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

SEC Continues to Review, And Delay, Crypto Funds

Posted by Securities Attorney Laura Anthony | May 22, 2018 Tags: And Delay, Crypto Funds, SEC Continues to Review, SEC Continues to Review Crypto Funds

On January 18, 2018, the SEC issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or mutual fund. The letter, authored by SEC Division of Investment Management director Dalia Blass, explains the SEC’s reservations and concerns about approving a crypto-related mutual fund or ETF. The letter advised against seeking registration of funds that invest heavily in cryptocurrency-related products until the raised questions and concerns can be properly addressed.

The SEC letter comes a year after the SEC rejected a proposal by Cameron and Tyler Winklevoss, famously linked to the founding of Facebook, to create a bitcoin-tracking ETF. Since that time the SEC has privately rejected several similar requests. Many in the industry appreciate the SEC letter as it offers specific guidance and concrete issues to be addressed as the march towards the eventual approval of a crypto-related fund continues.

Since the January 18 letter, the SEC has been reviewing and conducting proceedings on a New York Stock Exchange (NYSE) proposal to list and trade five bitcoin-related ETFs. The proceedings are expected to go on for a few months. This blog will begin with an explanation of what exactly is an ETF and then address the SEC’s concerns related to the clearance of crypto-related ETFs.

What is an ETF?

Exchange traded funds or ETFs are funds that track indexes. Historically, exchange traded funds have tracked big-board indexes such as the Nasdaq 100, S&P 500 or Dow Jones; however, as ETFs have risen in popularity, there are now funds that track lesser-known indexes or specially created indexes to feed the ETF market. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small-growth, large-growth, etc.); and commodities. The primary difference between an ETF and other index funds is that an ETF does not try to outperform the corresponding index, but rather tries to track and replicate the performance.

An ETF allows an investor the advantage of copying an index with a single stock trade, without the risk associated with a fund manager trying to outperform the market. Since the fund manager is simply copying and mirroring the particular index, the management style is referred to as “passive management.”

Passive management reduces the administrative costs from an actively managed portfolio, and that savings can be passed down to the investors. A typical private hedge fund charges 2% per annum for administrative fees. That fee is reduced to 1% for mutual or registered funds. The typical fee for an ETF is less than .20% per year. Moreover, since an ETF does not trade as actively as typical funds, it has fewer capital gain events and therefore lower taxes.

An ETF trades just like a stock, with continuous trading throughout a day. ETFs are generally margin-eligible and accordingly can be sold short. Conversely, mutual funds are generally only priced once a day after market closings and are not margin-eligible.

ETFs have become increasingly popular over the years, especially with investors that are interested in market sectors, regions or asset types. It is not surprising that investors are interested in crypto-related ETFs and that fund creators are likewise trying to meet this investor demand.

SEC Position on Crypto-related Mutual Funds and ETFs

As mentioned, On January 18, 2018, the SEC Division of Investment Management issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or similar investment product such as a mutual fund.

The SEC begins with its commitment to fostering innovation and the development of new types of investment products, ETFs being a primary example, but quickly continues with the assertion that multiple investor protection issues need to be resolved before a crypto-related fund could be offered. The primary issues are valuation, liquidity, custody, arbitrage, potential manipulation and other risks.

The concerns and questions raised by the SEC will also impact future changes to exchange listing standards by the Division of Corporation Finance, the Division of Trading and Markets and the Office of the Chief Accountant. The SEC foresees needed changes to accounting, auditing and reporting requirements for crypto-related funds and ETFs.

Valuation

Mutual funds and ETFs must value their assets on each business day in order to reach a net asset value (“NAV”). NAV is used to determine fund performance, what investors pay for mutual funds and what authorized participants pay for ETFs as well as what they receive when they redeem or sell. The SEC is concerned that a fund or ETF would not have the necessary information to value a cryptocurrency as a result of their volatility, fragmentation, lack of regulation, nascent state and current trading volume (or lack thereof) in the cryptocurrency futures markets.

The SEC has requested that the industry evaluate and provide information as to how valuations would be conducted. Furthermore, the SEC has asked how funds would develop and implement policies and procedures related to crypto-related valuations to ensure that the requirements as to fair value are met. Likewise, the SEC would need satisfaction that a fund or ETF could adequately address the accounting and valuation impacts of “forks” such as when a cryptocurrency diverges into two separate currencies with different prices.

The SEC questions the policies a fund would implement to identify and determine eligibility and acceptability for newly created cryptocurrencies. The SEC has concern as to how a fund would consider the impact of market information and manipulation in the underlying cryptocurrency markets as related to the determination of the settlement price of cryptocurrency futures.

Liquidity

Investments in open-ended funds such as mutual funds and ETFs are redeemable on a daily basis and as such, the funds must maintain sufficient liquid assets to satisfy redemptions. Rule 22e-4 promulgated under the Investment Company Act of 1940 (the “1940 Act”) requires funds to implement liquidity risk management programs. Under the rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets.

The SEC is concerned with the steps a fund or ETF that invests in cryptocurrencies or crypto-related products would take to ensure that it would have sufficient liquidity to meet daily redemptions. Moreover, the SEC raises questions as to how such funds would satisfy Rule 22e-4 and in particular, how could any crypto-related investment be classified as anything other than illiquid under the rule.

The SEC specifically asks how such funds would take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market-depth analysis in light of these factors. Similarly, given the fragmentation and volatility in the cryptocurrency markets, would these funds need to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the value of underlying assets.

Custody

The 1940 Act provides for certain requirements related to the custody of securities held by funds, including who may act as a custodian and when funds must verify holdings. The SEC questions how a fund or ETF could satisfy the custody requirements for cryptocurrency-related products. The SEC notes that there are currently no custodians providing fund custodial services for cryptocurrencies. Likewise, although currently all bitcoin future contracts are cash-settled, if physical settlement contracts develop, the SEC questions how a fund will custody the bitcoin to make delivery.

The SEC further questions how a fund will validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records. Another issue for cryptocurrencies is cybersecurity and the threat of hacking. The SEC has concerns about how custodians can satisfy their requirements for the safekeeping of crypto assets.

Arbitrage for ETFs

ETFs obtain SEC orders that enable them to operate in a specialized structure that provides for both exchange trading of their shares throughout the day at market-based prices, and “creation unit” purchases and redemptions transacted at NAV by authorized participants. In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV. The SEC questions how an ETF could comply with the terms of an order considering the fragmentation, volatility and trading volume in the cryptocurrency marketplace.

The SEC would like funds to engage with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products. The SEC also questions how trading halts or the shutdown of a cryptocurrency exchange would affect the market price or arbitrage.

Potential Manipulation and Other Risks

The SEC believes that the current cryptocurrency markets have substantially fewer investor protections than traditional securities markets. Moreover, the SEC, other federal regulators, and state regulators have found considerable fraud in the cryptocurrency marketplace. The SEC is concerned about how a fund would address fraud concerns in the underlying markets when offering investments in the fund to retail investors. Similarly, the SEC is concerned about the disclosure of, and ability for a retail investor to understand, the risks of an investment in a crypto-related fund.

Likewise, the SEC would like funds to engage in discussions with broker-dealers who may distribute the funds, as to how the broker-dealer will satisfy their suitability requirements. The SEC is also concerned with how an investment advisor will satisfy their fiduciary obligations when recommending a crypto-related fund.

Further Reading on DLT/Blockchain and ICOs

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

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

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

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

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

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

For a review of the CFTC 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.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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« OTC Markets Makes Several Regulatory Recommendations Multiple Classes of Stock and the Public Company »

OTC Markets Makes Several Regulatory Recommendations

Posted by Securities Attorney Laura Anthony | May 15, 2018 Tags: OTC Markets, OTC Markets Makes Several Regulatory Recommendations

On March 8, 2018, Cromwell Coulson, CEO of OTC Markets Group, made a presentation to the SEC’s Investor Advisory Committee (“IAC”) as part of a panel on “Discussion of Regulatory Approaches to Combat Retail Investor Fraud.” During the meeting, Mr. Coulson discussed the most serious market risks and presented a list of 14 OTC Market’s regulatory recommendations to improve disclosure and combat these market risks.

A review of OTC Markets website on April 24, 2018 shows 10,469 traded securities, $1.1 billion volume, 7.2 billion share volume and 174,268 trades. In his remarks to the IAC, Mr. Coulson points out that 98% of the traded dollar volume of companies on OTC Markets make current information available. Echoing the SEC’s “Main Street investor” focus, he states that “[W]e have many stocks on our markets that are completely appropriate to be part of a diversified, long term, investment portfolio, of a main street investor; we also have speculative securities that are only appropriate for risk tolerant trader.”

However, certainly the trading in all equity securities, and especially small-cap securities, has risk. Mr. Coulson identifies what he believes are the three biggest risks to retain investors. In particular: (i) manipulative online promotion, including fraudulent and misleading information; (ii) share dilution, including through equity line financings, toxic convertible instruments and illegal share distributions; and (iii) bad actors, with a suggestion to allow for a speedy trading freeze to prevent ongoing frauds. I note that in its recent comment letters to FINRA related to the 15c2-11 process, OTC Markets suggested that it be given the power to institute short-term trading halts in response to improper activity and/or a lack of proper disclosure (see).

As part of OTC Markets’ recently adopted stock promotion policy and best practices guidelines to improve investor transparency (see HERE), OTC Markets conducted an investigative initiative to track promotion activities. Coulson indicates that data reveals that 70% of dollar volume of securities impacted by promotional activities are listed and trade on national exchanges. Moreover, promoted securities usually have significant share dilution and are rarely suspended by the SEC. Although OTC Markets stock promotion policies are helpful, Mr. Coulson suggests that regulatory modernization is also needed to require increased disclosure of online paid stock promotion and the people behind such promotions.

Coulson also addressed the issue of short selling. Internet-based forums, especially anonymous forums that are used for stock manipulation, misinformation and fraudulent promotions, proclaim that short selling in small-cap securities is rampant and the cause of downward pricing pressure. The reality is that short selling in small-cap securities is generally minimal due to the high cost of borrow interest and coverage requirements. Most short selling is small companies is completed by market makers with a requirement to close out within 2 days. Coulson actually suggests that in addition to greater transparency and reporting of short selling activity, regulatory changes should be made to encourage heathy short selling and price stabilization efforts by market makers.

Another topic of concern and interest involves the illegal issuance of securities and affiliate trading. Coulson suggests transparency and information can help this issue. In particular, Coulson advocates for increasing the role of transfer agents as record keepers. I note that he did not use the words “gate keepers” and it is unclear from the transcript if that implication was there. On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. See HERE. No further action has been taken since that time, and rules related to transfer agents have been moved from the SEC short-term agenda to long-term actions.

Also to further transparency related to illegal issuances and affiliate trading, Coulson suggests ending anonymous Objecting Beneficial Owner (OBO) accounts for affiliates of issuers. Likewise, Coulson suggests adding a reporting requirement similar to Forms 3, 4 and 5 under Section 16 for non-SEC reporting companies. For more on Section 16, see HERE.

To help combat fraud and provide a deterrent to bad actors, Coulson supports increased cooperation and communication between market operators, such as OTC Markets, and regulators. Using the analogy of real-time monitoring for credit card fraud, Coulson suggests real-time monitoring and responses by market operators to red flags and indicia of fraud. In order to make preventative responses feasible, there would have to be a system to allow for a relatively quick investigation and re-onboarding of trading for affected companies.

Coulson notes that much of the fraud in smaller public company trading emanates from unregulated intermediaries that have acquired shares in the private financing markets and are seeking to stimulate investor buying interest, so they can sell their shares. Although Coulson does not talk about regulating finders as a response to this problem, he does talk about stimulating financing options for smaller companies. I am a champion of a workable regulatory regime for finders and, as such, cannot pass this opportunity to raise the issue. For more on the current state of the law and my views, see HERE.

To stimulate financing options, Coulson suggests allowing SEC reporting companies to utilize Regulation A+ and increasing shelf registration options. I’ve written many times about my support for an amendment to Regulation A+ to allow SEC reporting companies to complete offerings. For more on Regulation A+ in general, see HERE and particularly related to the OTC Markets comment letter and arguments for allowing reporting companies to be eligible to use the offering, see HERE.

Coulson completed his presentation by talking about another topic that has been oft debated and for which I have strong opinions, and that is venture exchanges. The OTC Markets has worked hard to position itself as a venture exchange, but unfortunately has not received legislative support. In fact, OTC Markets does not always receive due regard at all from the SEC and Wall Street. Back in December 2016, the SEC issued a white paper on penny stocks in which it inaccurately, albeit implicitly, lumped all OTC Markets securities together as penny stocks and as providing limited disclosure. See HERE. To the contrary, one of the requirements to trade on the OTCQX tier of OTC Markets is that the security not be a penny stock. See HERE. Both the OTCQB and OTCQX require fairly robust disclosure, including audited financial statements. OTC Markets also has a flag which appears on a company’s quote page to identify if a particular security is exempt from the definition of a penny stock.

Mr. Coulson points out that in 2017, 61 companies graduated from the OTC Markets to a national exchange, illustrating the venture function of OTC Markets. Furthermore, realizing the need for legislation, Coulson states that any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets). For more on the importance of venture exchanges and specifics on how they should operate, see HERE.

Coulson rightfully adds, “[E]xchange listing is not a clear solution to solving the problems at hand. We need a more holistic approach, focusing on better investor information, rather than the hard-and-fast assertion that every exchange-traded security is safe, while all other securities are risky.”

Complete List of OTC Markets Regulatory Recommendations

The following is the full list of the 14 regulatory recommendations by OTC Markets.

Increase Paid Promoter Disclosure – OTC Markets recommends amending Securities Act Section 17(b) to require additional disclosures related to paid stock promotion and the people involved in such promotions. For more on stock promotion and Section 17(b), see HERE.
Provide More Disclosures from Affiliates, Insiders and Institutions – As discussed above, OTC Markets suggests limiting anonymous Objecting Beneficial Owner accounts for affiliates. Moreover, insider and affiliate trading should be reported by all publicly traded companies and not just those subject to the Exchange Act reporting requirements. The reporting requirements should be similar to those under Section 16 for reporting companies. OTC Markets also suggests expanding Exchange Act Section 13(f) to OTC traded securities, requiring institutional investment managers to disclosure their holdings in all publicly traded securities, including short positions.
Improve Share Issuance Compliance – OTC Markets suggest that transfer agent regulations be modernized to provide broker-dealers with reliable information on the issuance, ownership and transfer history of shares.

4, Enable More Real-time SEC Enforcement – Interdealer quotation systems (IDQS) (like OTC Markets) should monitor ongoing disclosure by companies and have the ability to monitor and label late or deficient disclosures (such as OTC Markets does now). Furthermore, the SEC should work with these market operators to take quick action where there are indications of fraud, including with trading halts and suspensions.

Short Sale Reform – Require the timely disclosure of short sale positions and of aggregate industry activity. Also, allow more market maker short selling activity by amending Regulation SHO to extend the close-out time for short positions in OTC equity securities to 6 days as is current allowed for exchange traded securities.
Allow SEC Reporting Companies to Use Regulation A+ – See discussion above. In addition, 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.
Allow Companies to Sell Shares Directly into the Market – Allow companies that trade on an exchange or an established public market to easily sell their shares directly in the market.
Facilitate Competition in Venture Exchange Legislation – A monopoly venture exchange should be avoided. As discussed above, any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets).
Adopt Investor Suitability Standards Based on Experience and Risk Tolerance – Broker-dealers should be allowed to establish risk profiles based on trading experience and overall risk tolerance. Similar to this suggestion, I would suggest a modification to the accredited investor definition in line with the SEC Advisory Committee on Small and Emerging Companies’ prior recommendations, including expanding the definition to take into account trading experience. See HERE.
Allow Payments for Market Making – FINRA Rule 5210 should be amended to allow broker-dealers to be compensated for out-of-pocket expenses associated with preparing and submitting a Form 211 to FINRA. For more, see HERE.
Bring Back the Federal Reserve OTC Margin List – Non-penny stock OTC securities should be marginable. OTC Markets suggests two possible solutions: (i) give the SEC, rather than the Federal Reserve Board, oversight of margin eligibility, or (ii) the margin list that was historically published by the Federal Reserve under Regulation T should be reinstated to make margin-eligible all non-penny stocks that are actively traded on “established public markets.”
Allow Small Companies to Effectively Provide Employee Stock Ownership Plans (ESOPs) – IRS regulations limit the ability for non-exchange traded companies to effectively offer ESOP’s to employees. The definition of an “established securities market” contained in IRS regulations should be updated to include securities quoted on OTC Markets Group’s OTCQX and OTCQB markets.
Allow Trading Venues to Review and/or Submit FINRA Form 211 Filings – Currently only market makers may submit a Form 211 to FINRA. Trading venues registered with the SEC and FINRA should also be allowed to do so. For more on this, see HERE.
Update the SEC Definition of Penny Stocks (Exchange Act Rule 3a51-1) – Currently, biotech and other research-heavy companies may not meet the net tangible assets exemption (Subsection (g)(1)) from the definition of a penny stock. The review standard for net tangible assets (Subsection (g)(3)) should be updated to take into account interim capital raises for these types of companies. For more on the penny stock rules, see HERE.

The Author

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« Going Public Without An IPO SEC Continues to Review, And Delay, Crypto Funds »

Going Public Without An IPO

Posted by Securities Attorney Laura Anthony | May 8, 2018 Tags: Going Public Without An IPO, Spotify

On April 3, 2018, Spotify made a big board splash by debuting on the NYSE without an IPO. Instead, Spotify filed a resale registration statement registering the securities already held by its existing shareholders. The process is referred to as a direct listing. As most of those shareholders had invested in Spotify in private offerings, they were rewarded with a true exit strategy and liquidity by becoming the company’s initial public float.

In order to complete the direct listing process, NYSE had to implement a rule change. NASDAQ already allows for direct listings, although it has historically been rarely used. To the contrary, a direct listing has often been used as a going public method on the OTC Markets and in the wake of Spotify, may gain in popularity on national exchanges as well.

As I will discuss below, there are some fundamental differences between the process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol up front and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol. For more on the 15c2-11 process, see HERE. Moreover, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A benefit to the company is that it has received funds much earlier in the process, rather than after a registration statement has cleared the SEC. The cost of completing an audit and legal fees associated with the registration process is expensive and is usually borne up front prior to receiving investor funds in a traditional IPO process.

Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering. One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees. For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.

The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Generally a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.

Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering.

Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace, a debate which has resulted in increased offering exemptions for non-accredited investors such as Regulation Crowdfunding, the fact remains that the early investors take on greater risk and as such need to be able to financially withstand that risk. For more on the accredited investor definition, see HERE.

The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.

Although Spotify’s shares increased in value since debuting on the NYSE, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option.

An overallotment option, often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing, is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.

A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).

Direct Listing on OTC Markets

There are some fundamental differences between the direct listing process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol upfront and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol. For more on the 15c2-11 process, see HERE.

When completing a direct listing onto OTC Markets, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

Overall the direct listing process is a little less expensive and little quicker than a direct IPO process. The reason for this is that the company can work with a market maker to apply for a trading symbol immediately upon effectiveness of the S-1 as opposed to having to wait until after an offering has been sold and closed out.

The following is a summary of the direct listing process for an OTC Markets listing. To begin, a company should retain its team including legal, accounting and auditor. The company will also need a transfer agent and EDGAR agent. Our firm often makes referrals and recommendations as to various other service providers. Moreover, a company may use a broker-dealer placement agent in the private offering phase.

Generally, counsel will prepare a full transaction checklist including who is responsible for what items from the beginning until completion of the direct listing. The beginning of the process includes gathering due diligence and completing any corporate cleanup or reorganization that may be necessary in advance of a public listing. All companies need some level of cleanup, which can include amending articles of incorporation and bylaws to make them public company-friendly; creating employee stock option plans; entering into employment contracts with key officers; ensuring that licensing agreements and intellectual property rights are secure; adding board members and committees such as an audit committee; and establishing corporate governance including an insider trading policy.

While the company’s accounting and auditing are being completed, legal counsel will complete corporate cleanup and begin to draft the private offering documents, if the company is completing a new private offering round (sometimes a company begins the process after several prior rounds of offerings and will not need to complete another). In addition, legal counsel, together with the investment bankers if any, and other advisors will work with the company to determine valuation and the best structure for the private offering and the registration statement pricing. The final registration statement pricing will not need to be determined until the final pre-effective amendment is filed with the SEC.

Ultimately a company will be registering common stock and that common stock will trade on the OTC Markets, but the private placement investment itself can take many forms, including convertible preferred stock, units consisting of current equity in the form of common and/or preferred stock and options or warrants, or units consisting of any combination of debt and equity. For more on the form of an investment and various options, see HERE. Furthermore, private offerings often include registration rights agreements to require the company to file a resale registration statement within a certain period of time.

In structuring the private offering(s) and subsequent resale registration statement, thought must be given to the public trading markets, including obtaining a trading symbol, qualifying for various tiers of OTC Markets, and hopefully, having an active trading market. Part of this process includes planning for the Form 211 Application, which will be filed by a market maker after effectiveness of the S-1 registration statement.

When reviewing a market maker’s Form 211 application for the issuance of a trading symbol, FINRA conducts an in-depth review of the company, its shareholders and capitalization. See HERE. One matter which FINRA reviews in determining whether to grant a trading symbol is “concentration of ownership.” FINRA will not grant a trading symbol unless there are enough non-affiliated shareholders holding freely tradeable shares, to establish a public float. Although there is no rule on this, my experience indicates that an initial float must be comprised of a minimum of 30 shareholders with more being better. FINRA will also consider the percentage of the company owned by these non-affiliated shareholders. Again, although there is no hard rule, in order to obtain a trading symbol, at least 20% or greater of the company’s common stock, on a fully diluted basis, should be in the hands of the public float.

Likewise, OTC Markets now considers concentration of ownership in determining whether to grant an application to trade on the OTCQB or OTCQX tiers. OTC Markets generally follows the same parameters as FINRA, though if other red flags or negative factors exist, such as recent shell company status, at least 25%-30% of the company common stock, on a fully diluted basis, will need to be in the hands of the public float in order to trade on these higher tiers.

Furthermore, counsel must be sure to assist with any blue sky compliance in the process. For more on blue sky compliance, see my two-part blog HERE and HERE.

Once all private offerings are completed and the company has its intended capital structure and number of shareholders, and the company audit is completed, the S-1 registration statement will be drafted and filed with the SEC. A company can choose to file confidentially but will need to make all filings public at least 15 days prior to the registration statements effectiveness. For more on confidential filings, see HERE.

Within 30 days of filing the S-1 registration statement, the company will receive initial comments from the SEC. The comment and review process will continue with the SEC for approximately 3-4 months, at which time the SEC will clear the S-1 to be declared effective. When a company is trading on a national exchange, they have generally timed the application with the exchange so that the shares begin trading shortly after the S-1 is declared effective and in particular, upon filing and effectiveness of a Form 8-A to complete the full registration process for the company. A Form 8-A is discussed further below.

In an OTC Markets listing, a Form 211 Application must be filed with FINRA to receive a ticker symbol and begin trading. The Form 211 is filed by a market maker. Generally, a company will begin to speak with a market maker shortly before the filing. The FINRA process will take a minimum of two weeks and can go on for several months. Preparation of an organized and complete file will make a big difference in the timing of the process.

Concurrent with the Form 211 process, the company will apply to OTC Markets and determine which tier it qualifies for. Once FINRA issues a ticker symbol, the company can trade; however, to gain liquidity the company will also need to obtain DTC eligibility. The market maker that assists with the Form 211 Application can submit the DTC application as well. The stockholders listed in the S-1 registration statement are free to sell their registered shares at the price registered with the SEC.

Direct Listing on NASDAQ

NASDAQ has allowed for a direct listing although historically it has rarely been used. The process to achieve a direct listing on NASDAQ is substantially the same as OTC Markets with some key differences. This section will only discuss the differences. The biggest difference is that when completing a direct listing onto an exchange, the exchange issues a trading symbol upon effectiveness of the registration statement and filing of an 8-A, and the shares are then available to be sold by the selling stockholders at prevailing market prices.

An S-1 registration statement is a registration statement filed under the Securities Act of 1933. In order to qualify to trade on a national exchange, a company must also be registered under the Securities Exchange Act of 1934. This is not a requirement for OTC Markets. A Form 8-A is a simple (generally 2-page) Exchange Act registration form used instead of a Form 10 for companies that have already filed the substantive Form 10 information with the SEC (generally through an S-1). When the Form 8-A is for registration with a national securities exchange under Section 12(b) of the Exchange Act, the 8-A becomes effective on the later of the day the 8-A if filed, the day the national exchange files a certification with the SEC confirming the listing, or the effective date of the S-1 registration statement.

Direct Listing on NYSE

An NYSE direct listing follows the same process on NASDAQ; however, previously NYSE rules required an underwriter to determine or at least sign off on valuation in connection with an initial public offering. On February 2, 2018, the SEC approved a proposed rule change by the NYSE to allow a company that had not previously been registered with the SEC and which is not being listed as part of an underwritten initial public offering, to apply for and if qualified, trade on the NYSE. The amended rules modify the provisions relating to qualification of companies listing without a prior Exchange Act registration in connection with an underwritten initial public offering and amend Exchange rules to address the opening procedures on the first day of trading of such securities.

The rule amendments modify the determination of market value such that the NYSE has discretion to determine that a company meets the minimum market value requirements for a listing based on an independent third-party valuation.

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« ABA Comment Letter On Disclosures Under Regulation S-K OTC Markets Makes Several Regulatory Recommendations »

ABA Comment Letter On Disclosures Under Regulation S-K

Posted by Securities Attorney Laura Anthony | May 1, 2018 Tags: ABA Comment Letter On Disclosures Under Regulation S-K

In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. Like the SEC’s ongoing Disclosure Effectiveness Initiative, the ABA has a Disclosure Effectiveness Working Group as part of its Federal Regulation of Securities Committee (of which I am a member) and its Law and Accounting Committee.

The ABA comment letter begins with a general discussion of the materiality concept, which is the underlying basis of disclosure, and then provides input on various specific areas of disclosure under Regulation S-K. The ABA comment letter specifically responded to the SEC concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

I’ve been writing about Regulation S-K and the SEC Disclosure Initiative since at least early 2015. Although consistently a priority, with the finalization of proposed rule changes on the SEC short-term agenda (see HERE), a complete overhaul of Regulation S-K (and Regulation S-X) is a fluid, ongoing process that will likely continue for years to come.

Materiality

Materiality is a concept I’ve written about several times (see HERE, for example,). Regulation S-K and Regulation S-X provide specific disclosure requirements that are measured and supplanted by the materiality concept. Specific disclosure requirements generally involve objective quantitative or bright-line-rule-based standards. In addition, to those specific disclosure requirements, a company must disclose any other material information necessary to make required disclosures not misleading. Materiality requires a facts-and-circumstances analysis. In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.

The ABA comment letter discusses the materiality standard’s application to specific Regulation S-K disclosure requirements. As noted by the ABA, the SEC recognizes that it has “adopted different approaches to guide registrants in evaluating materiality for purposes of disclosure, including in some cases using quantitative thresholds to address uncertainty in the application of materiality.” In some cases, Regulation S-K is “principles-based” in that it directs the company to apply the materiality standard directly to the facts at hand. 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 ABA comment letter notes the necessity of balancing rule-based disclosures with those that require a materiality analysis. There is a degree of uncertainty in a materiality analysis and coupled with situations with a potential conflict of interest, such as disclosures related to officers and directors, or those that have a social application such as conflict minerals, the SEC leans towards a more specific rule-based approach. However, with ever-lengthening disclosure documents filled with irrelevant and non-material information, the principles-based materiality standard is gaining favor.

To balance the approaches, the ABA suggests subjecting almost all Regulation S-K disclosure items to a materiality analysis. A company would be required to evaluate each Item in Regulation S-K , thereby preserving the rigor of a rules-based system, but would be permitted to omit information, even if disclosure would otherwise be specifically required, if such information is not material and the inclusion of the information is not necessary to make any required statements not materially misleading. Exceptions to this approach would include disclosures involving conflicts of interest such as related party transactions and executive compensation.

The ABA specifically recommend amending Item 10 of Regulation S-K to add the following subsection (g):

(g) In addition to the information expressly required to be disclosed, the registrant shall disclose such additional material information, if any, as may be necessary to make the required statements in the light of the circumstances under which they are made not misleading. Issuers may omit information otherwise called for by a line item, except for Items 402 and 404, if such information is not material, as long as the effect of omitting the information would not be materially misleading. It shall be presumed, in the absence of facts to the contrary, that the omission of any disclosure called for by a Regulation S-K line item was an intentional omission by the registrant in reliance upon this sub-section (g) and not a failure to provide the disclosure called for by such line item.

Known Trends or Uncertainties

Known trends and uncertainties is a category of discussion included in Management Discussion and Analysis of Financial Conditions (MD&A). Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons. The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others). The SEC proposed rule change published on October 11, 2017 would allow a company to eliminate the earliest year in its discussion as long as (1) the discussion is not material to an understanding of the current financial condition; and (ii) the company has filed a prior Form 10-K with an MD&A discussion of the omitted year. The proposed amendment would also eliminate the reference to a five-year look-back in the instructions, but rather a company would be able to use any presentation or information that it believes will enhance a reader’s understanding. The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.

Item 303(a) also requires a discussion of known trends or uncertainties that have had or that the company reasonably expects will have a material effect, either positive or negative, on its liquidity, capital resources or results of operations. A discussion of trends is forward-looking, related to potential future performance. Although the ABA believes the information is relevant and important, it expresses concerns about the SEC’s interpretations and guidance on the disclosure requirement.

The SEC guidance on trends (SEC Release 33-6385, published in 1989) states that where a trend, demand, commitment, event or uncertainty is known, management must: (i) assess whether the trend is reasonably likely to come to fruition, and if not disclosure is not required; (ii) if unsure, management should assume it is reasonably likely and then determine the impact on the company financial condition and if such impact is material. Unless the impact is not material, disclosure is required.

The ABA advocates replacing the SEC’s current guidance with an analysis based on the Supreme Court case of Basic, Inc. v. Levinson, which created a probability vs. magnitude test for materiality. In Basic the Supreme Court set the standard as “Under such circumstances, materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’”

The ABA also notes recent uncertainty in the law on the question of whether a failure to disclose is necessarily a violation of the antifraud provisions under Section 10(b) and Rule 10(b)(5). In particular, different federal circuit courts have reached different conclusions on the subject, and the U.S. Supreme Court has recently refused to review the matter to provide clarity. The ABA would like the SEC to address this discrepancy in rule making by affirmatively asserting that whether a failure to disclose is a violation of antifraud provisions depends on a facts-and-circumstances analysis.

Critical Accounting Estimates

MD&A also requires a discussion of critical accounting estimates. The ABA suggests that the SEC amend Item 303 to specifically require a discussion of the judgements and assumptions that management must make in order to prepare, and that have the most significant impact on, the company financial statements. The ABA suggests that the SEC clarify that the discussion should not just be a cut-and-paste of the critical accounting footnote in the financial statements, as is often the case now. Rather, the MD&A discussion should supplement the more technical footnote disclosure to help investors have a better understanding of the impact these assumptions have on the company’s financial disclosure. The discussion could even provide examples of what the financial statements might contain if different assumptions were made.

The SEC has made inroads into eliminating duplicative disclosure, including requesting comment and raising the issue of whether items duplicated in financial statement footnotes and other parts of a report should be maintained in only one or the other section or incorporated by reference from the footnotes to another section such as MD&A. Several important factors affect this dialogue, including that (i) an auditor must audit and therefore has responsibility for the contents in the financial statement footnotes, including any related discussion in the audit report (see HERE related to the new audit report requirements) which could increase audit costs and burdens; and (ii) items in the financial statement footnotes are not protected by the forward-looking statements’ safe harbors. As such, the ABA recommends any enhanced disclosure related to accounting estimates and judgments only be included in the MD&A section of a report.

Strategy

Although SEC rules do not require a disclosure of business strategy, many companies include a stand-alone discussion, especially in an IPO context. The ABA suggests adding business strategy as a required category under Item 101 Description of Business. The ABA also suggests leaving the category undefined instead letting companies look to generally accepted understandings and their own business ideas. I do not agree with this suggestion from the ABA. I am generally not an advocate of additional requirements and would suggest leaving it as is with voluntary discussion where appropriate.

Intellectual Property Rights

The SEC has discussed expanding the intellectual property disclosures in Item 101. The ABA advocates protection of intellectual property and trade secret information. Among many issues is the loss of protection afforded trade secret or confidential information once published and in the public, the ability to identify copyright information created by employees, and identifying which distinctive marks are subject to common law trademark protection. As such, it recommends that the SEC not expand its current requirements.

Sustainability

The topic of social disclosure has been much debated over the past few years. In a report issued in October 2017, the U.S. Department of the Treasury recommended eliminating special interest and social disclosure from the SEC disclosure rules, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Financial Choice Act would eliminate these provisions as well. See HERE. Climate change disclosure is another area of debate. On the other hand, institutional investors have asserted a social agenda, and disclosure of same, in the proxy process and voting on directors. The power of these funds and investors is not one a company can ignore.

The ABA supports the SEC’s guidance related to social issues, which is principles-based and generally would be included in MD&A or risk factor disclosures. The ABA includes sustainability, public policy, environmental, social and governance matters in this broad category. The comment letter supports a materiality analysis related to disclosure. However, I note that materiality would require an analysis as to whether such disclosure is important to a “reasonable investor.” As noted above, many institutional investors push their own social agenda, and thus disclosures related to same, even if a reasonable investor may not find the information material.

Disclosure of these social issues breeds emotional arguments and extreme viewpoints. Those that advocate for eliminating the disclosure requirements do so strongly, and those that believe there is not enough disclosure or enforcement in the area, believe so fervently. The ABA comment letter suggests adding rules that will assist companies in determining the level of disclosure, but qualifying those rules with a materiality standard. However, the ABA notes the complexity in this area and the need for careful evaluation, as well as the probability of a fluid, changing investor environment and thus a changing view of the “reasonable investor.”

Litigation

Item 103 requires disclosure of material pending private civil and governmental regulatory legal proceedings and certain other specified pending or contemplated legal proceedings to which an issuer or its property is subject. Legal proceeding disclosures may also be appropriate in MD&A, risk factors and financial footnotes. Although Item 103 puts all matters in one location, it often does not include any important information beyond factual information about the proceedings. The ABA suggests even further reducing the disclosure in Item 103 to a catalogue with cross-references to more robust disclosures in other sections of a report. Finally, the ABA recommends reevaluating the requirement related to disclosure of “contemplated” governmental proceedings to those that have been asserted or have a probability of being asserted.

Risk Factors

The disclosure of risk factors is complex enough that I once wrote a blog on just that topic. See HERE. Almost all SEC guidance on disclosure matters includes a discussion of risk factors, such as the recent guidance on cybersecurity disclosure (see HERE).

Risk factor disclosures are entirely principles-based. That is, there are no bright-line prescriptive rules that require a specific risk disclosure. Although the SEC consistently suggests only including risk factors that actually impact a company, and not boilerplate disclosures that could impact all businesses, most companies include the boilerplate disclosures. Companies are more concerned with the plaintiff’s bar and potential shareholder lawsuits for the failure to include a risk factor than the SEC guidance in this regard. Likewise, an SEC suggestion to limit the number of risk factor disclosures, or to order these disclosures in terms of management’s view of their priority or assessment of probability and magnitude of the potential impact, was met with strong issuer opposition—again, likely from a fear of shareholder litigation.

The ABA comment letter makes a number of specific recommendations related to risk factor disclosures. Despite opposition, the ABA suggests that the SEC consider limiting the number of risk factors and require that they be listed in order of priority. Similarly, the ABA suggests a specific requirement that companies omit generic risk factors from their reports and registration statements. Although it does not suggest disclosing the probability of a particular risk, the ABA does advise that companies conduct a probability/magnitude assessment in its risk factor disclosures.

Further Background on SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.

In October, 2017 the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.

On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE.

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. This proposal is slated for action in this year’s SEC regulatory agenda.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Both of these items are slated for action in this year’s SEC regulatory agenda.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE. These items are all included in this year’s SEC regulatory agenda.

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« What is a SAFT? Going Public Without An IPO »

What is a SAFT?

Posted by Securities Attorney Laura Anthony | April 24, 2018 Tags: What is a SAFT

A Simple Agreement for Future Tokens (“SAFT”) is an investment contract originally designed to provide a compliant alternative to an initial coin offering (ICO). A SAFT as used today was intended to satisfy the U.S. federal securities laws, money services and tax laws and act as an alternative to an ICO when the platform and other utilization for the cryptocurrency or token was not yet completed. The form of the SAFT is the result of a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” As discussed in this blog, the SAFT’s compliance with federal securities laws has now come into question by both the SEC and practitioners.

SAFT’s are offered and sold to accredited investors as an investment to fund the development of a business or project in a way not dissimilar to the way equity changes hands in traditional venture capital. A SAFT was developed from the oft-used simple agreement for future equity (SAFE) contract in the venture capital setting. In a SAFT sale, no coins are ever offered, sold or exchanged. Rather, money is exchanged for traditional paper documents that promise access to future product. Fundamentally, a SAFT has been relying on the premise that the future product is not in and of itself a security.

Although the SEC had been looking at ICO’s for a while, on July 25, 2017 it issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO concluding that the ICO was a securities offering. The Section 21(a) Report established that the Howey Test is the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. SEC Chair Jay Clayton has confirmed this standard in several public statements and in testimony before the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”). For a review of the Howey Test, see HERE.

Following the Section 21(a) Report, in a slew of enforcement proceedings by both the SEC and state securities regulators, and in numerous public statements, it is clear that regulators have viewed most, if not all, ICO’s as involving the sale of securities. At the same time, the SAFT grew in popularity as an attempt to comply with the securities laws. The SEC’s position is based on an analysis of the current market for ICO’s and the issuance of “coins” or “tokens” for capital raising transactions and as speculative investment contracts.

SAFT users rely on the premise that a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility. Investors in a SAFT automatically receive the cryptocurrency when it is publicly distributed in an ICO. The SAFT investors generally receive the crypto at a discount to the public offering price. However, this premise is taking a direct hit lately. Although I’ll lay out more on the SAFT history and why it was thought of as a solution further in this blog, I’ll jump right to the current analysis, and why a SAFT might not provide the intended protections.

The SAFT Problem

Although everyone, including regulators, agree that the state of the law in the area of cryptocurrencies and tokens is unsettled, regulators, including both the CFTC and SEC, have increasingly taken positions that would bring cryptocurrencies within their jurisdiction. I believe regulators are reacting to overarching fraud and therefore a necessity to take action to protect investors. Without congressional rule making and definitive guidance, regulators have no choice but to make the current law fit the circumstances. In some cases that works fine, but in others it does not and I suspect continuing changes in interpretations, enforcement premises and ultimately rule making will occur.

As I’ve previously discussed, the CFTC first found that Bitcoin and other virtual currencies were properly defined as commodities in 2015. Accordingly, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law. See HERE.

The SEC has also taken the stance that ICO’s involve the sale of securities, and that exchanges providing for the after-market trading of cryptocurrencies must register unless an exemption applies. The SEC is now taking it one step further, postulating that the tokens or cryptocurrencies underlying the SAFT could also be a security (and when I say “could” I mean “are”), in which case the SAFT structure is nothing more than a convertible security and fails to comply with the federal securities laws and makes it even more likely that it would result in an enforcement proceeding, or private litigation.

A SAFT is a type of pre-ICO investment with the investors automatically receiving the crypto when the company completes its public ICO. If the underlying token is a security, then the future ICO fails to comply with the federal securities laws and the original SAFT also fails to comply.

Getting ahead of this issue, many companies have structured a SAFT such that the future ICO is also labeled a security, and the SAFT investor will receive the crypto when the future ICO is registered with the SEC. However, this results in a private pre-public security sale, which in and of itself is prohibited by the securities laws.

In particular, Securities Act CD&I 139.01 provides:

Question: Where the offer and sale of convertible securities or warrants are being registered under the Securities Act, and such securities are convertible or exercisable within one year, must the underlying securities be registered at that time?

Answer: Yes. Because the securities are convertible or exercisable within one year, an offering of both the overlying security and underlying security is deemed to be taking place. If such securities are not convertible or exercisable within one year, the issuer may choose not to register the underlying securities at the time of registering the convertible securities or warrants. However, the underlying securities must be registered no later than the date such securities become convertible or exercisable by their terms, if no exemption for such conversion or exercise is available. Where securities are convertible only at the option of the issuer, the underlying securities must be registered at the time the offer and sale of the convertible securities are registered since the entire investment decision that investors will be making is at the time of purchasing the convertible securities. The security holder, by purchasing a convertible security that is convertible only at the option of the issuer, is in effect also deciding to accept the underlying security. [Aug. 14, 2009] (emphasis added)

In a Crowdfund Insider article published March 26, 2018, one practitioner (Anthony Zeoli) has had discussions with the SEC on the subject. As reported in the article, the SEC has stated that if the SAFT investor will automatically receive tokens in the future when and if the tokens are registered, without any further action on the part of the investor, then the tokens must be registered as of the date of the SAFT investment.

Of course, the future ICO or token offering could be completed in a private offering in compliance with the federal securities laws, such as using Rule 506(c) and limiting all sales to accredited investors (see HERE on Rule 506(c)). However, assuming the token or coin really is designed to create a decentralized community or to have utility value that can be widely used by the public, limiting sales to accredited investors does not meet the needs of the issuers. Moreover, even if the future offering is structured as a private securities offering, the SAFT sale disclosure documents would need to include full disclosure on the future coin or token such that the investor could make an informed investment decision at the time of the SAFT investment.

In the same article, Zeoli delves into a more nuanced issue, which is the rising difference in the meaning of a “coin” vs a “token.” A SAFT is a simple agreement for future “tokens” but is being used to pre-sell initial “coin” offerings. If a coin and a token are two very different things (as Zeoli suggests—think stock vs. LLC interest), then the underlying contract has systemic problems beyond the registration and exemption provisions of the federal securities laws and may be a misrepresentation resulting in fraud claims.

More On SAFT; Background

As mentioned, the current form of a SAFT was created by a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” The SAFT was intended to comply with the federal securities, money transmittal and tax laws. Also, as discussed, the SAFT relies on the premise that a cryptocurrency which today may be an investment contract (security) will tomorrow be a non-security digital asset satisfying the Howey Test. The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility.

The original SAFT white paper states:

The SAFT is an investment contract. A SAFT transaction contemplates an initial sale of a SAFT by developers to accredited investors. The SAFT obligates investors to immediately fund the developers. In exchange, the developers use the funds to develop genuinely functional network, with genuinely functional utility tokens, and then deliver those tokens to the investors once functional. The investors may then resell the tokens to the public, presumably for a profit, and so may the developers.

The SAFT is a security. It demands compliance with the securities laws. The resulting tokens, however, are already functional, and need not be securities under the Howey test. They are consumptive products and, as such, demand compliance with state and federal consumer protection laws.

Despite its good intentions, as of today, the model SAFT no longer works.

Further Reading on DLT/Blockchain and ICO’s

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 summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

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

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« Regulation A+ Continues To Grow ABA Comment Letter On Disclosures Under Regulation S-K »

Regulation A+ Continues To Grow

Posted by Securities Attorney Laura Anthony | April 17, 2018 Tags: Regulation A+ Continues To Grow

The new Regulation A/A+, which went into effect on June 19, 2015, is now three years old and continues to develop and gain market acceptance. In addition to ongoing guidance from the SEC, the experience of practitioners and the marketplace continue to develop in the area. Nine companies are now listed on national exchanges, having completed Regulation A+ IPO’s, and several more trade on OTC Markets. The NYSE even includes a page on its website related to Regulation A+ IPO’s. As further discussed herein, most of the exchange traded companies have gone down in value from their IPO offering price, which I and other practitioners attribute to the lack of firm commitment offerings and the accompanying overallotment (greenshoe) option.

On March 15, 2018, the U.S. House of Representatives passed H.R. 4263, the Regulation A+ Improvement Act, increasing the Regulation A+ Tier 2 limit from $50 million to $75 million in a 12-month period. 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 change the entire marketplace is advocating for. See HERE. On June 8, 2017, the U.S. House of Representatives passed the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (the “Financial Choice Act 2.0”), which also included a provision increasing the Tier 2 offering limit to $75 million. See HERE. The SEC has included Regulation A amendments on its long-term legislation action list as of December 2017.

This firm has been deep in the Regulation A space. A February 2018 Audit Analytics report named our firm one of the top three Regulation A firms in the country, and we are working on multiple new offerings that have yet to be filed. Furthermore, we are working on Regulation A+ offerings that will include an equity security in the form of a token based on blockchain or distributed ledger technology, an exciting new development in the field.

This blog will provide a comprehensive overview of Regulation A+, including updates based on experience and guidance in the industry.

Summary of Regulation A/A+

I’ve written about Regulation A+ on numerous occasions, including detailing the history and intent of the rules. Title IV of the JOBS Act, which was signed into law on April 5, 2012, set out the framework for the new Regulation A and required the SEC to adopt specific rules to implement the new provisions. The new rules came into effect on June 19, 2015. For a refresher on such history and intent, see my blog HERE.

Importantly, as discussed further below, Tier 2 of Regulation A (Regulation A+) preempts state blue sky law, and securities issued in a Regulation A+ offering are “covered securities.” In addition to the federal government, every state has its own set of securities laws and securities regulators. Unless the federal law specifically “preempts” or overrules state law, every offer and sale of securities must comply with both the federal and the state law. There are 54 U.S. jurisdictions, including all 50 states and 4 territories, each with separate and different securities laws. Even in states that have identical statutes, the states’ interpretations or focuses under the statutes differ greatly. On top of that, each state has a filing fee and a review process that takes time to deal with. It’s difficult, time-consuming and expensive.

However, as I will discuss below, this does not include preemption of state law related to broker-dealer registration. Five states (Florida, New York, Texas, Arizona and North Dakota) do not have “issuer exemptions” for public offerings such as a Regulation A offering. Companies completing a Regulation A offering without a broker-dealer will need to register as an “issuer dealer” in those states. Although each state has differing requirements, they all require certain uniform information and the process has not been overly cumbersome.

Two Tiers of Offerings

Regulation A is divided into two offering paths, referred to as Tier 1 and Tier 2. A Tier 1 offering allows for sales of up to $20 million in any 12-month period. Since Tier 1 does not preempt state law, it is really only useful for offerings that are limited to one but no more than a small handful of states. Tier 1 does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements. Tier 1 is generally not used for an initial going public transaction. Tier 1 is most often used by existing public companies that are not subject to the SEC reporting requirements.

Both Tier I and Tier 2 offerings contain minimum basic requirements, including issuer eligibility provisions and disclosure requirements. Resales of securities by affiliate selling security holders are limited to no more than $6,000,000 for a Tier 1 offering and $15,000,000 for a Tier 2 offering. Resales of securities by non-affiliate selling security holders are limited to 30% of the aggregate offering amount for the company’s first Regulation A offering or subsequent offering that is completed within one year of the first offering. Although no company has yet completed a second Regulation A offering after the one-year period, such offering would not have a limit on non-affiliate resales.

For offerings up to $20 million, an issuer can elect to proceed under either Tier 1 or Tier 2. Both tiers will allow companies to submit draft offering statements for non-public SEC staff review before a public filing, permit continued use of solicitation materials after the filing of the offering statement and use the EDGAR system for filings.

Tier 2 allows a company to file an offering circular with the SEC to raise up to $50 million in a 12-month period. Tier 2 preempts state blue sky law. A company may elect to either provide the disclosure in Form 1-A format or the disclosure in a traditional Form S-1 when conducting a Tier 2 offering. The Form S-1 format is a precondition to being able to file a Form 8-A to register under the Exchange Act. Either way, the SEC review process is a little shorter, and a company can market in a way that it cannot with a traditional IPO. However, we have noticed that as more and more issuers are using the process, the reviewers have become busier and the review time has extended accordingly.

Both Tiers of Regulation A have specific company eligibility requirements, investor qualifications and associated per-investor investment limits. Also, the process is not inexpensive. Attorneys’ fees, accounting and audit fees and, of course, marketing expenses all add up. A company needs to be organized and ready before engaging in any offering process, and especially so for a public offering process. Even though a lot of attorneys, myself included, will provide a flat fee for parts of the process, that flat fee is dependent on certain assumptions, including the level of organization of the company.

In a CD&I, the SEC confirmed that a company may withdraw a Tier 2 offering after qualification but prior to any sales or the filing of an annual report, by filing an exit report on Form 1-Z, and thereafter be relieved of any further filing requirements.

Eligibility Requirements

Regulation A is available to companies organized and operating in the United States and Canada. A company will be considered to have its “principal place of business” in the U.S. or Canada for purposes of determination of Regulation A eligibility if its officers, partners, or managers primarily direct, control and coordinate the company’s activities from the U.S. or Canada, even if the actual operations are located outside those countries.

The following issuers are not eligible for a Regulation A offering:

Companies currently subject to the reporting requirements of the Exchange Act;
Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s. However, a company that operates investments that are exempt from the registration requirements under the 1940 Act would qualify, such as REIT’s and companies that transact in certain loans such as small business loans, student loans, auto loans, and personal loans.
Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents; or assets consisting of any amount of cash and cash equivalents and nominal other assets. Accordingly, a start-up business or minimally operating business may utilize Regulation A;
Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;
Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years. Accordingly, a company that is deregistered for delinquent reporting would not be eligible for Regulation A;
Issuers that became subject to Regulation A reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and
Issuers that are disqualified under the Rule 262 “bad actor” provisions.

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 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. 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.

Unfortunately, in what is clearly a legislative miss, companies that are already publicly reporting – that is, are already required to file reports with the SEC – are not eligible. OTC Markets has petitioned the SEC to eliminate this eligibility criterion, and pretty well everyone in the industry supports a change here, but for now it remains. 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. Also, as discussed at the beginning of this blog, the House has now passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A.

Regulation A can be used for business combination transactions, but is not available for shelf SPAC’s (special purpose acquisition companies).

Eligible Securities

Regulation A is limited to equity securities, including common and preferred stock and options, warrants and other rights convertible into equity securities, debt securities and debt securities convertible or exchangeable into equity securities, including guarantees. If convertible securities or warrants are offered that may be exchanged or exercised within one year of the offering statement qualification (or at the option of the issuer), the underlying securities must also be qualified and the value of such securities must be included in the aggregate offering value. Accordingly, the underlying securities will be included in determining the offering limits of $20 million and $50 million, respectively.

Recently our firm, and several others that I am aware of, are using Regulation A to create equity digital tokens using blockchain technology. For my most recent blog on that subject, see HERE.

Asset-backed securities are not allowed to be offered in a Regulation A offering. REIT’s and other real estate-based entities may use Regulation A and provide information similar to that required by a Form S-11 registration statement.

General Solicitation and Advertising; Solicitation of Interest (“Testing the Waters”)

Other than the investment limits, anyone can invest in a Regulation A offering, but of course they have to know about it first – which brings us to marketing. All Regulation A offerings will be allowed to engage in general solicitation and advertising, at least according to the SEC. Tier 1 offerings are also required to comply with applicable state law related to such solicitation and advertising, including any prohibitions of same.

Marketing in the Prequalification Period

Regulation A allows for prequalification solicitations of interest in an offering, commonly referred to as “testing the waters.” Issuers can use “test-the-waters” solicitation materials both before and after the initial filing of the offering statement, and by any means. A company can use social media, Internet websites, television and radio, print advertisements, and anything they can think of prior to qualification of the offering. Marketing can be oral or in writing, with the only limitations being certain disclaimers and antifraud. Although a company can and should be creative in its presentation of information, there are laws in place with serious ramifications requiring truth in the marketing process. Investors should watch for red flags such as clearly unprovable statements of grandeur, obvious hype or any statement that sounds too good to be true – as they are probably are just that.

When using “test-the-waters” or prequalification marketing, a company must specifically state whether a registration statement has been filed and if one has been filed, provide a link to the filing. Also, the company must specifically state that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC. Any investor indications of interest during this time are 100% non-binding – on both parties. That is, the potential investor has no obligation to make an investment when or if the offering is qualified with the SEC and the company has no obligation to file an offering circular or if one is already filed, to pursue its qualification. In fact, a company may decide that based on a poor response to its marketing efforts, it will abandon the offering until some future date or forever.

Solicitation material used before qualification of the offering circular must contain a legend stating that no money or consideration is being solicited and none will be accepted, no offer to buy securities can be accepted and any offer can be withdrawn before qualification, and a person’s indication of interest does not create a commitment to purchase securities.

For a complete discussion of Regulation A “test-the-waters” rules and requirements, see my blog HERE.

All solicitation material must be submitted to the SEC as an Exhibit under Part III of Form 1-A. This is a significant difference from S-1 filers, who are not required to file “test-the-waters” communications with the SEC. There is no requirement that the materials be filed prior to use—only that they be included as an exhibit to the final qualified offering circular. In a CD&I the SEC has also confirmed that the requirement under Industry Guide 5 that sales material be submitted to the SEC before use, does not apply to Regulation A offerings. Industry Guide 5 relates to registration statements involving interests in real estate limited partnerships.

A company can use Twitter and other social media that limits the number of characters in a communication, to test the waters as long as the company provides a hyperlink to the required disclaimers. A company can use a hyperlink to satisfy the disclosure and disclaimer requirements in Rule 255 as long as (i) the electronic communication is distributed through a platform that has technological limitations on the number of characters or amount of text that may be included in the communication; (ii) including the entire disclaimer and other required disclosures would exceed the character limit on that particular platform; and (iii) the communication has an active hyperlink to the required disclaimers and disclosures and, where possible, prominently conveys, through introductory language or otherwise, that important or required information is provided through the hyperlink.

Unlike the “testing of the waters” by emerging growth companies that are limited to QIB’s and accredited investors, a Regulation A company can reach out to retail and non-accredited investors. After the public filing but before SEC qualification, a company may use its preliminary offering circular to make written offers.

Of course, all “test-the-waters” materials are subject to the antifraud provisions of federal securities laws.

Like registered offerings, ongoing regularly released factual business communications, not including information related to the offering of securities, is allowed and is not considered solicitation materials.

Post-qualification Marketing

Once an offering has been qualified by the SEC and a company is soliciting the purchase of the securities, and not merely an indication of interest, the company has offering circular delivery requirements. That is, the company must deliver the qualified Final Offering Circular to all purchasers and prospective purchasers. This delivery requirement can be satisfied by providing an active hyperlink to the URL where the Final Offering Circular is filed on EDGAR. Accordingly, once an offering has been qualified with the SEC, a company cannot solicit the sale of securities using print, TV, radio or other forms of advertising that do not allow for the inclusion of an active hyperlink.

Continuous or Delayed Offerings

Continuous or delayed offerings (a form of a shelf offering) are allowed only if the offering statement pertains to: (i) securities to be offered or sold solely by persons other than the issuer (however, note that under the rules, this is limited to 30% of non-affiliates for first-time offerings and by dollar limit for affiliates for any offering); (ii) securities that are offered pursuant to a dividend or interest reinvestment plan or employee benefit plan; (iii) securities that are to be issued upon the exercise of outstanding options, warrants or rights; (iv) securities that are to be issued upon conversion of other outstanding securities; (v) securities that are pledged as collateral; or (vi) securities for which the offering will commence within two days of the offering statement qualification date, will be made on a continuous basis, will continue for a period of in excess of thirty days following the offering statement qualification date, and at the time of qualification are reasonably expected to be completed within two years of the qualification date.

Under this last continuous offering section, issuers that are current in their Tier 2 reporting requirements may make continuous or delayed offerings for up to three years following qualification of the offering statement. Moreover, in the event a new qualification statement is filed for a new Regulation A offering, unsold securities from a prior qualification may be included, thus carrying those unsold securities forward for an additional three-year period. When continuously offering securities under an open Regulation A offering, a company must update its offering circular, via post-qualification amendment, to disclose material changes of fact and to keep the financial statements current.

Where a company seeks to qualify an additional class of securities via post-qualification amendment to a previously qualified Form 1-A, Item 4 of Part I, which requires “Summary Information Regarding the Offering and Other Current or Proposed Offerings,” need only include information related to the new class of securities seeking qualification.

Additional Tier 2 Requirements; Ability to List on an Exchange

In addition to the basic requirements that apply to all Regulation A offerings, Tier 2 offerings also require: (i) audited financial statements (though I note that the majority of state blue sky laws require audited financial statements, so this federal distinction does not have a great deal of practical effect); (ii) ongoing reporting requirements, including the filing of an annual and semiannual report and periodic reports for current information (Forms 1-K, 1-SA and 1-U, respectively); and (iii) a limitation on the number of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth.

The investment limitations for non-accredited investors resulted from a compromise with state regulators that opposed the state law preemption for Tier 2 offerings. It is the obligation of the issuer to notify investors of these limitations. Issuers may rely on the investors’ representations as to accreditation (no separate verification is required) and investment limits.

A company completing a Tier 2 offering that has used the S-1 format for their offering circular may file a Form 8-A with the qualification of the Form 1-A as long as it is filed no later than 5 days following qualification, to register under the Exchange Act, and may make immediate application to a national securities exchange. A Form 8-A is a simple (generally 2-page) registration form used instead of a Form 10 for companies that have already filed the substantive Form 10 information with the SEC (generally through an S-1).

The Form 8-A will only be allowed if it is filed within five (5) days of the qualification of the Form 1-A or a post-qualification amendment to the initial qualified Form 1-A As with any SEC filings based on calendar days, where the fifth day falls on a Saturday, Sunday or federal holiday, the certification may be received on the next business day.

For registration under Section 12(g) of the Exchange Act, the 8-A becomes effective upon the later of the filing of the Form 8-A or the qualification of the Regulation A offering statement.

Where the securities will be listed on a national exchange, the accredited investor limitations will not apply. When the Form 8-A is for registration with a national securities exchange under Section 12(b) of the Exchange Act, the 8-A becomes effective on the later of the day the 8-A if filed, the day the national exchange files a certification with the SEC confirming the listing, or the qualification of the offering circular.

Upon effectiveness of the Form 8-A, the company will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A reporting will automatically be suspended. Accordingly, upon effectiveness of the Form 8-A, a company no longer qualifies to use Regulation A as an offering method and as such, the company would need to discontinue future sales under the qualified offering circular. As a result of this, most companies file a post-qualification amendment to their Form 1-A when all sales have been completed, and then file a Form 8-A in conjunction with that post-qualification amendment.

In their September 14, 2017 CD&I, the SEC confirmed that an issuer may also file a Form 8-A concurrently (i.e., within five days) with the qualification of a post-qualification amendment to a Form 1-A. Financial statements in any qualified Form 1-A must be current at the time of qualification, and the same holds true for a post-qualification amendment. The SEC notes that the reason a Form 8-A may only be filed concurrently with qualification is to ensure that financial statements are current at the time a company becomes registered under the Exchange Act and subject to its reporting requirements.

The SEC has clarified the timing of an annual report on Form 10-K once an 8-A has been filed. In particular, in the event that a qualified Form 1-A did not contain an audit of the last full fiscal year, the SEC will allow the company to file its annual report within 90 days of effectiveness of a Form 8-A. A Form 8-A is usually effective as of its filing, but can be preconditioned on certain events, such as a certification of a national exchange as described above. For example, if a company with a calendar year-end qualifies a Form 1-A on March 30, 2018 and files an 8-A on April 4, 2018, it would be required to file a Form 10-K for fiscal year-end December 31, 2017 (with the 2016 comparable period) within 90 calendar days from the effectiveness of the Form 8-A.

Likewise, the SEC provided guidance on the timing of a quarterly report on Form 10-Q following effectiveness of a Form 8-A. Generally, a company must file its 10-Q within 45 days of the effectiveness of a registration statement, or on the due date of its regular 10-Q if the company was already subject to the Exchange Act reporting requirements. The SEC has confirmed that it will allow a 10-Q to be filed within 45 days of effectiveness of a Form 8-A filed in connection with a Form 1-A qualification. Moreover, a company may actually have to file two Form 10-Q’s in that time period. A Form 1-A does not require (or allow for) the filing of quarterly stub periods; rather, a stub period must be for a minimum of a six-month financial period. Accordingly, it is possible that a company would need to file two Form 10-Q’s for two stub periods, within 45 days of effectiveness of its Form 8-A.

For example, let’s say a company with a calendar year-end qualifies a Form 1-A on August 10, 2018 and files a Form 8-A, which goes effective on the same day. The qualified Form 1-A contains an audit for fiscal year-end December 31, 2016 and 2017, but does not contain any stub period financial statements for 2018 (note that the 2017 year-end audit would not go stale for purposes of Regulation A until September 30, 2018 in this example). In this case, the company would need to file its Form 10-Q’s for both quarters ending March 31, 2018 and June 30, 2018 by September 24, 2018.

Nine companies are now listed on national exchanges having completed Regulation A+ IPO’s and several more trade on OTC Markets. Most of the exchange traded companies have gone down in value from their IPO offering price, which I and other practitioners attribute to the lack of firm commitment offerings and the accompanying overallotment (greenshoe) option. An overallotment option, often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing, is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.

A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).

The federal securities laws only allow overallotment options in “firm commitment offerings. In a firm commitment offering, the underwriter firmly commits to buying a certain number of shares” from the company and then resells those shares into the market, either directly or through a syndicate of other underwriters. As of now, all Regulation A offerings have been on a “best-efforts basis.” In a best-efforts offering, the underwriter does not commit to any sales but merely uses its best efforts to sell the offering into the market (either directly or through a syndicate).

As Regulation A grows in use and popularity, and attracts more institutional players and higher-quality deals, I would expect firm commitment offerings and the use of the overallotment option. In a Regulation A offering, the overallotment would need to be considered in determining the maximum allowable offering amounts ($20 million for Tier 1 and $50 million for Tier 2).

Integration

The final rules include a limited-integration safe harbor such that offers and sales under Regulation A will not be integrated with prior or subsequent offers or sales that are (i) registered under the Securities Act; (ii) made under compensation plans relying on Rule 701; (iii) made under other employee benefit plans; (iv) made in reliance on Regulation S; (v) made more than six months following the completion of the Regulation A offering; or (vi) made in crowdfunding offerings exempt under Section 4(a)(6) of the Securities Act (Title III crowdfunding–Regulation CF).

The SEC has confirmed that a Regulation A offering can rely on Rule 152 such that a completed exempt offering, such as under Rule 506(b), will not integrate with a subsequent Regulation A offering. Under Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the company subsequently makes a public offering. The SEC has also issued guidance that Rule 152 applies to prevent integration between a completed 506(b) offering and a subsequent 506(c) offering, indicating that the important factor in the Rule 152 analysis is the ability to publicly solicit. As Rule 506(c) is considered a public offering for this analysis, there would be nothing preventing a company from completing a Rule 506(c) offering either before, concurrently or after a Regulation A offering.

In the absence of a clear exemption from integration, companies would turn to the five-factor test. In particular, the determination of whether the Regulation A offering would integrate with one or more other offerings is a question of fact depending on the particular circumstances at hand. The following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Offering Statement – General

A company intending to conduct a Regulation A offering must file an offering circular with, and have it qualified by, the SEC. The offering circular is filed with the SEC using the EDGAR database filing system. Prospective investors must be provided with the filed, prequalified offering statement 48 hours prior to a sale of securities. Once qualified, investors must be provided with the final qualified offering circular. Like current registration statements, Regulation A rules provide for an “access equals delivery” model, whereby access to the offering statement via the Internet and EDGAR database will satisfy the delivery requirements. As discussed above, this access must be via an active hyperlink.

There are no filing fees for the process. The offering statement is reviewed, commented upon and then declared “qualified” by the SEC with an issuance of a “notice of qualification.” The notice of qualification can be requested or will be issued by the SEC upon clearing comments. The SEC has been true to its word in that the review process has been lighter than that normally associated with an S-1 or other Securities Act registration statement. However, I have noticed over time that offering circulars are being reviewed more in line with an S-1 than when the process first started.

Issuers may file offering circular updates after qualification in lieu of post-qualification amendments similar to the filing of a post-effective prospectus for an S-1. In a CD&I, the SEC clarified the calculation of a 20% change in the price of the offering to determine the necessity of filing a post-qualification amendment which would be subject to SEC comment and review, versus a post-qualification supplement which would be effective immediately upon filing. Rule 253(b) provides that a change in price of no more than 20% of the qualified offering price, may be made by supplement and not require an amendment. An amendment is subject to a whole new review and comment period and must be declared qualified by the SEC. A supplement, on the other hand, is simply added to the already qualified Form 1-A, becoming qualified itself upon filing. The 20% variance can be either an increase or decrease in the offering price, but if it is an increase, it cannot result in an offering above the respective thresholds for Tier 1 ($20 million) or Tier 2 ($50 million).

To qualify additional securities, a post-qualification amendment must be used. In a CD&I the SEC has clarified that where a company seeks to qualify an additional class of securities via post-qualification amendment to a previously qualified Form 1-A, Item 4 of Part I, which requires “Summary Information Regarding the Offering and Other Current or Proposed Offerings,” need only include information related to the new class of securities seeking qualification.

In a reminder that Regulation A is technically an exemption from the registration requirements under Section 5 of the Securities Act, the SEC confirmed that under Item 6 of Part I, requiring disclosure of unregistered securities issued or sold within the prior year, a company must disclose all securities issued or sold pursuant to Regulation A in the prior year.

Offering Statement – Non-public (Confidential) Submission

The rules permit a company to submit an offering statement to the SEC on a confidential basis. The rule provides that only companies that have not previously sold securities under a Regulation A or a Securities Act registration statement may submit the offering confidentially.

Confidential submissions will allow a Regulation A issuer to get the process under way while soliciting interest of investors using the “test-the-waters” provisions without negative publicity risk if it alters or withdraws the offering before qualification by the SEC. The confidential filing, SEC comments, and all amendments must be publicly filed at least 15 calendar days before qualification.

Confidential submissions to the SEC are completed by choosing a “confidential” setting in the EDGAR system. To satisfy the requirement to publicly file the previous confidential information, the company can file all prior confidential information as an exhibit to its non-confidential filing, or change the setting in the EDGAR system on its prior filings, from “confidential” to “public.” In the event the company chooses to change its EDGAR setting to “public,” it would not have to re-file all prior confidential material as an exhibit to a new filing.

If a company wants to keep certain information confidential, even after the required time to make such information public, it will need to submit two confidential requests, one as part of the offering review process and one when prior confidential filings are made public. During the confidential Form 1-A review process, the company should submit a request under Rule 83 in the same manner it would during a typical review of a registered offering. Once the company is required to make the prior filings “public” (15 days prior to qualification), the company would make a new request for confidential treatment under Rule 406 in the same manner other confidential treatment requests are submitted. For a confidential treatment request under Rules 83 and 406, a company must submit a redacted version of the document via EDGAR with the appropriate legend indicating that confidential treatment has been requested. Concurrently, the company must submit a full, unredacted paper version of the document to the SEC using the ordinary confidential treatment procedure (such filings are submitted via a designated fax line to a designated person to maintain confidentiality).

Offering Statement – Form and Content

An offering statement is submitted on Form 1-A. Form 1-A consists of three parts: Part I – Notification, Part II – Offering Circular, and Part III – Exhibits. Part I calls for certain basic information about the company and the offering, and is primarily designed to confirm and determine eligibility for the use of the Form and a Regulation A offering in general. Part I includes issuer information; issuer eligibility; application of the bad-actor disqualifications and disclosures; jurisdictions in which securities are to be offered; and unregistered securities issued or sold within one year. As Regulation A is technically an unregistered offering, all Regulation A securities sold within the prior year must be included in this section.

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

The required information in Part 2 of Form 1-A is scaled down from the requirements in Regulation S-K applicable to Form S-1. Issuers can complete Part 2 by either following the Form 1-A disclosure format or by including the information required by Part I of Form S-1 or Form S-11 as applicable. Note that only issuers that elect to use the S-1 or S-11 format will be able to subsequently file an 8-A to register and become subject to the Exchange Act reporting requirements or to trade on a national exchange.

Companies that had previously completed a Regulation A offering and had thereafter been subject to and filed reports with the SEC under Tier 2 can incorporate by reference from these reports in future Regulation A offering circulars.

Form 1-A requires two years of financial information. All financial statements for Regulation A offerings must be prepared in accordance with GAAP. Financial statements of a Tier 1 issuer are not required to be audited unless the issuer has obtained an audit for other purposes. Audited financial statements are required for Tier 2 issuers. Audit firms for Tier 2 issuers must be independent and PCAOB-registered. An offering statement cannot be qualified if the date of the balance sheet is more than nine months prior to the date of qualification. Financial statements do not go stale for nine months, as opposed to 135 days for other filings under Regulation S-X. Interim financial statements should be for a minimum period of six months following the date of the fiscal year-end.

A recently created entity may choose to provide a balance sheet as of its inception date as long as that inception date is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date. The date of the most recent balance sheet determines which fiscal years, or period since existence for recently created entities, the statements of comprehensive income, cash flows and changes in stockholders’ equity must cover. When the balance sheet is dated as of inception, the statements of comprehensive income, cash flows and changes in stockholders’ equity will not be applicable.

In a CD&I the SEC confirmed that companies using Form 1-A benefit from Section 71003 of the FAST Act. The SEC interprets Section 71003 of the FAST Act to allow an emerging growth company (EGC) to omit financial information for historical periods if it reasonably believes that those financial statements will not be required at the time of the qualification of the Form 1-A, provided that the company file a prequalification amendment such that the Form 1-A qualified by the SEC contains all required up-to-date financial information. Section 71003 only refers to Forms S-1 and F-1, but the SEC has determined to allow an EGC the same benefit when filing a Form 1-A. Since financial statements for a new period would result in a material amendment to the Form 1-A, potential investors would need to be provided with a copy of such updated amendment prior to accepting funds and completing the sale of securities.

Part III requires an exhibits index and a description of exhibits required to be filed as part of the offering statement. A tax opinion is not required to be filed as an exhibit to Form 1-A, but a company may do so voluntarily.

Offering Price

All Regulation A offerings must be at a fixed price. That is, no offerings may be made “at the market” or for other than a fixed price. This applies to all aspects of the Regulation A offering. For example, a company could not complete an offering whereby a purchaser exercises an option or warrant at a variable price with the resale of such securities being registered at a fixed price. As a result of this, and the inability to obtain any prequalification commitment from a purchaser whatsoever, a Regulation A offering is not conducive for use in equity line transactions.

Ongoing Reporting

Both Tier I and Tier 2 issuers must file summary information after the termination or completion of a Regulation A offering. A Tier I company must file certain information about the Regulation A offering, including information on sales and the termination of sales, on a Form 1-Z exit report no later than 30 calendar days after termination or completion of the offering. Tier I issuers do not have any ongoing reporting requirements.

Tier 2 companies are also required to file certain offering termination information and have the choice of using Form 1-Z or including the information in their first annual report on Form 1-K. In addition to the offering summary information, Tier 2 issuers are required to submit ongoing reports including: an annual report on Form 1-K, semiannual reports on Form 1-SA, current event reports on Form 1-U and notice of suspension of ongoing reporting obligations on Form 1-Z.

A Tier 2 issuer may file an exit form 1-Z and relieve itself of any ongoing requirements if no securities have been sold under the Regulation A offering and the Form 1-Z is filed prior to the company’s first annual report on Form 1-K.

The ongoing reporting for Tier 2 companies is less demanding than the reporting requirements under the Securities Exchange Act. In particular, there are fewer 1-K items and only the semiannual 1-SA (rather than the quarterly 10-Q) and fewer events triggering Form 1-U (compared to Form 8-K). Companies may also incorporate text by reference from previous filings. In a CD&I, the SEC confirmed that it will not object if an auditor’s consent is not included as an exhibit to an annual report on Form 1-K, even if the report contains audited financial statements. The report would still need to contain the auditor’s report, but a separate consent is not required.

The annual Form 1-K must be filed within 120 calendar days of fiscal year-end. The semiannual Form 1-SA must be filed within 90 calendar days after the end of the semiannual period. The current report on Form 1-U must be filed within 4 business days of the triggering event. Successor issuers, such as following a merger, must continue to file the ongoing reports.

The rules also provide for a suspension of reporting obligations for a Regulation A issuer that desires to suspend or terminate its reporting requirements. Termination is accomplished by filing a Form 1-Z and requires that a company be current over stated periods in its reporting, have fewer than 300 shareholders of record, and have no ongoing offers or sales in reliance on a Regulation A offering statement. Of course, a company may file a Form 10 to become subject to the full Exchange Act reporting requirements.

The ongoing reports will qualify as the type of information a market maker would need to support the filing of a 15c2-11 application. Accordingly, an issuer that completes a Tier 2 offering could proceed to engage a market maker to file a 15c2-11 application and trade on the OTC Markets. The OTC Markets allows Regulation A reporting companies to apply for any of its tiers of listing, including the OTCPink, OTCQB or OTCQX, depending on which tier the company qualifies for.

A company that reports under the scaled-down Regulation A requirements is not considered to be subject to the Exchange Act reporting requirements, and therefore shareholders that have purchased restricted securities in exempt offerings (including 506(b) or 506(c) offerings in advance of the Regulation A) will need to satisfy the longer one-year holding period under Rule 144. Shares purchased in the Regulation A offering itself are freely tradable.

Freely Tradable Securities

Securities issued to non-affiliates in a Regulation A offering are freely tradable. Securities issued to affiliates in a Regulation A offering are subject to the affiliate resale restrictions in Rule 144, except for a holding period. The same resale restrictions for affiliates and non-affiliates that apply to Regulation A offerings also apply to securities registered in a Form S-1.

Since neither Tier 1 nor Tier 2 Regulation A issuers are subject to the Exchange Act reporting requirements (unless a Form 8-A is filed), the Rule 144 holding period for shareholders that have purchased restricted securities in exempt offerings (including 506(b) or 506(c) offerings in advance of the Regulation A) will need to satisfy the longer one-year holding period under Rule 144. Shareholders would not be able to rely on Rule 144 at all if the company has been a shell company at any time in its history. For more information on Rule 144 as it relates to shell companies, see HERE.

Treatment under Section 12(g)

Exchange Act Section 12(g) requires that an issuer with total assets exceeding $10,000,000 and a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited, register with the SEC, generally on Form 10, and thereafter be subject to the reporting requirements of the Exchange Act.

Regulation A exempts securities in a Tier 2 offering from the Section 12(g) registration requirements if the issuer meets all of the following conditions:

The issuer utilizes an SEC-registered transfer agent. Such transfer agent must be engaged at the time the company is relying on the exemption from Exchange Act registration;
The issuer remains subject to the Tier 2 reporting obligations;
The issuer is current in its Tier 2 reporting obligations, including the filing of an annual and semiannual report; and
The issuer has a public float of less than $75 million as of the last business day of its most recently completed semiannual period or, if no public float, had annual revenues of less than $50 million as of its most recently completed fiscal year-end.

Moreover, even if a Tier 2 issuer is not eligible for the Section 12(g) registration exemption as set forth above, that issuer will have a two-year transition period prior to being required to register under the Exchange Act, as long as during that two-year period, the issuer continues to file all of its ongoing Regulation A reports in a timely manner with the SEC.

State Law Preemption

Tier I offerings do not preempt state law and remain subject to state blue sky qualification. The SEC encourages Tier 1 issuers to utilize the NASAA-coordinated review program for Tier I blue sky compliance. For a brief discussion on the NASAA-coordinated review program, see my blog HERE. However, in practice, I do not think this program is being utilized; rather, when Tier 1 is being used, it is limited to just one or a very small number of states and companies are completing the blue sky process independently.

Tier 2 offerings are not subject to state law review or qualification – i.e., state law is preempted. State law can still require a notice filing. Securities sold in Tier 2 offerings were specifically added to the NSMIA as federally covered securities. Federally covered securities are exempt from state registration and overview. Regulation A provides that “(b) Treatment as covered securities for purposes of NSMIA… Section 18(b)(4) of the Securities Act of 1933… is further amended by inserting… (D) a rule or regulation adopted pursuant to section 3(b)(2) and such security is (i) offered or sold on a national securities exchange; or (ii) offered or sold to a qualified purchaser, as defined by the Commission pursuant to paragraph (3) with respect to that purchase or sale.” For a discussion on the NSMIA, see my blogs HERE and HERE.

State securities registration and exemption requirements are only preempted as to the Tier 2 offering and securities purchased pursuant to the qualified Tier 2 Form 1-A offering circular. Subsequent resales of such securities are not preempted. However, securities traded on a national exchange are covered securities. Moreover, the OTCQB and OTCQX levels of OTC Markets are becoming widely recognized as satisfying the manual’s exemption for resale trading in most states.

State law preemption only applies to the securities offering itself and not to the person or persons who sell the securities. Unfortunately, not all states offer an issuer exemption for issuers that sell their own securities in public offerings such as a Regulation A offering. In particular, Arizona, Florida, Texas, New York and North Dakota require issuers to register with the state as issuer broker-dealers to qualify to sell securities directly. Each of these states has a short-form registration process in that regard. In addition, Alabama and Nevada require that the selling officers and directors of issuers register with the state.

Federally covered securities, including Tier 2 offered securities, are still subject to state antifraud provisions, and states may require certain notice filings. In addition, as with any covered securities, states maintain the authority to investigate and prosecute fraudulent securities transactions.

Broker-dealer Placement

Broker-dealers acting as placement or marketing agents are required to comply with FINRA Rule 5110 regarding filing of underwriting compensation, for a Regulation A offering.

Regulation A – Private or Public Offering?

The legal nuance that Regulation A is an “exempt” offering under Section 5 has caused confusion and the need for careful thought by practitioners and the SEC staff alike. Regulation A is treated as a public offering in almost all respects except as related to the applicability of Securities Act Section 11 liability. Section 11 of the Securities Act provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement. Any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket, can sue a company, its underwriters, and experts for damages where a false or misleading registration statement had been filed related to those securities. Regulation A is not considered a public offering for purposes of Section 11 liability.

Securities Act Section 12, which provides a private cause of action by a purchaser of securities directly against the seller of those securities, specifically imposes liability on any person offering or selling securities under Regulation A. The general antifraud provisions under Section 17 of the Securities Act, which apply to private and public offerings, of course apply to Regulation A.

As mentioned above, the SEC has now confirmed that a Regulation A offering can rely on Rule 152 such that a completed exempt offering, such as under Rule 506(b), will not integrate with a subsequent Regulation A filing. Under Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently makes a public offering. Along the same lines, as Rule 506(c) is considered a public offering for this analysis, there would be nothing preventing a company from completing a Rule 506(c) offering either before, concurrently or after a Regulation A offering.

Regulation A is definitely used as a going public transaction and, as such, is very much a public offering. Securities sold in a Regulation A offering are not restricted and therefore are available to be used to create a secondary market and trade, such as on the OTC Markets or a national exchange.

Tier 2 issuers that have used the S-1 format for their Form 1-A filing are permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements and to register with a national exchange. The Form 8-A must be filed within 5 days of the qualification of the Form 1-A or any post-qualification amendments. A Form 8-A is a simple registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC. Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. A form 8-A can also be used as a short-form registration to list on a national exchange under Section 12(b) of the Exchange Act. Registration under 12(g) occurs automatically; however, Registration under 12(b) requires that the applicable national securities exchange certify the registration within five calendar days. As with any SEC filings based on calendar days, where the fifth day falls on a Saturday, Sunday or federal holiday, the certification may be received on the next business day.

A Regulation A process is clearly the best choice for a company that desires to go public and raise less than $50 million. An initial or direct public offering on Form S-1 does not preempt state law. By choosing a Tier 2 Regulation A offering followed by a Form 8-A, the issuer can achieve the same result – i.e., become a fully reporting trading public company without the added time and expense of complying with state blue sky laws. In addition to the state law preemption benefit, Regulation A provides relief from the strictly regulated public communications that exist in an S-1 offering.

Practice Tip on Registration Rights Contracts

In light of the fact that Regulation A is technically an exemption from the Section 5 registration requirements, it might not be included in contractual provisions related to registration rights. In particular, the typical language in a piggyback or demand registration right provision creates the possibility that the company could do an offering under Regulation A and take the position that the shareholder is not entitled to participate under the registration rights provision because it did not do a “registration.” As an advocate of avoiding ambiguity, practitioners should carefully review these contractual provisions and add language to include a Form 1-A under Regulation A if the intent is to be sure that the shareholder is covered. Likewise, if the intent is to exclude Regulation A offerings from the registration rights, that exclusion should be added to the language to avoid any dispute.

Further Thoughts

Although I am a big advocate of Regulation A, companies continue to learn that it is just a legal process with added benefits, such as active advertising and solicitation including through social media. There is no pool of funds to tap into; it is not a line of credit; it is just another process that companies can use to reach out to the investing public and try to convince them to buy stock in, or lend money to, their company.

As such, companies seeking to complete a Regulation A offering must consider the economics and real-world aspects of the offering. Key to a successful offering are a reasonable valuation and rational use of proceeds. A company should demonstrate value through its financial statements and disclosures and establish that the intended use of proceeds will result in moving the business plan ahead and hopefully create increased value for the shareholders. Investors want to know that their money is being put to the highest and best use to result in return on investment. Repayment of debt or cashing out of series A investors is generally not a saleable use of proceeds. Looking for $50 million for 30% of a pre-revenue start-up just isn’t going to do it! The company has to be prepared to show you, the investor, that it has a plan, management, vision and ability to carry out the business proposition it is selling.

From the investors’ perspective, these are risky investments by nature. Offering materials should be scrutinized. The SEC does not pass on the merits of an offering – only its disclosures. The fact that the registration statement has been qualified by the SEC has no bearing on the risk associated with or quality of the investment. That is for each investor to decide, either alone or with advisors, and requires really reviewing the offering materials and considering the viability of the business proposal. At the end of the day, the success of the business, and therefore the potential return on investment, requires the company to perform – to sell their widgets, keep ahead of the competition, and manage their business and growth successfully.

The Author

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« The Division of Corporation Finance’s Disclosure Review And Comment Process What is a SAFT? »

The Division of Corporation Finance’s Disclosure Review And Comment Process

Posted by Securities Attorney Laura Anthony | April 11, 2018 Tags: CorpFin, The Division of Corporation Finance's Disclosure Review And Comment Process

Those that regularly read my blog know that I sometimes like to go back to basics. This blog will revisit and discuss the SEC’s Division of Corporation Finance (“CorpFin”) comment and review process. Back in March 2016, I wrote about the SEC comment and review process, including a description of the internal review process, review levels and breakup of industry sector reviewers. That blog can be read HERE. Since that time, the SEC has eliminated the Tandy Letter requirement. See HERE. Furthermore, on March 22, 2018, CorpFin updated its “Filing Review Process” page on the SEC website.

At the end of each calendar year, the big four accounting firms generally publish studies on CorpFin’s Comment Priorities. Their studies, and other recent publications, uniformly found that the number of comments, especially in a registration process, has dramatically declined. I have noticed this trend as well in my practice.

Also consistent in reports is a list of recent comment priorities, including: (i) non-GAAP financial measures (see HERE for more information on this topic; (ii) application of the new revenue recognition standards; (iii) disclosure of cyber risks and cyber incidents; (iii) management, discussion and analysis presentation and disclosures, including segment reporting and income taxes; (iv) disclosures of intangible assets and goodwill; (v) state sponsors of terrorism; (vi) related to acquisitions, mergers and business combinations; and (vii) signatures, exhibits and agreements.

This past year, in September 2017, the SEC Office of Inspector General published an Evaluation of the Division of Corporation Finance’s Disclosure Review and Comment Letter Process (the “September 2017 Report”). The purpose of the Inspector General’s examination and report was to review CorpFin’s process for issuing, tracking and facilitating public access to comment letters and related correspondence.

In addition to summarizing the September 2017 Report, this blog includes information on the updated CorpFin Filing Review Process page and general commentary and information on the process.

Background

The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and the general anti-fraud provisions which require disclosure of material information necessary to make required disclosures, not misleading. The standard for required disclosure is generally the materiality of the information. In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.

CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed. The Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 408 of the Sarbanes-Oxley Act requires CorpFin to focus on companies that have the largest market capitalization. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

There are three basic levels of review. A review by CorpFin can be a “full review” in which CorpFin will review a filing from cover to cover, including both legal and accounting aspects and basic form for compliance with the federal securities laws. A partial review may include either legal or accounting, but generally a partial review is related to financial statements and related disclosures, including Management Discussion and Analysis of Financial Condition and Results of Operations, and is completed by CorpFin accounting staff. A review may also be a targeted review in which CorpFin will examine the filing for one or more specific items of disclosure. Moreover, although not a designated level of review, CorpFin sometimes “monitors” a filing, which is a term used for a light review.

Reviewers are appointed files based on industry sectors. CorpFin has broken down its reviewers into the following 11 broad industry sectors: healthcare and insurance; consumer products; information technologies and services; natural resources; transportation and leisure; manufacturing and construction; financial services; real estate and commodities; beverages, apparel and mining; electronics and machinery and telecommunications. Each industry office is staffed with an assistant director and approximately 25 to 35 professionals, primarily accountants and lawyers. Each filing has more than one reviewer with a frontline contact person and supervisor. A full review file will have an accounting and legal reviewer as well as a supervisor.

Internally at CorpFin, a file will have a reviewer and an examiner. The examiner conducts an initial review and recommends comments to the reviewer. The reviewer may accept the examiner’s work, add comments or remove proposed comments. In addition, other CorpFin support offices may propose comments for a particular company. Each participant in the process is required to keep detailed notes and reports and upload the information into an internal workstation.

Neither the SEC nor the CorpFin evaluates the merits of any transaction or makes an assessment or determination as to whether a transaction or company is appropriate for any particular investor or the marketplace as a whole. The purpose of a review is to ensure compliance with the disclosure requirements of the securities laws. In that regard, CorpFin may ask for increased risk factors and clear disclosure related to the merits or lack thereof of a particular transaction, but they do not assess or comment upon those merits beyond the disclosure.

Comment Letters and Responses

Comment letters are based on a company’s filings and other public information about the company. For instance, CorpFin will review press releases and a company’s website, management communications and speeches, and conference presentations in addition to the company’s filings with the SEC. In comment letters, CorpFin may ask that a company provide additional supplemental information to the staff (such as backup materials to justify factual information such as reference to reports, statistics, market or industry size, etc.), revise disclosure in the document, provide additional disclosure in the reviewed filing or provide additional or different disclosure in future filings. Where a change is requested in future filings, intended disclosures may be provided in the comment letter response for SEC advance approval.

A company generally responds to the particular comment letter with a responsive letter that addresses each comment and, where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure. CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses. Where a comment letter asks for additional disclosure in future filings, proposed language should be provided to avoid an additional comment once the disclosure is made.

Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance, and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Responses should address the company’s unique facts and circumstances, and should avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, the company should explain how it is burdened and how the alternative provided by the company will provide adequate disclosure for investors.

The comment-and-response process continues until the staff has resolved all comments. No sooner than 20 business days after completion of its review, the SEC will upload all comment letters and responses to the EDGAR database. These comment letters and responses are searchable but are organized by company, not topic, making particular topic searches difficult. When generally searching for comments and responses on a specific topic, third-party advanced searching software is helpful.

Although the basic process involves letters and responses, the CorpFin staff is available to discuss comments with a company and its legal, accounting and other advisors. The process can and often does involve such conversations. CorpFin will not give legal or accounting advice, but it will talk through comments and responses and discuss the analysis and adequacy related to disclosures. The initial comment letter received from CorpFin will have the reviewer’s direct contact information. The back-and-forth process does not require a formal protocol other than the required written response letter. That is, a company or its advisors may engage in conversations regarding comments, or request the staff to reconsider certain comments prior to putting pen to paper.

Moreover, CorpFin encourages this type of conversation, especially where the company or its advisors do not understand a particular comment. The staff would rather discuss it than have the company guess and proceed in the wrong direction. Where the staff suggests that a company should revise its disclosure or its financial statements, the company may, and should as appropriate, provide the staff with a written explanation of why it provided the disclosure it did. This explanation may resolve the comment without the need for the requested amendment. A CorpFin review is not an attack and should not be approached as such. My experience with CorpFin has always been pleasant and involves a type of collaboration to improve company disclosures.

A company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director. Matters of legal disclosure or application of GAAP accounting principles are not an exact science, and discussions are encouraged such that the end result is an enhanced disclosure by the company and consistent disclosures across different companies. The SEC provides all of these individuals contact information on its website and will willingly engage in productive conversations with a company.

When responding to comment letters and communicating with SEC staff, it is important that a person who understands the process, such as SEC counsel, take the lead in communication. Responses should be consistent, both related to a particular comment letter and over time. A company that flip-flops on accounting treatment or disclosures will lose credibility with the SEC and invoke further review and comments.

CorpFin is also willing to provide a reasonable amount of extra time to respond to comment letters when requested. Most comment letters request a response within 10 days. CorpFin is usually willing to give an extra 10 days but will balk at much longer than that without a very good reason by the company for the delay.

If the reviewed filing is a Securities Act registration statement, such as an S-1, the CorpFin staff will verbally inform the company that it has cleared comments and the company may request that the SEC declare the registration statement effective. Where the reviewed filing is an Exchange Act filing that does not need to be declared effective, CorpFin will provide the company with a letter stating that it has resolved all of its comments.

September 2017 Report

The September 2017 Report reveals that CorpFin is developing a new system to improve and streamline certain aspects of the disclosure review process. The new system is called the System for Workflow Activity Tracking, which is referred to as SWAT. SWAT will automate certain aspects of the review process such as providing notifications of filing review status to other review team members. In addition, SWAT will generate a draft comment letter based on comments input into and approved within the system. The reviewer or another designated member of the relevant assistant director’s staff will review and revise the draft letter to ensure that it meets CorpFin’s policies for format, tone, and content. Once the draft letter is approved, a final comment letter will be generated within SWAT.

In its examination, the Office of Inspector General found that: (i) examiners and reviewers did not always properly document comments before issuing comment letters to companies; (ii) some case files were incomplete as of the date CorpFin issued a comment letter to a company; and (iii) examiners and reviewers inconsistently documented oral comments to companies.

As a result, the Office of Inspector General made three recommendations for CorpFin to improve its internal process. In particular, CorpFin should: (i) establish a mechanism or control for staff members to trace all comments provided to companies for inclusion in examiner and reviewer reports before issuing comment letters; (ii) establish a mechanism or control that ensures the staff follows policies to upload all examiner and reviewer reports to the internal workstation before issuing comment letters; and (iii) establish detailed guidance on how examiners and reviewers should document oral comments provided to companies during disclosure reviews. The recommendations were agreed to and will be closed upon verification that the corrective measures have been implemented. It is anticipated that the full implementation of the SWAT process will effectively resolve these issues as well.

Conclusion

A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting. The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included. As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports.

Although a full discussion of confidential treatment and requests is beyond the scope of this blog, a company may seek confidential treatment of materials and responses to comments under Rule 83. Rule 83 requires the company to respond to comments with two separate letters: one containing the confidential information, and the other not. Unlike confidential treatment requests under Rules 406 and 24b-2, a confidential treatment request for a comment response letter does not require that the company provide a justification for such confidential treatment. However, if a Freedom of Information Act (FOIA) request is submitted by a third party related to such comment letter response, the SEC will inform the company and request justification for continued confidential treatment. Confidential treatment under Rule 83 expires after 10 years unless a renewal is requested. Both Rule 83 and other confidential treatment rules require very specific transmittal procedures, and the documents must all clearly indicate that confidential treatment is requested.

For a review of basic public company disclosures, see my blog HERE. For more information regarding officer and director liability associated with signing SEC reports, see my blog HERE.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« The SEC’s 2018 Flex Regulatory Agenda Regulation A+ Continues To Grow »

The SEC’s 2018 Flex Regulatory Agenda

Posted by Securities Attorney Laura Anthony | April 3, 2018 Tags: SEC Flex Regulatory Agenda, The SEC’s 2018 Flex Regulatory Agenda

In December 2017, the SEC posted its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. Prior to issuing the agenda, SEC Chair Jay Clayton had promised that the SEC’s regulatory agenda’s would be “more realistic” and he seems to have been true to his word.

The agenda is separated into two categories: (i) Existing Proposed and Final Rule Stages; and (ii) Long-term Actions. The Existing Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The semiannual list published in July 2017 only contained 33 legislative action items to be completed in a 12-month time frame, and the newest list is down to 26 items, whereas the prior fall 2016 list had 62 items.

The Unified Agenda of Regulatory and Deregulatory Actions

The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, though the fall edition contains statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year. Interestingly, the SEC did not include a statement on regulatory priorities, letting the list speak for itself.

The Office of Information and Regulatory Affairs, under the current administration, has stated that the Agenda “represents the beginning of fundamental regulatory reform and a reorientation toward reducing unnecessary regulatory burden on the American people.” Furthermore, the Office states, “[B]y amending and eliminating regulations that are ineffective, duplicative, and obsolete, the Administration can promote economic growth and innovation and protect individual liberty.”

Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives. Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action. The SEC is not the only agency with a reduced Agenda. In total, agencies withdrew 1,579 actions that were initially proposed in the fall 2016 Agenda. Agencies moved 700 actions to either long-term or inactive. Also, adding transparency for those of us who like to stay up on these matters, the agencies will now post and make public their list of “inactive” rules.

SEC Flex Regulatory Agenda

On the agenda in the final rule stages are Regulation S-K disclosure updates and simplification rule changes we have all expected. The proposed rule change was issued in October 2017, a summary of which can be read HERE. Included in the final rule stage is amendments to smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems. Amendments to the interactive data (XBRL) program have been moved up from proposed to final rule stage since July 2017.

Also included for final rules are the treatment of communications involving security-based swaps, modernization of property disclosure for mining companies, investment company reporting modernization and amendments to the investment advisor act, disclosure handling information, amendments to covered securities under Section 18 of the Securities Act and amendments to municipal securities rules.

Items of interest in the proposed rule stage include amendments to financial disclosures about entities other than the registrant (see HERE), implementation of FAST Act report recommendations (see HERE), disclosure of payments by resource extraction issuers, amendments to the financial disclosure for registered debt security offerings, auditor independence with respect to loans or debtor-creditor relationships, various rules related to the Investment Company Act and Investment Advisors Act, and amendments to the Whistleblower Program Rules.

Rule on exchange traded products, personalized investment advice standard of conduct, and disclosures of payments by resource extraction issuers were moved from long-term to the proposed rule stage.

Removed from the July 2017 Existing Proposed and Final Rule Stages list and added to long-term actions are rules related to business and financial disclosure required by Regulation S-K, reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), Form 10-K summary, and revisions to audit committee disclosures.

Items on the long-term agenda which were also on the July 2017 long-term list include registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

Other items of interest on the long-term action list include Regulation Crowdfunding amendments, business, financial and management disclosure required by Regulation S-K, hedging disclosures, several securities-based swaps regulatory actions, conflict minerals amendments, amendments to Guide 5 on real estate offerings and Form S-11, extending testing-the-waters provisions to non-emerging growth companies, and incentive-based compensation arrangements.

Regulation A amendments are on the long-term action list. I am hopeful that these amendments may include an increase in the offering limits and opening up Regulation A to reporting issuers. See HERE.

Still not on the short-term agenda are future Dodd-Frank rules, including proposed regulatory actions related to pay for performance (see HERE), executive compensation clawback (see HERE) (which is not on the agenda at all), hedging (see HERE), universal proxies (see HERE), and clawbacks of incentive compensation at financial institutions (also not on the list at all), although some of these items remain on the “long-term actions” schedule.

The SEC rulemaking agenda may not include further rulemaking on many Dodd-Frank rules, but it also does not include specific rulemaking to repeal existing regulations, such as the pay ratio disclosure rules which were adopted in August 2015 and initially apply to companies for their first fiscal year beginning on or after January 1, 2017. See HERE for more information on this rule. The pay ratio rules do not apply to emerging-growth companies, smaller reporting companies, foreign private issuers, U.S-Canadian Multijurisdictional Disclosure System filers, and registered investment companies. All other reporting companies are subject to the new rules. In October 2016 the SEC published five new compliance and disclosure interpretations (C&DI’s) on certain aspects of the final rules. The C&DI’s covered two main topics: (i) the use of a consistently applied compensation measure in identifying a company’s median employee; and (ii) the application of the term “employee” to furloughed employees and independent contractors or “leased” workers.

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« The SEC Has Issued New Guidance On Cybersecurity Disclosures The Division of Corporation Finance’s Disclosure Review And Comment Process »

The SEC Has Issued New Guidance On Cybersecurity Disclosures

Posted by Securities Attorney Laura Anthony | March 27, 2018 Tags: The SEC Has Issued New Guidance On Cybersecurity Disclosures

On February 20, 2018, the SEC issued new interpretative guidance on public company disclosures related to cybersecurity risks and incidents. In addition to addressing public company disclosures, the new guidance reminds companies of the importance of maintaining disclosure controls and procedures to address cyber-risks and incidents and reminds insiders that trading while having non-public information related to cyber-matters could violate federal insider-trading laws.

The prior SEC guidance on the topic was dated, having been issued on October 13, 2011. For a review of this prior guidance, see HERE. The new guidance is not dramatically different from the 2011 guidance.

Introduction

The topic of cybersecurity has been in the forefront in recent years, with the SEC issuing a series of statements and creating two new cyber-based enforcement initiatives targeting the protection of retail investors, including protection related to distributed ledger technology (DLT) and initial coin or cryptocurrency offerings (ICO’s). Moreover, the SEC has asked the House Committee on Financial Services to increase the SEC’s budget by $100 million to enhance the SEC’s cybersecurity efforts. See my two-part blog series, including a summary of the recent speeches and initiatives, HERE and HERE.

The SEC incorporates cybersecurity considerations in its disclosure and supervisory programs, including in the context of its review of public company disclosures, its oversight of critical market technology infrastructure, and its oversight of other regulated entities, including broker-dealers, investment advisors and investment companies. Considering rapidly changing technology and the proliferation of cybersecurity incidents affecting both private and public companies (including a hacking of the SEC’s own EDGAR system and a hacking of Equifax causing a loss of $5 billion in market cap upon disclosure), threats and risks, public companies have been anticipating a needed update on the SEC disclosure-related guidance.

SEC Commissioner Kara Stein’s statement on the new guidance is grim on the subject, pointing out that the risks and costs of cyberattacks have been growing and could result in devastating and long-lasting collateral affects. Commissioner Stein cites a Forbes article estimating that cyber-crime will cost businesses approximately $6 trillion per year on average through 2021 and an Accenture article citing a 62% increase in such costs over the last five years.

Commissioner Stein also discusses the inadequacy of the 2011 guidance in practice and her pessimism that the new guidance will properly fix the issue. She notes that most disclosures are boilerplate and do not provide meaningful information to investors despite the large increase in the number and sophistication of, and damaged caused by, cyberattacks on public companies in recent years. Commissioner Stein includes a list of requirements that she would have liked to see in the new guidance, including, for example, a discussion of the value to investors of disclosing whether any member of a company’s board of directors has experience, education, expertise or familiarity with cybersecurity matters or risks.

I have read numerous media articles and blogs related to the disclosure of cyber-matters in SEC reports. One such blog was written by Kevin LaCroix and published in the D&O Diary. Mr. LaCroix’s blog points out that according to a September 19, 2016, Wall Street Journalarticle, cyber-attacks are occurring more frequently than ever but are rarely reported. The article cites a report that reviewed the filings of 9,000 public companies from 2010 to the present and found that only 95 of these companies had informed the SEC of a data breach.

As reported in a blog published by Debevoise and Plimpton, dated September 12, 2016, (thank you, thecorporatecounsel.net), a review of Fortune 100 cyber-reporting practices revealed that most disclosures are contained in the risk-factor section of regular periodic reports such as Forms 10-Q and 10-K, as opposed to interim disclosures in a Form 8-K. Moreover, only 20 incidents were reported at all in the period from January 2013 through the third quarter of 2015.

However, as Commissioner Stein notes, the SEC only has so much authority or power through guidance, as opposed to rulemaking. Commissioner Stein strongly advocates for new rulemaking in this regard. I do not think in the current environment advocating for fewer rules, that rulemaking related to cybersecurity disclosure will be made a priority. Moreover, I would not advocate for in-depth or robust further rules. Disclosure is based on materiality, and a company has an ongoing obligation to disclose any material information, including that which is related to cybersecurity matters. I think the SEC can question principals-based specific disclosures, and whether they are robust enough, through review and comment on public company filings. Certainly, the SEC staff, who reviews thousands of filings, has the knowledge of a lack of cybersecurity disclosure and can comment. In fact, if the SEC wrote a few standard cybersecurity-related disclosure comments and included them in a lot of comment letters, the marketplace would respond accordingly and beef up disclosure to avoid the comments.

Although I do not generally advocate for additional rules, Commissioner Stein makes one suggestion that I would support and that is adding the disclosure of cybersecurity event to the Form 8-K filing requirements. Although the new SEC guidance does not specifically require a Form 8-K, in light of the importance of these events, it seems it would be appropriate and the guidance itself requires “timely disclosure.” However, without a specific requirement, a company could elect to disclose via a press release and/or the filing of a Form 8-K under Item 7.01 Regulation FD disclosure. When disclosing using a press release and Regulation FD item in a Form 8-K, a company may elect for the information to be “furnished, not filed.” Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The antifraud provisions under Rule 10b-5 would still apply to the disclosure, but the stricter Section 18 liability would not.

New Guidance on Public Company Cybersecurity Disclosures

The new guidance begins with an introduction describing the importance of cybersecurity in today’s business world, driving the point home by comparing it to the importance of electricity. Cyber-incidents can take many forms, both intentional and unintentional, and commonly include the unauthorized access of information, including personal information related to customers’ accounts or credit information, data corruption, misappropriating assets or sensitive information or causing operational disruption. Attacks use increasingly complex methods, including malware, ransomware, phishing, structured query language injections and distributed denial-of-service attacks. A cyber-attack can be in the form of unauthorized access or a blocking of authorized access.

The purpose of a cyber-attack can vary as much as the methodology used, including for financial gain such as the theft of financial assets, intellectual property or sensitive personal information on the one hand, to a vengeful or terrorist motive through business disruption on the other hand. Perpetrators may be insiders and affiliates, or third parties including cybercriminals, competitors, nation-states and “hacktivists.”

When victim to a cyber-attack or incident, a company will have direct financial and indirect negative consequences, including but not limited to:

Remediation costs, including liability for stolen assets, costs of repairing system damage, and incentives or other costs associated with repairing customer and business relationships;
Increased cybersecurity protection costs to prevent both future attacks and the potential damage caused by same. These costs include organizational changes, employee training and engaging third-party experts and consultants;
Lost revenues from unauthorized use of proprietary information and lost customers;
Litigation;
Increased insurance premiums;
Damage to the company’s competitiveness, stock price and long-term shareholder value; and
Reputational damage.

Whereas the 2011 disclosure guidance was conservative in its tone, trying to strike a balance between satisfying the disclosure mandates of providing material information related to risks to the investing community with a company’s need to refrain from providing disclosure that could, in and of itself, provide a road map to the very breaches a company attempts to prevent, the new guidance is more blunt in the critical need to inform investors about material cybersecurity risks and incidents when they occur.

A company’s ability to timely and properly make any required disclosure of cybersecurity risks and incidents requires the company to implement and maintain disclosure controls and procedures that provide an appropriate method of discerning the impact that such matters may have on the company and its business, financial condition, and results of operations, as well as a protocol to determine the potential materiality of such risks and incidents.

Insider Trading

It is also important that public company officers, directors and other insiders respect the importance and materiality of cybersecurity risk and incident knowledge and not trade a company’s security when in possession of non-public information related to cybersecurity matters. In that regard, companies should include cybersecurity matters in their insider trading policies and procedures. These insider trading policies should (i) guard against trading in the period between when a company learns of a cybersecurity incident and the time it is made public; and (ii) require the timely disclosure of such non-public information.

Guidance

Public companies have many disclosure requirements, including through periodic reports on Forms 10-K, 10-Q and 8-K, through Securities Act registration statements such as on Forms S-1 and S-3 and generally through the antifraud provisions of both the Exchange Act and Securities Act, which requires a company to disclose “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” The SEC considers omitted information to be material if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or that disclosure of the omitted information would have been viewed by the reasonable investor as having significantly altered the total mix of information available.

As with all disclosure requirements, the disclosure of cybersecurity risk and incidents requires a materiality analysis. Although there continues to be no specific disclosure requirement or rule under either Regulation S-K or S-X that addresses cybersecurity risks, attacks or other incidents, many of the disclosure rules encompass these disclosures indirectly, such as risk factors, internal control assessments, management discussion and analysis, legal proceedings, disclosure controls and procedures, corporate governance and financial statements. As mentioned, as with all other disclosure requirements, an obligation to disclose cybersecurity risks, attacks or other incidents may be triggered to make other required disclosures not misleading considering the circumstances.

A company has two levels of cybersecurity disclosure to consider. The first is its controls and procedures and corporate governance to both address cybersecurity matters themselves and to address the timely and thorough reporting of same. The second is the reporting of actual incidents. In determining the materiality of a particular cybersecurity incident, a company should consider (i) the importance of any compromised information; (ii) the impact of an incident on company operations; (iii) the nature, extent and potential magnitude of the event; and (iv) the range of harm such incident can cause, including to reputation, financial performance, customer and vendor relationships, litigation or regulatory investigations.

Of course, the new guidance is also clear that a company would not need to disclose the depth of information that could, in and of itself, provide information necessary to breach cyber-defenses. A company would not need to disclose specific technical information about cybersecurity systems, related networks or devices or specific devices and networks that may be more susceptible to attack due to weaker systems.

The new guidance also reminds companies that they have a duty to correct prior disclosures that the company determines were untrue at the time material information was made or omitted, and to update disclosures that become inaccurate after the fact.

Like the prior guidance, the new guidance provides specific input into areas of disclosure.

Risk Factors

Obviously, where appropriate, cybersecurity risks need to be included in risk factor disclosures. The SEC guidance in this regard is very common-sense. Companies should evaluate their cybersecurity risks and take into account all available relevant information, including prior cyber-incidents and the severity and frequency of those incidents. Companies should consider the probability of an incident and the quantitative and qualitative magnitude of the risk, including potential costs and other consequences of an attack or other incident. Consideration should be given to the potential impact of the misappropriation of assets or sensitive information, corruption of data or operational disruptions. A company should also consider the adequacy of preventative processes and plans in place should an attack occur. Actual threatened attacks may be material and require disclosure.

As with all risk-factor disclosures, the company must adequately describe the nature of the material risks and how such risks affect the company. Likewise, generic risk factors that could apply to all companies should not be included. Risk factor disclosure may include:

Discussion of the company’s business operations that give rise to material cybersecurity risks and the potential costs and consequences, including industry specific risks and third-party and service-provider risks;
The costs associated with maintaining cybersecurity protections, including insurance coverage;
The probability of an occurrence and its potential magnitude;
Potential for reputational harm;
Description of past incidents, including their severity and frequency;
The adequacy of preventative actions taken to reduce cybersecurity risks and the associated costs, including any limits on the company’s ability to prevent or mitigate risks;
Existing and pending laws and regulations that may affect the companies cybersecurity requirements and the associated costs; and
Litigation, regulatory investigation and remediation costs associated with cybersecurity incidents.

Management Discussion and Analysis (MD&A)

In MD&A a company should consider all the same factors that it would consider in its risk factors. A company would need to include discussion of cybersecurity risks and incidents in its MD&A if the costs or other consequences associated with one or more known incidents or the risk of potential future incidents result in a material event, trend or uncertainty that is reasonably likely to have a material effect on the company’s results of operations, liquidity or financial condition, or could impact previously reported financial statements. The discussion should include any material realized or potential reduction in revenues, loss of intellectual property, remediation efforts, maintaining insurance, increase in cybersecurity protection costs, addressing harm to reputation and litigation and regulatory investigations. Furthermore, even if an attack did not result in direct losses, such as in the case of a failed attempted attack, but does result in other consequences, such as a material increase in cybersecurity expenses, disclosure would be appropriate.

Business Description; Legal Proceedings

Disclosure of cyber-related matters may be required in a company’s business description where they affect a company’s products, services, relationships with customers and suppliers or competitive conditions. Likewise, material litigation would need to be included in the “legal proceedings” section of a periodic report or registration statement. The litigation disclosure should include any proceedings that relate to cybersecurity issues.

Financial Statements

Cyber-matters may need to be included in a company’s financial statements prior to, during and/or after an incident. Costs to prevent cyber-incidents are generally capitalized and included on the balance sheet as an asset. GAAP provides for specific recognition, measurement and classification treatment for the payment of incentives to customers or business relations, including after a cyber-attack. Cyber-incidents can also result in direct losses or the necessity to account for loss contingencies, including those related to warranties, direct loss of revenue, providing customers with incentives, breach of contract, product recall and replacement, indemnification or remediation. Incidents can result in loss of, and therefore accounting impairment to, goodwill, intangible assets, trademarks, patents, capitalized software and even inventory. Financial statement disclosure may also include expenses related to investigation, breach notification, remediation and litigation, including the costs of legal and other professional service providers.

Broad Risk Oversight

A company must disclose the extent of its board of directors’ role in the risk oversight of the company, such as how the board administers its oversight function and the effect this has on the board’s leadership structure. To the extent cybersecurity risks are material to a company’s business, this discussion should include the nature of the board’s role in overseeing the management of that risk. Information should also be included on how the board engages with management on cybersecurity risk management.

Controls and Procedures

The new guidance clearly provides that companies should adopt comprehensive policies and procedures related to cybersecurity and to assess their compliance regularly, including policy/procedure compliance related to the sufficiency of disclosure controls and procedures. Procedures must address a company’s ability to record, process, summarize and report financial and other information in SEC filings. Additionally, any deficiency in these controls and procedures should be reported.

The SEC reminds companies that their principal executive officer and principal financial officer must make individual certifications regarding the design and effectiveness of disclosure controls and procedures. These certifications should take into account cybersecurity-related controls and procedures.

Furthermore, as discussed above, a company should have proper policies and procedures preventing officers, directors and other insiders from trading on material nonpublic information related to cybersecurity risks and incidents.

Regulation FD and Selective Disclosure

Companies may have disclosure obligations under Regulation FD related to cybersecurity matters. Under Regulation FD, “when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons it must make public disclosure of that information.” The SEC reminds companies that these requirements also relate to cybersecurity matters and that, along with all the other disclosure requirements, policies and procedures should specifically address any disclosures of material non-public information related to cybersecurity.

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« OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules The SEC’s 2018 Flex Regulatory Agenda »

OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules

Posted by Securities Attorney Laura Anthony | March 20, 2018 Tags: FINRA Rule 5250, FINRA Rule 6432, Form S-1, Rule 15C2-11, Rule 6432

January 8, 2018, OTC Markets Group, Inc. (“OTC Markets”) submitted a comment letter to FINRA related to FINRA Rule 6432. Rule 6432 requires that a market maker or broker-dealer have the information specified in Securities Exchange Act Rule 15c2-11 before making a quotation in a security on the over-the-counter market. Although I summarize the salient points of the OTC Markets comment letter, I encourage those interested to read the entire letter, which contains an in-depth analysis and comprehensive arguments to support its position. On February 8, 2018, OTC Markets submitted a second comment letter to FINRA, this one related to FINRA Rule 5250. Rule 5250 prohibits companies from compensating market makers in connection with the preparation and filing of a Form 211 application.

Rule 6432 – Compliance with the Information Requirements of SEA Rule 15c2-11

Subject to certain exceptions, including the “piggyback exception” discussed below, Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA. Although the rule requires that the Form 211 be filed at least three days prior to initiating a quotation, in reality FINRA reviews and comments on the filing in a back-and-forth process that can take several weeks or even months.

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

In addition, Rule 6432 requires the submittal of specified information about the security being quoted (for example, common stock, an ADR or warrant), the quotation medium (for example, OTCQB) and if priced, the basis upon which the price was determined.

Rule 6432 requires a certification confirming that the member broker-dealer has not accepted any payment or other consideration in connection with the submittal of the Form 211 application as prohibited by Rule 5250.

Rule 15c2-11(f)(2) allows a member firm to quote or process an unsolicited order on behalf of a customer without compliance with the information requirements. In such case, the member must document the name of the customer, date and time of the unsolicited order and identifying information on the security.

Rule 5250 – Payments for Market Making

Rule 5250 specifically prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith. In other words, a market maker cannot accept any consideration whatsoever for preparing and submitting a Form 211 application with FINRA.

However, the fact is that putting together the information required by the Form 211 and responding to FINRA comments takes administrative time and effort, and I would advocate that a broker-dealer should be able to accept some form of compensation to cover this internal expense. Moreover, the Form 211 process has changed over time, becoming much more arduous for the submitting market maker. I remember when a Form 211 could actually be submitted three days prior to a quotation and based on the market maker’s assertion that they were in possession of the required information, the Form was processed, oftentimes in 24 hours.

Today, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information and challenges the market maker’s position that the information is adequate. This process takes weeks at a minimum and oftentimes much longer.

Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all.

The “Piggyback” Exception

The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted on at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted.

As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.

The OTC Markets Comment Letter on Rule 6432

The opening paragraph of OTC Markets’ comment letter sets the tone for the entire letter, stating, “[W]e continue to believe that the cumbersome operational processes around Rule 6432, and the related Rule 15c2-11… under the… Exchange Act, unnecessarily impede capital formation by small issuers.” They continue, and I agree, that the process creates an unnecessary difficulty on smaller companies seeking to access public markets in the U.S.

OTC Markets suggests that the recent boom in ICO’s is a natural response to the difficulties with navigating the capital and secondary markets for smaller companies, including the Form 211 process, DTC eligibility, depositing non-exchange traded securities (see HERE, which factors have only intensified since publication of that blog), and market liquidity. A re-working of Rule 6432 and the interaction with the 45-year-old Rule 15c2-11 would help improve the marketplace dramatically.

Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent microcap fraud. At the time of enactment of the rule, the Internet was not available for access to information. The premise of the rule was to require broker-dealers, who would be quoting the securities, to maintain information and provide that information to investors upon request. Rule 6432 requires FINRA member firms to comply with Rule 15c2-11 by filing a Form 211 with FINRA. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures.

The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. OTC Markets proposes the following changes to Rule 6432 and its administration:

(i) Make the Form 211 review process more objective and efficient. FINRA’s role should be changed from a subjective gatekeeper to an objective administrator, only ensuring that the market maker has the required information. FINRA should not review the merits of the information itself. Furthermore, FINRA should be bound by the three-day requirement set forth in Rule 15c2-11 such that a market maker can proceed with a quote (and receive a ticker symbol where necessary) within the mandated three days. The goal should be to ensure a market maker has the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.

I agree with this suggestion. FINRA can adequately address its gatekeeper role in its annual or biannual audit and review of member firms. Moreover, if FINRA believes that a member firm has violated its requirements under Rule 6432, as a self-regulatory organization, it has the authority and ability to institute an investigation into such member firm. By performing subjective reviews of the information itself and merits of such information, FINRA is asserting substantive control over issuers for which it lacks jurisdiction and for which such issuer has no due process rights or recourse. The same overreaching of authority relates to Rule 6490 and the processing of corporate actions. See HERE. The SEC itself, who has direct jurisdiction over a company, does not review the merits of a company’s operations, business model or capital structure, but rather only the proper disclosure of same such that an investor can make an informed decision. FINRA, who does not have direct jurisdiction or governing authority over a company, has found a way to exert subjective influence, without due process, or even published rules or information as to the criteria used in their subjective analysis.

(ii) Form 211 materials should be made public and issuers should be liable for any misrepresentations. Currently, Form 211 materials are not publicly available. Making the information publicly available would further the clear objective of SEC Rule 15c2-11.

In practice, as part of its review process, FINRA not only requests additional information, but often material non-public information, which is not only beyond the scope of Rule 15c2-11, but which information has no reasonable expectation of being made public. Clearly, if information is important for the marketplace and investors to make informed investment decisions, it should be required by the rules and should be publicly available.

(iii) Outsource Form 211 processes to IDQS’s. A broker-dealer should file a Form 211 directly with the interdealer quotation system (IDQS) on which it plans to quote the security. The IDQS should review such information for completeness and submit the package to FINRA within the three-day rule time frame. Also, FINRA member IDQS’s should be allowed to submit their own Form 211 application for issuers that meet certain lower risk criteria, such as those already trading on a Qualified Foreign Exchange.

(iv) Allow IDQS’s to monitor ongoing disclosure and institute trading halts. FINRA member IDQS’s should be responsible for developing a system that ensures ongoing disclosure of Rule 15c2-11 information for quoted securities, including the power to respond to indications of fraud and institute trading halts.

This seems so obvious to me. Where FINRA exercises subjective merit reviews of initial Form 211 applications, it then takes no action whatsoever to ensure ongoing current information. I have seen stocks trade large volumes that have been completely dark or devoid of current information for years. By allowing an IDQS to require ongoing public information by an issuer for the privilege of having market makers make markets, the SEC and FINRA would add a layer of gatekeeping responsibility that does not exist today. Separately, I note that OTC Markets does have a system and regime that responds to certain issues, such as improper stock promotion (see HERE), but has no power to institute a trading halt.

(v) Allow broker-dealer compensation for Form 211 filing. See more discussion on this topic below. I agree that allowing compensation for a Form 211 filing is not only advisable but if structured properly, has no downside. The compensation can be capped and subject to specific disclosure and reasonableness rules, including compliance with Section 17(b) of the Securities Act (see HERE).

(vi) Allow multiple market makers to quote a security after a Form 211 is cleared. This would replace the current rules of only allowing one market maker to quote a security for the first 30 days. Moreover, I would go further and suggest that the piggyback exception only be allowed if there is publicly available current information.

Encouraging Capital Markets

Following its discussion on the rules and suggested changes, the OTC Markets comment letter turns to the need to encourage secondary trading of securities as an important aspect of encouraging capital formation for smaller companies as a whole. Investors are much more likely to participate in capital raising if they have an exit strategy such as a liquid secondary marketplace where they can reasonably deposit and re-sell freely tradeable securities.

The costs and burdens of being public on a national exchange are a huge disincentive for smaller companies. The decline in the US IPO markets is a constant discussion by SEC top brass, other regulators and politicians (for example, see HERE and HERE). As the OTC Markets comment letter points out, a small company seeking to raise $10 million to finance a promising new software, is in no position to shoulder the costs and burdens of a national exchange listing, but is also stifled by the inability to properly access liquidity for its investors on IDQS’s such as OTC Markets due to antiquated and improperly administered rules such as Rule 6432.

In fact, as of today OTC Markets is the only viable operating secondary marketplace for the trading of non-exchange traded public securities. OTC Markets is comprised of three tiers: the OTCQX; the OTCQB and the Pink Open Market. For a review of the OTCQX standards, see HERE. For a review of the OTCQB standards, see HERE. For more information on the Pink Open Market, see HERE.

By implementing OTC Markets suggested changes to Rule 6432 and its implementation and administration, more small companies would access public markets, better information would be made available to investors and the marketplace, and secondary market liquidity would improve.

The OTC Markets Comment Letter on Rule 5250

On February 8, 2018, OTC Markets group submitted a second comment letter to FINRA related to Exchange Act 15c2-11 and its implementation by FINRA. The second letter directly addresses Rule 5250, which prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith.

As discussed above, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information for completeness but also the merits of the information using undisclosed subjective standards. In response to comments, a market maker must work with a company to provide information, which can often involve material non-public information that is not, and may never be, made public. The process takes weeks at a minimum and oftentimes much longer.

As a basic premise for the market maker, it must conduct adequate due diligence on the company and properly gather and analyze information prior to submittal to FINRA. The process can be labor-intensive for the market maker.

Furthermore, part of the process involves the market maker’s analysis and backup for the requested pricing of the security in its initial quotation. When a company goes public on a national exchange, a market maker is not restricted from charging for its investment banking services, including the part of the service that involves a valuation and determination of initial offering price. The process of determination valuation for an initial quote on the OTC Markets is substantially similar. The inability to charge for such service acts as a disincentive for a market maker to give adequate thought and attention to the process.

Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all. Moreover, market makers have no incentive to engage with issuers in completing due diligence or creating on ongoing relationship which ensures access to information, that is made public to the investing community. In addition to assisting investors and the market place in making informed decisions, market maker/company engagement will help detect red flags and indicia of fraud, facilitating the purpose of the rules and benefiting the markets as a whole.

A responsible rule could be put into place that allows a market maker to charge for their services and encourages productive engagement and communication between a market maker and their client company. The rule should require public disclosure of a market makers fee (as well as the application itself as discussed above). In addition, market makers should be allowed to receive reimbursements for actual out-of-pocket expenses associated with preparing and filing a Form 211. Again, this amount should be fully disclosed to the investment community.

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