system that lenders and vendors use to obtain borrower tax transcripts is outdated and should be modernized in order to minimize delays in accessing tax information, which would facilitate the consumer and small business credit origination process.
- Payments – Treasury recommends that the states work to harmonize money transmitter requirements for licensing and supervisory examinations, and urges the Bureau to provide more flexibility regarding the issuance of remittance disclosures. Treasury encourages the Federal Reserve to move quickly in facilitating a faster retail payments system, such as through the development of a real-time settlement service that would allow for more efficient and widespread access to innovative payment capabilities.
- Wealth Management and Digital Financial Planning – Under the current regulatory structure, financial planners may be regulated at both the federal and state levels. Although many financial planners are regulated by the SEC or state securities regulators, they may also be subject to regulation by the Department of Labor, the Bureau, federal or state banking regulators, state insurance commissioners, state boards of accountancy, and state bars. This patchwork of regulatory authority increases costs and potentially presents unnecessary barriers to the development of digital financial planning services. Treasury recommends that an appropriate existing regulator of a financial planner be tasked with primary oversight of that financial planner and other regulators defer to that regulator.
Supporting Experimentation in the Financial Sector
The theme of the Treasury Report is to support innovation and permit experimentation and changes in the financial services industry. Many other countries have created innovation facilitators and other groups to test new technologies in the financial sector. Unfortunately the fragmentation of the U.S. regulatory system makes it more difficult for the U.S. to maintain global competitiveness. The Treasury Report recommendations focus on defragmenting the regulatory system and supporting innovative changes.
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SEC Solicits Comment On Earnings Releases And Quarterly Reports
On December 18, 2018, the SEC published a request for comment soliciting input on the nature, content, and timing of earnings releases and quarterly reports made by reporting companies. The comment period remains open for 90 days from publication. The request is not surprising as earnings releases and quarterly reports were included in the pre-rule stage in the Fall 2018 SEC semiannual regulatory agenda and plans for rulemaking.
The request for comment seek input on how the SEC can reduce burdens on publicly reporting companies associated with quarterly reports while maintaining disclosure effectiveness and investor protections. The SEC also seeks comment on how the existing reporting system, earnings releases and earnings guidance may foster an overly short-term focus by companies and market participants. In addition, the SEC is looking for input on how to make the reporting process less cumbersome to investors, such as by having to compare an earnings release and Form 10-Q for differences.
This has been a hot topic over the years, with President Trump publicly calling for an elimination of quarterly reporting. The April 2016 concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements also requested comment on the subject. See my two-part blog on the S-K Concept Release HERE and HERE. The newest request for comment takes into consideration comments received in response to the 2016 release and drills down further on the quarterly reporting process.
The request for comment specifically addresses (i) the nature and timing of disclosures in quarterly reports, including when the disclosures overlap with voluntary earnings releases in Forms 8-K; (ii) how the SEC can make the process more efficient by eliminating duplication and how that can affect capital formation; (iii) whether the SEC should allow some or all reporting companies flexibility on the frequency of periodic reporting; and (iv) how the existing periodic reporting system may affect corporate decision making and may foster an inefficient outlook by focusing on short-term results.
Background on Form 10-Q
In addition to annual reports on Form 10-K and current reports on Form 8-K, companies subject to the periodic reporting requirements under the Securities Exchange Act of 1934 (“Exchange Act”), other than foreign private issuers, must file quarterly reports on Form 10-Q, which include independent auditor-reviewed interim financial statements and other disclosure items. For more information on SEC reporting requirements, see HERE and related to foreign private issuers, see HERE. Foreign private issuers must file annual but not quarterly reports.
These quarterly reports, as well as other periodic reports, may be forward incorporated by reference into Securities Act of 1933 (“Securities Act”) registration statements such as Forms S-1 and S-3, reducing the need for duplication of this information through post effective updates. As an aside, 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 (see HERE), which category of company has recently increased with the amended definition of a smaller reporting company (see HERE). Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference.
A Form 10-Q is subject to the anti-fraud provisions of Sections 10(b) and 18 of the Exchange Act and Rule 10(b)(5) and can be the source of liability to the company, affiliates and underwriters under Sections 11, 12 and 17 of the Securities Act, related to the offer and sales of securities offerings. Each of these provisions imposes liability on companies in certain instances for making any untrue statements of a material fact or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. The difference in the Sections relate to whether the cause of action is private or can only be pursued by a regulator or governmental body, if private, who has a right to pursue the action (for example, Section 11 provides an action for any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket), the elements of proof (such as scienter or intent or loss causation), allowable damages, the standard of proof, etc..
Liability under certain of these provisions, such as Sections 11 and 12 of the Securities Act and Section 18 of the Exchange Act, attaches only to documents that are filed with the SEC or incorporated by reference into a Securities Act registration statement. A Form 10-Q is always deemed filed with the SEC.
However, the SEC allows certain information to be furnished as opposed to filed as long as the company specifically discloses that it is avowing itself of the ability to furnish and not file. For example, reports in a Form 8-K under Regulation FD and earnings press releases under Item 2.02 related to results of operations and financial condition are allowed to be furnished and not filed. Although liability under Section 10(b) and Rule 10b-5 of the Exchange Act may attach to documents that are “furnished,” the standard of proof and elements to state a cause of action are different under these rules.
As mentioned above, foreign private issuers must file annual but not quarterly reports. However, a foreign private issuer has obligations to furnish certain information under a Form 6-K, including, for example, information it (i) makes or is required to make public pursuant to the law of the jurisdiction of its domicile or in which it is incorporated or organized, or (ii) files or is required to file with a stock exchange on which its securities are traded and which was made public by that exchange, or (iii) distributes or is required to distribute to its security holders. This information is subject to liability under Section 10(b) and Rule 10b-5 of the Exchange Act and if incorporated into a registration statement, becomes filed in that registration statement, and subject to liability under Sections 11, 12 and 17 of the Securities Act.
As a result of these requirements, reports on Form 6-K often include quarterly reports or financial statements. For example, Canada, Hong Kong and Japan all require quarterly reporting. On the other hand, in 2013 the European Union (“EU”) amended its reporting requirements to eliminate the requirement to file quarterly reports altogether, which even prior to that time did not include financial statements. The EU found that quarterly reports were a burden for small and medium-sized companies, didn’t add to investor protection, encouraged a focus on short-term performance and discouraged long-term investments. Companies may still voluntarily file quarterly.
Earnings Releases
Many companies that file quarterly Form 10-Q’s also voluntarily issue quarterly financial results through earnings press releases, earnings calls and/or forward-looking earnings guidance. Other than through the anti-fraud rules, the presentation of non-GAAP financial measures (see HERE) and the requirement to file a Form 8-K, the SEC does not regulate these disclosures. Although when a company does issue earnings release information, it is generally duplicative to some information in the Form 10-Q, the Form 10-Q is more robust and includes XBRL interactive data. Disclosures in a Form 10-Q that are not in an earnings release also include full financial statements and notes to financial statements as opposed to summaries and a management discussion and analysis. Moreover, the financial statements in the Form 10-Q are reviewed by an independent auditor and the filing includes Sarbanes-Oxley certifications by the principal executive and financial officers. Contrarily, a Form 10-Q generally does not include expectations of future performance or forward-looking earnings guidance.
Request for Comments
In addition to the general request for comment on the issues and matters described above, the SEC drills down their requests into specific questions on the topic, such as why companies choose to issue earnings releases in addition to a Form 10-Q and what would be the impact on these releases if quarterly reports were not required. The SEC seeks information on the specific benefits of both earnings releases and Form 10-Q and standard market expectations and responses to both. Certainly, as a regulator the SEC understands the legal impact of “furnished vs. filed” and the various liability provisions, but their questions are more focused on the market players and investors uses of and needs for information as well as the burdens of providing same. The SEC also touches on XBRL, which has also been oft debated, especially for smaller reporting companies. The SEC lists 14 multifaceted in this area under the heading “Information Content Resulting from the Quarterly Reporting Process.”
The SEC requests comment on 3 additional multi-layered points related to the timing of the quarterly reporting process including vis-à-vis earnings releases. In particular, some companies issue an earnings release prior to the Form 10-Q while others wait until the same day or close thereafter. Earnings calls can be scheduled anywhere around the time of either filing or after. The SEC queries the reasons why and impacts of the timing.
The next area of questions relates to whether earnings releases should be the core quarterly disclosure, with 12 multi-layered queries. In this area it seems that the SEC is considering making an earnings release an optional alternative to a Form 10-Q by allowing the Form 10-Q to incorporate the earnings release by reference and/or only provide supplemental information in the Form 10-Q to the extent it was not included in the earnings release.
Finally, the SEC tackles the topic of reporting frequency, including considering semi-annual reporting with 17 in-depth, multifaceted questions for consideration.
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 siting 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.
Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.
Listen to our podcast on iTunes Podcast channel.
Noun
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, Corporate Finance in Focus. Example; “LawCast expounds on NASDAQ listing requirements.”
Anthony L.G., PLLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Anthony L.G., PLLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Anthony L.G., PLLC 2019
« SEC Updates CDI Related to Smaller Reporting Company Definition The Treasury Department Report To The President On FinTech And Innovation »
SEC Updates CDI Related to Smaller Reporting Company Definition
On June 28, 2018, the SEC adopted the much-anticipated amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. For more information on the new rules, see HERE
Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.
As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float. Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.
The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.
The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.” As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton has directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.
Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K. On November 7, 2018, the SEC made conforming changes to its Compliance and Disclosure Interpretations (C&DI).
In particular, the SEC issued four new C&DI to reflect the impact of the larger size threshold for SRC status and withdrew four C&DI addressing transition issues for SRCs and two additional obsolete C&DI which still referred to the old Regulation S-B.
New C&DI 102.01 illustrates that, under the new amendments, companies can now be both accelerated filers and SRCs, which means that, as SRCs, they can use the scaled disclosure rules but, as accelerated filers, their periodic reports are due under the time frames for accelerated filers and they must provide Sarbanes-Oxley Section 404(b) auditor attestation reports in their 10-Ks. In an example, a company was an accelerated filer with respect to filings due in 2018 and had a public float of $80 million on the last business day of its second fiscal quarter of 2018. Because its public float at that measurement date was below $250 million, the company would qualify as an SRC for filings due in 2019; however, it would also need to file its 10-K within 75 days as an accelerated filer and would need to comply with Section 404(b). Since the company was an accelerated filer with respect to filings due in 2018, it would be required to have less than $50 million in public float on the last business day of its second fiscal quarter in 2018 to exit accelerated filer status for filings due in 2019.
New C&DI 102.02 recaps the circumstances under which a reporting company that fails to qualify as an SRCcan later re-qualify if its revenues or public float decreases. Once a reporting company determines that it does not qualify as a smaller reporting company, it will remain unqualified unless, when making a subsequent annual determination, either:
- It determines that its public float is less than $200 million; or
- It determines that:
(i) for any threshold that it previously exceeded, it is below the subsequent annual determination threshold (public float of less than $560 million and annual revenues of less than $80 million); and
(ii) for any threshold that it previously met, it remains below the initial determination threshold (public float of less than $700 million or no public float and annual revenues of less than $100 million).
The C&DI provides an example where the company had exceeded one of the caps, but not the other: “A company has a December 31 fiscal year end. Its public float as of June 28, 2019 was $710 million and its annual revenues for the fiscal year ended December 31, 2018 were $90 million. It therefore does not qualify as a smaller reporting company. At the next determination date, June 30, 2020, it will remain unqualified unless it determines that its public float as of June 30, 2020 was less than $560 million and its annual revenues for the fiscal year ended December 31, 2019 remained less than $100 million.”
New C&DI 202.01 provides that in calculating annual revenues to determine whether a company qualifies as a SRC as defined in Regulation S-K, the company should include all annual revenues on a consolidated basis. As such, a holding company with no public float as of the last business day of its second fiscal quarter would qualify as a smaller reporting company only if it had less than $100 million in consolidated annual revenues in the most recently completed fiscal year for which audited financial statements are available.
New C&DI 104.13 confirms that a company that is transitioning from an SRC (in the example, the company qualifies as an SRC in 2019 but will no longer qualify in 2020 based on its public float on the last day of its 2019 second quarter) may still rely on General Instruction G(3) to incorporate by reference executive compensation and other disclosure required by Part III of Form 10-K into the 2019 Form 10-K from its definitive proxy statement to be filed not later than 120 days after its 2019 fiscal year-end.
« Regulation A+ Now Available For Publicly Reporting Companies SEC Solicits Comment On Earnings Releases And Quarterly Reports »
Regulation A+ Now Available For Publicly Reporting Companies
On December 19, 2018, the SEC adopted final rules allowing reporting companies to Rely on Regulation A to conduct securities offerings. On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law requiring the SEC to amend Regulation A to allow for its use by Exchange Act reporting companies. Since that time, the marketplace has been waiting, somewhat impatiently, for the final rule change to be implemented.
Section 508 of the Act directed the SEC to amend Regulation A to remove the provision making companies subject to the SEC Securities Exchange Act reporting requirements ineligible to use the offering exemption and to add a provision such that a company’s Exchange Act reporting obligations will satisfy Regulation A+ reporting requirements.
I have often blogged about this peculiar eligibility standard. Although Regulation A is unavailable to Exchange Act reporting companies, a company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to use Regulation A. Moreover, a company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A. A wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued. It just didn’t make sense to preclude Exchange Act reporting issuers, and the marketplace has been vocal on this.
In September 2017 the House passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A/A+ (see HERE). OTC Markets also petitioned the SEC to eliminate this eligibility criterion, and pretty well everyone in the industry supports the change. For more information on the OTC Markets’ petition and discussion of the reasons that a change is needed in this regard, see my blog HERE.
For a recent comprehensive review of Regulation A/A+, see HERE.
Recent changes in capital markets have made it more difficult for small public companies to raise capital. I believe that by opening up the simplified offering circular and SEC review procedures available through Regulation A, these companies will have a resource that allows them to access capital markets more efficiently. Furthermore, by being able to offer investors freely tradable securities, small public companies will have less pressure to enter into highly dilutive financing arrangements.
In addition to the obvious benefit to small and emerging company capital formation of allowing small reporting companies to utilize Regulation A, there is also an added potential benefit to the capital markets as a whole. The flow of freely tradable securities into the marketplace for existing public companies could have a positive uptick on the liquidity and overall growth and vitality of small-cap market trading. Institutional investors generally do not invest in thinly traded securities and accordingly, increased liquidity in the secondary marketplace could attract more institutional investments in small public companies. Likewise, increased activity could prompt additional analyst coverage for these companies.
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 siting 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.
Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.
Listen to our podcast on iTunes Podcast channel.
Noun
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, Corporate Finance in Focus. Example; “LawCast expounds on NASDAQ listing requirements.”
Anthony L.G., PLLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Anthony L.G., PLLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Anthony L.G., PLLC 2019
« SEC Provides Enforcement Driven Guidance On Digital Asset Issuances And Trading SEC Updates CDI Related to Smaller Reporting Company Definition »
SEC Provides Enforcement Driven Guidance On Digital Asset Issuances And Trading
On November 16, 2018, the SEC settled two actions involving cryptocurrency offerings which settlement requires the registration of the digital assets. On the same day, the SEC issued a public statement stating, “[T]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”
The two settled actions, CarrierEQ Inc., known as Airfox and Paragon Coin Inc., both involved an unregistered issuance of a cryptocurrency. In its statement the SEC highlighted three other recent settled actions involving digital assets and, in particular, the actions involving Crypto Asset Management, TokenLot and EtherDelta. The three additional cases involved investment vehicles investing in digital assets and the providing of investment advice, and secondary market trading of digital asset securities.
The SEC has developed a consistent mantra declaring both support for technological innovation while emphasizing the requirement to “adhere to [our] well-established and well-functioning federal securities law framework…” However, as Commissioner Hester Peirce has pointed out in her speeches, the current federal securities law may not be the best framework for the regulation of digital asset securities and their secondary trading. Although the overall purpose and structure of the Securities Act of 1933 (“Securities Act”) and its implementing rules, including the idea that the offer and sale of securities must either be registered or issued under an available exemption, and that investors are entitled to disclosure, may be appropriate, the granular requirements under the Act need to be updated to encompass new technology including blockchain and digital assets. Likewise, and maybe even more so, the broker-dealer, ATS and national exchange registration requirements, and the reporting requirement of issuers found in the Securities Exchange Act of 1934 (“Exchange Act”) and its implementing rules, need to be reviewed and updated.
Airfox and Paragon Coin Inc. – Offers and Sales of Digital Asset Securities
The SEC has brought many actions related to the offers and sales of digital assets – some before, and many after, the issuance of its Section 21(a) Report related to the offer and sale of tokens by the DAO. The Section 21(a) Report clearly laid out that a determination of whether a digital asset is a security requires an analysis using the Howey test as set out in the U.S. Supreme Court case SEC v. W. J. Howey Co. In various speeches and public statements following that Report, SEC officials, including Chair Jay Clayton, expressed their views that pretty well all ICOs to date involved the offer and sale of a security and, unfortunately, many had not complied with the federal securities laws. A slew of enforcement proceedings followed and a shift in the ICO craze to a more compliant securities token offering (STO) resulted.
However, to date, STOs have relied on registration exemptions, such as Regulation D, in their offerings rather than registration under the Securities Act. When registering an issuance under the Securities Act, an issuer must comply with the full disclosure obligations under Regulations S-K and S-X. This has proven challenging for both issuers and the SEC when the security being registered is a digital asset. Among the numerous issues to figure out have been providing a wallet to recipients, the custody of digital securities, the maintenance of a registrar and transfer agent duties, the lack of a licensed operational secondary market, cybersecurity issues, programming the digital security for the myriad of rights it may have (analogous to common stock, or completely different such that it could morph into a utility), selling and distribution methods, and the numerous issues with accepting other digital assets or cryptocurrencies as payment for the registered securities token.
If a placement agent or underwriter is involved, that placement agent or underwriter must not only resolve all of these matters, but additional issues such as escrow provisions, KYC and AML matters and even their own compensation, which typically involves not only cash, but payment in the security being sold either directly or through convertible instruments such as warrants.
These issues have not only added cost to a registration process, but time as well. The SEC has unapologetically informed registrants that the process would not follow the usual comment review timeline. Yet time has been beneficial to the entire industry as the SEC has continued to make efforts to educate its staff and figure out how to help companies successfully register digital securities. At the American Bar Association’s fall meeting in November, SEC Division of Corporation Finance (“Corp Fin”) Director, William Hinman, remarked that about half a dozen ICO S-1’s and a dozen ICO Regulation A+ filings are currently being reviewed by Corp Fin on a confidential basis.
Unlike a registration for the issuance and sale of specified securities, a registration statement under the Exchange Act registers a class of securities and thereafter makes the registrant subject to ongoing reporting requirements. Registration under the Exchange Act provides information about a company and its securities but does not involve an issuance of a security and therefore does not contain disclosures related to offers, sales, issuances, plans of distribution and the like. A registration under the Exchange Act (i.e., a Form 10) is slightly more robust than an annual report on Form 10-K and much less robust than a registration statement under the Securities Act. Although subject to some comment and review, a Form 10 registration statement automatically goes effective 60 days following the date of filing.
In the AirFox and Paragon Coin settlements, the SEC is requiring both companies to file registration statements on Form 10 to register their class of tokens under the Exchange Act. Both companies will thereafter have to file periodic reports with the SEC, including quarterly Forms 10-Q with reviewed financial statements, an annual Form 10-K with audited financial statements and interim Forms 8-K upon certain triggering events. Furthermore, the companies will be subject to the proxy rules under Section 14 of the Exchange Act and insider filing and related requirements under Sections 13 and 16 of the Exchange Act. The settlement also included penalties and an agreement to compensate an investors who elect to make a claim. Interestingly, in its statement, the SEC indicates that “[T]he registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933 (“Securities Act”) prior to the offer and sale of tokens in their respective ICOs.” As described above, I don’t really agree with the statement, but I do agree that the ongoing disclosure will provide information to investors in deciding whether to seek reimbursement or continue to hold their tokens.
Investment Vehicles Investing in Digital Assets
The Investment Company Act of 1940 (“Investment Company Act”) establishes a registration and regulatory framework for pooled vehicles that invest in securities. This framework applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities. There are several exemptions for private pooled investment funds with Section 3(c)(1) (a fund with less than 100 investors) and 3(c)(7) (a fund with only “qualified purchasers”) being the most commonly utilized. Both exemptions prohibit the fund from making a public offering of its securities. In fact, there are no Investment Company Act exemptions where a company has engaged in a public offering. Separately, the Investment Advisors Act of 1940 (“Advisors Act”) requires the registration of managers and advisors to investment companies.
On Sept. 11, 2018, the SEC issued a settlement Order in the case involving the Crypto Asset Management LP and its principal Timothy Enneking, finding that the manager of a hedge fund formed for the purpose of investing in digital assets had improperly failed to register the fund as an investment company. The Order found that the manager engaged in an unlawful, unregistered, non-exempt, public offering of the fund. The Order also found that the fund was an investment company, and that it had engaged in a public offering of interests in the fund and thus no exemption was available. The Order additionally found that the fund’s manager was an investment adviser, and that the manager had violated the antifraud provisions of the Advisers Act by making misleading statements to investors in the fund.
This case is interesting because it provided the SEC with an opportunity to make a public announcement and provide enforcement-related guidance under the Investment Company Act and Investment Advisors Act related to digital assets for the first time. Although the Investment Company Act does not allow for an exemption where there is a public offering of securities, it does allow exempted funds to utilize Regulation D, Rule 506(c) which, in turn, allows for general solicitation and advertising. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.
In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited. Generally speaking, an offering that allows for general solicitation and advertising is considered a public offering (see HERE for more information). However, in a securities law nuance, the legislation implementing Rule 506(c) specifies that if all of the requirements of Rule 506(c) are satisfied, the offering will not be deemed a public offering under the Investment Company Act (see HERE).
The Crypto Asset Management LP made a mistake in that it engaged in general solicitation and advertising, but did not comply with Rule 506(c) by ensuring that all investors were accredited and verifying accredited status. This mistake gave the SEC the opportunity to issue a statement that “[I]nvestment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.”
Trading of Digital Asset Securities
The SEC has brought multiple enforcement actions and has made public statements related to the secondary trading of digital assets, including the requirement to register as a national securities exchange or be exempt from such registration such as by operating as a broker-dealer ATS (see HERE). To date, although several broker-dealers are registered as an ATS, there is no operational secondary securities digital asset market place. In addition to SEC registration, broker-dealers must be members of FINRA, who regulates specific operations, including related to an ATS (see HERE and HERE).
The SEC’s recent enforcement action against the founder of EtherDelta, a platform facilitating the trading of digital assets securities, underscored the SEC’s Division of Trading and Markets’ ongoing concerns about the failure of platforms that facilitate trading in digital asset securities to register with the SEC or operate under a proper exemption from registration. According to the SEC’s order, EtherDelta, which was not registered with the SEC in any capacity, provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain. EtherDelta’s smart contract was coded to, among other things, validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. The SEC found that EtherDelta’s activities clearly fell within the definition of an exchange.
An analysis as to whether an entity is operating as an exchange requires a substance-over-form facts-and-circumstances review, regardless of terminology used by the operator. For example, if a system “brings together orders of buyer and sellers” – if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution – it is likely an exchange. Likewise, a system that uses non-discretionary methods to facilitate trades or bring together and execute orders, may fall within the definition of an exchange.
Even if an entity is not operating as an exchange, or would not require a full ATS license, it may be required to register as a broker-dealer. Entities that facilitate the issuance of digital asset securities or their secondary trading may be required to register as a broker-dealer. Section 15(a) of the Exchange Act provides that, absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered in accordance with Section 15(b) of the Exchange Act. Section 3(a)(4) of the Exchange Act generally defines a “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others. Section 3(a)(5) of the Exchange Act generally defines a “dealer” to mean any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise. As with the “exchange” determination, a substance-over-form analysis must be applied to assess whether an entity meets the definition of a broker or dealer, regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.
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 Journalop-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.
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 siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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