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

The 2017 SEC Government-Business Forum On Small Business Capital Formation

Posted by Securities Attorney Laura Anthony | March 13, 2018 Tags: 2017, SEC, The 2017 SEC Government-Business Forum On Small Business Capital Formation

On November 30, 2017, the SEC held its annual Government-Business Forum on Small Business Capital Formation (the “Forum”). It will be several months until the final report with recommendations from the forum is published, but the opening remarks from SEC Chair Jay Clayton and Commissioners Kara Stein and Michael Piwowar provide ongoing and consistent guidance as to the current focus of the SEC. For a review of the recommendations by last year’s forum, see HERE.

As expected, the topics of cryptocurrency and ICO’s were front and center at the Forum. In his opening remarks at the Forum, Division of Corporation Finance Director William Hinman confirmed that the SEC believes that ICO’s generally involve securities offerings and that the securities laws must be complied with. Hinman continued that the SEC is providing guidance through enforcement and public statements on the topic.

As with other statements and speeches, the SEC hedges by pointing out the validity of an ICO as a capital raising tool, and of course, the innovation potential of blockchain. The SEC is not trying to discourage ICO’s or blockchain innovation; they are trying to discourage ICO’s that fail to comply with securities laws, and the unfortunate, multiple frauds being perpetuated as a result of the frenzy surrounding this new technology.

Remarks by Chairman Jay Clayton

Chair Clayton is consistent with the theme he has been putting forth since taking office: The SEC is committed to helping Main Street investors. The Forum provides a key opportunity for the small-cap marketplace to have their voices heard regarding issues and desired changes to federal securities regulations and the regulatory system.

Chair Clayton reiterates the SEC’s three-part mission to (i) protect investors; (ii) maintain fair, orderly and efficient markets; and (iii) facilitate capital formation. Furthermore, although capital formation is important for all businesses, small and medium-sized businesses contribute the most to U.S. job creation, generating 62% of new jobs. Along the same lines, the SEC wants to open more investment opportunities into small businesses for Main Street investors. In that regard, Jay Clayton points out the Regulation A public offering process. As an aside, I was happy to see him recognize Regulation A as an IPO, whereas when he first took office, he seemed to view Regulation A as outside the IPO realm.

Remarks by Commissioner Michael Piwowar

Michael Piwowar’s statement was short and pointed. As anyone that follows my blog knows, I am a fan of Piwowar, agreeing with most of his views, and more so his willingness to express those views, even when contrary to other SEC chiefs or the legislature. Mr. Piwowar has been vocal about his disagreement with the pay ratio disclosure requirements mandated by the Dodd-Frank Act and uses his statement as an opportunity to reiterate that view, while pointing out that the recent interpretative guidance on the subject will help with the compliance burden. I have not written about that guidance as of yet, but my prior blog on the pay ratio rules can be read HERE.

Commissioner Piwowar also points out other SEC actions to assist with small businesses and capital formation, including the newest proposed rules to modernize and simplify disclosures (see HERE) and the SEC’s action to allow all companies to file confidential registration statements (see HERE).

Commissioner Piwowar ends his statement by promising that he will personally give careful consideration to this year’s recommendations of the Forum. I hope so, as the recommendations are always on point to assist the small-cap marketplace.

Remarks by Commissioner Kara Stein

Commissioner Stein began with the usual niceties regarding the forum and its importance for communication between regulators and the small-cap market. Adding her own perspective, Commissioner Stein points out that a lot of the SEC’s effort and rules are “designed to facilitate trust between… market participants – the small businesses seeking to raise capital, the investors who wish to support their growth, and their service providers.” Continuing to add her own unique voice, Ms. Stein talked about the need for diversity of companies and investors and bringing capital raising (and a voice in the process) to different parts of the country.

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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« The Senate Banking Committee’s Hearing On Cryptocurrencies OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules »

The Senate Banking Committee’s Hearing On Cryptocurrencies

Posted by Securities Attorney Laura Anthony | March 6, 2018 Tags: The Senate Banking Committee’s Hearing On Cryptocurrencies

On February 6, 2018, the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”) held a hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.” Both SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo testified and provided written testimony. The marketplace as a whole had a positive reaction to the testimony, with Bitcoin prices immediately jumping up by over $1600. This blog reviews the testimony and provides my usual commentary.

The SEC and CFTC Share Joint Regulatory Oversight

The Banking Committee hearing follows SEC and CFTC joint statements on January 19, 2018 and a joint op-ed piece in the Wall Street Journal published on January 25, 2018 (see HERE). As with other areas in capital markets, such as swaps, the SEC and CFTC have joint regulatory oversight over cryptocurrencies. Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets.

Bitcoin has been determined to be a commodity and as such, 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. Nevertheless, the CFTC does NOT have regulatory jurisdiction over markets or platforms conducting cash or “spot” transactions in virtual currencies or other commodities or over participants on such platforms. These spot virtual currency or cash markets often self-certify or are subject to state regulatory oversight. However, the CFTC does have enforcement jurisdiction to investigate fraud and manipulation in virtual currency derivatives markets and in underlying virtual currency spot markets.

The SEC does not have jurisdiction over currencies, including true virtual currencies. However, many, if not all, token offerings have been for the purpose of raising capital and have involved speculative investment contracts, thus implicating the jurisdiction of the SEC, in the offering and secondary trading markets.

Chair Clayton repeated that “every ICO I’ve seen is a security,” and added, “[T]hose who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement division.” Chair Clayton is very concerned that Main Street investors are getting caught up in the hype and investing money they cannot afford to lose, without proper (if any) disclosure, and without understanding the risks. He also reiterates previous messaging that to date no ICO has been registered with the SEC and that ICO’s are international in nature such that the SEC may not be able to recover lost funds or effectively pursue bad actors. Cybersecurity is also a big risk associated with ICO investments and the cryptocurrency market as a whole. Chair Clayton cites a study that more than 10% of total ICO proceeds, estimated at over $400 million, has been lost to hackers and cyberattacks.

It is becoming increasingly certain that the U.S. will impose a new regulatory regime over those tokens that are not a true cryptocurrency, which would likely include all tokens issued on the Ethereum blockchain for capital raising purposes. Clayton made the distinction between Bitcoin, which is decentralized, on a public Blockchain and mined or produced by the public and other “securities tokens” which are the cryptocurrencies that developed by an organization and created and issued primarily for capital formation and secondary trading.

Many tokens are being fashioned that outright and purposefully resemble equity in an enterprise as a new way to represent equity and capital ownership. Clearly this falls directly within the SEC jurisdiction, and state corporate regulatory oversight as well. Furthermore, there are instances where a token is issued in a capital-raising securities offering and later becomes a commodity, or instances where a token securities offering is bundled to include options or futures contracts, implicating both SEC and CFTC compliance requirements.

In the Banking Committee testimony, the SEC and CFTC presented a united front, confirming that they are cooperating and working together to ensure effective oversight. Both agencies have established virtual currency task forces and their respective enforcement divisions are cooperating and sharing information. Also, both agencies have launched efforts to educate the public on virtual currencies, with the CFTC publishing numerous articles and creating a dedicated “Bitcoin” webpage.

In addition to cooperating with each other, they are also cooperating and communicating with the NASAA, the Consumer Financial Protection Bureau, FinCen, the IRS, state regulators and others.

The Technology

Consistent with all statements by the regulators, both the SEC and CFTC agree that that blockchain technology is disruptive and has the potential to, and likely will, change the capital markets. Moreover, both agencies consistently reiterate their support of these changes and desire to foster innovation. In fact, the new technology has the potential to help regulators better monitor transactions, holdings and obligations and other market activities.

Chair Giancarlo’s testimony states that “DLT is likely to have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis. When tied to virtual currencies, this technology aims to serve as a new store of value, facilitate secure payments, enable asset transfers, and power new applications.” In addition, smart contracts have the ability to value themselves in real time and report information to data repositories.

However, regulation and oversight need to be fashioned that properly address the new technology and business operations. Both agencies are engaging in discussions with industry participants at all levels. A few of the key issues that will need to be resolved include custody, liquidation, valuation, cybersecurity at all levels, governance, clearing and settlement, and anti-money laundering and know-your-customer matters.

Overall, Chair Giancarlo seemed more positive and excited about blockchain and Bitcoin, pointing out current uses including a recent transaction where 66 million tons of American soybeans were handled in a blockchain transaction to China. Chair Clayton, while likely also very enthusiastic about the technology, is currently more focused on the fraud and misuse that has consumed this space recently.

Current Regulations and Needed Change

While the agencies investigate and review needed changes to the regulatory environment, both maintain that current regulations can be relied upon to address the current state of the market. On the SEC side, Chair Clayton walked the Banking Committee through previous SEC statements and the DAO Section 21(a) report issued in July 2017. He again confirmed that the Howey Test remains the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. The current registration and exemption requirements are also appropriate for ICO offerings. An issuer can either register an offering, or rely on exemptions such as Regulation D for any capital-raising transaction, including those involving tokens.

Conversely, the current regulatory framework related to exchange traded fund products (ETF’s) needs some work before a virtual currency product could be approved. Issues remain surrounding liquidity, valuation, custody of holdings, creation, redemption and arbitrage. In that regard, in a coming blog, I will review an SEC letter dated January 18, 2018 entitled “Engaging on Fund Innovation and Cryptocurrency-related Holdings” outlining why a crypto-related ETF would not be approved at this time. Senator Mark Warner was quick to point out that there seems to be a regulatory disconnect where an SEC governed ETF is not approved, but a CFTC-governed Bitcoin future is allowed.

The current federal broker-dealer registration requirements remain the best test to determine if an exchange or other offering participant is required to be registered and a member of FINRA. Chair Clayton repeats his warning shot to gatekeepers such as attorneys and accountants that are involved in ICO’s and the crypto marketplace as a whole. Chair Clayton expresses concern that crypto markets often look similar to regulated securities markets and even are called “exchanges”; however, “investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems (ATSs), such as best execution, prohibitions on front running, short sale restrictions, and custody and capital requirements.”

CFTC Chair Giancarlo reiterated that current regulations related to futures, options, and derivatives contracts, and the registration (or lack thereof through self-certification) of spot currency exchanges are being utilized in the virtual currency market. However, the part of the regulatory system that completely defers to state law may need change. In particular, check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC, and both agencies expressed concern about this jurisdictional gap.

Giancarlo was especially critical of this state-by-state approach and suggested new federal legislation, including legislation related to data reporting, capital requirements, cybersecurity standards, measures to prevent fraud, price manipulation, anti-money laundering, and “know your customer” protections. “To be clear, the CFTC does not regulate the dozens of virtual currency trading platforms here and abroad,” Giancarlo said, clarifying that the CFTC can’t require cyber-protections, platform safeguards and other things that consumers might expect from traditional marketplaces.

Chair Clayton expressed the same concerns, especially the lack of protections for Main Street investors. Chair Clayton stated, “I think our Main Street investors look at these virtual currency platforms and assume they are regulated in the same way that a stock is regulated and, as I said, it’s far from that and I think we should address that.”

I am always an advocate of federal oversight of capital markets matters that cross state lines. A state-by-state approach is always inconsistent, expensive, and inefficient for market participants.

Both agencies are clear that regardless of the technology and nomenclature, they are and will continue to actively pursue cases of fraud and misconduct. Current regulations or questions related to needed changes do not affect this role. However, Chair Clayton did impress upon the Banking Committee that the current hiring freeze and budgetary restraints are an impediment. The SEC specifically needs more attorneys in their enforcement and trading and markets divisions.

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 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 ICO’s, 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 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 ICO’s, see HERE.

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

The Author

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« The Treasury Department Report To The President On Capital Markets The 2017 SEC Government-Business Forum On Small Business Capital Formation »

The Treasury Department Report To The President On Capital Markets

Posted by Securities Attorney Laura Anthony | February 27, 2018 Tags: The Treasury Department Report To The President On Capital Markets

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 was issued in response to an executive order dated February 3, 2017. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports; this one on capital markets discusses and makes specific recommendations related to the federal securities laws.

The Core Principles are:

Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
Prevent taxpayer-funded bailouts;
Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
Enable American companies to be competitive with foreign firms in domestic and foreign markets;
Advance American interests in international financial regulatory negotiations and meetings;
Make regulation efficient, effective, and appropriately tailored; and
Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

This blog will summarize key portions of the 232-page report that directly affect the small and lower middle equity markets. In addition to the areas discussed in this blog, the report covers business development and investment companies, Title III crowdfunding, the bond and treasury markets, securitization, derivatives and multiple other topics. For those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken by category.

Summary of Recommendations and Findings

The U.S. equities market represents $29 trillion in publicly traded U.S. stocks, with an average daily volume of over $270 billion. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), together with state securities regulators, are responsible for regulating U.S. markets. Further self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) oversee parts of the markets and its participants.

Encouraging Going Public Transactions

There are many benefits to a going public transaction. As summarized by the Treasury Report:

Access to the public equity markets means obtaining a source of permanent capital, usually at a cost lower than other alternatives. Proceeds from IPOs can be used to hire employees, develop new products and technologies, and expand operations. Furthermore, IPOs give institutional and other early stage investors an exit, allowing them to reallocate their capital and talent to other ventures. IPOs also have important implications for employees, who may have accepted pre-IPO compensation in the form of options and stock grants. After an IPO, an employee can monetize his or her compensation by selling into the market. This feature can incentivize employee job performance and work commitment.

As I’ve written about several times, the U.S. economy has experienced an extremely slow recovery since the latest financial crisis, though fortunately, that seems to be improving dramatically over the last year. However, over the last 20 years, the number of public companies in the U.S. has declined by nearly 50%. Many factors have been cited for the decrease in IPO’s, including: (i) compliance costs and risk related to regulations, including Sarbanes-Oxley and Dodd-Frank; (ii) changes in equity market structure, such as decimalization, fragmentation of the market and a decline in small and mid-sized investment banks; (iii) nonfinancial disclosure requirements based on social and political issues; (iv) shareholder litigation risk; (v) shareholder pressure to prioritize short-term returns over long-term growth; (vi) inadequate oversight and accountability of proxy advisor firms; and (vii) lack of research coverage for smaller public companies. At the same time, the availability of private equity funds has increased.

The Treasury Department’s recommendations include numerous measures to encourage IPO’s, including eliminating duplicative requirements, liberalizing pre-initial public offering communications (testing the waters), and removing non-material disclosure requirements. he Report makes several recommendations to assist all public companies, including amending the $2000 holding requirement for shareholder proposals and amending resubmission thresholds for repeat shareholder proposals.

Removal of Non-Material Disclosure Requirements

Materiality is an objective standard meant to provide disclosure that would be important to a “reasonable investor” as opposed to a subjective standard meant to serve varied special interest groups. However, Dodd-Frank added special interest disclosure requirements, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Treasury Report notes that the securities laws are not equipped to deal with social issues and that requiring such disclosures for public companies and not private companies not only undermines the overall social aspect of the goals but creates an incentive to remain private.

The Treasury Report recommends eliminating each of these disclosure requirements (conflict minerals, mine safety, resource extraction and pay ratio). I note that the Financial Choice Act eliminates these provisions as well. See HERE.

Eliminate Duplicative Disclosures

The Treasury Report recommends that the SEC proceed to amend Regulation S-K to eliminate duplicative, overlapping, outdated or unnecessary disclosures. The Report mentions that the SEC has been working on this, but doesn’t give real credit to the progress made. I’ve written about the SEC Disclosure Effectiveness Initiative on numerous occasions, including a review of the October 11, 2017 proposed rule amendment to simplify and modernize disclosure requirements (see HERE).

Permit Additional Pre-IPO Communications

Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. Communications made by the company during the IPO process, beginning with the pre-registration filing period, depending on the mode and content, result in violations of Section 5 of the Securities Act. Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.” For a more complete discussion of allowable communications during the IPO process, see HERE.

In April 2012, the JOBS Act was enacted which created emerging growth companies (EGC’s) and provided provisions to allow EGC’s to communicate with qualified institutional buyers (QIB’s) and institutional accredited investors during the pre-filing period. The JOBS Act also allows EGC’s to file confidential registration statements with the SEC. It is thought that testing the waters, together with the ability to file a confidential registration statement, reduces the risk of an IPO by allowing a company to gauge investor interest without having exposed its financial and business information to the public and competitors.

On June 19, 2017, the SEC expanded to the ability to file confidential registration statements to all companies completing an IPO and for some follow-on secondary offerings (see HERE). The Treasury Report recommends that all companies be allowed to test the waters with QIB’s and institutional accredited investors.

Not only do I agree with this recommendation, but I think it should be taken one step further and that testing the waters, to the extent allowed in a Regulation A offering, should be allowed for all companies completing an initial IPO under a certain dollar limit such as $100 million. Regulation A allows for pre-filing and pre-qualification indications of interest as long as no funds are solicited or accepted and proper disclaimers are provided. Regulation A does not limit solicitation recipients and all forms of solicitation and advertising are permitted, subject to the disclaimer requirements and antifraud provisions.

One of the SEC and regulator concerns with gun jumping is that it will create an illusory market interest or prime the market in an unsustainable fashion. One of the reasons why such solicitation is allowed in a Regulation A offering is that it is thought that companies engaging in such offerings, with a high end limit of $50 million, will be smaller and less likely to create overwhelming market interest. In addition, with the offering limitation, it is less likely that the offering marketing will result in an unsustainable initial market price.

Just as all companies can now file confidential registration statements, I think all companies should be allowed to engage in public test-the-waters communications, subject to investor protections through disclaimers, rules against accepting funds, requiring the delivery of a filed prospectus once filed, and subject to offering dollar limitations.

Shareholder Rights and Dual Class Stock

Generally corporate governance and shareholder rights are a matter of state law. Under state law, a corporation may have multiple classes of stock with differing rights, including voting rights. A class of stock may have voting control, regardless of the number of shares or holders of public or common stock.

The Treasury Report recommends that corporate governance, including stock classes, remain under state law. I agree. In fact, I think the Report only addresses this topic because it has been debated recently, especially following the Snapchat IPO, whose public offering only included non-voting stock.

Shareholder Proposals

Exchange Act Rule 14a-8 allows shareholders to include proposals in a company’s proxy materials. The rule requires the company to include the proposal unless it falls within a list of allowable exclusions and provided that the shareholder follow the procedural requirements. To submit a proposal, a shareholder must have held, for at least one year, either (i) company securities with a value of $2,000 or more, or (ii) at least 1% of the outstanding voting securities.

The Treasury Report states that “According to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”

Shareholder proposals are an oft-debated topic as they cost companies tens of millions of dollars and significant time and management resources. The SEC often issues guidance on proposals, including recently in November 2017, about which I will write more in the future. Prior guidance was published in January 2015 (see HERE).

The Treasury Report recommends that the $2,000 holding requirement, which was instituted over 30 years ago, be substantially increased, and adding additional eligibility requirements. The Treasury Report also recommends substantial changes to the resubmission thresholds.

Smaller Public Companies

Smaller public companies face additional challenges, including just by virtue of complying with regulatory requirements with fewer economic and human resources. Furthermore, institutional investors generally favor invest larger companies.

The Treasury has identified opportunities to ease challenges for smaller public companies, including amending the definition of a “smaller reporting company” to increase the public float threshold from $75 million to $250 million and increasing scaled disclosure requirements. Moreover, the Report recommends extending the length of time a company may be considered an emerging growth company (EGC) to up to ten (10) years based on revenue and public float thresholds.

The Treasury Department also recognizes that liquidity remains an issue for smaller public companies. In that regard, the Report recommends increasing “tick size” and making changes to the practices at ATS’s (which would include OTC Markets).

Amend the Definition of a Smaller Reporting Company

Currently a smaller reporting company (SRC) is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. SRC’s have the benefit of scaled disclosure requirements and are not required to comply with Sarbanes-Oxley Section 404(b), requiring independent auditor attestation of management’s assessment on internal controls.

Consistent with SEC proposals, the Treasury Report recommends increasing the threshold for an SRC to $250 million of public float. The Report does not mention the revenue threshold. The SEC has proposed rules to amend the definition of a SRC, which rule change is slated for action this year. For a review of the proposed rule amendment, see HERE.

Increase Time to Qualify for Emerging Growth Company Status

An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).

The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process. The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed. For a discussion of EGCs and the impact of losing EGC status, see HERE.

The Treasury Report recommends increasing the time a company may be considered an EGC to up to 10 years.

Research Analyst Rules

In 2003 and 2004, SEC enforcement settlements with some of the major broker-dealers and investment banks required the firms to separate their research analysts from investment banking. The JOBS Act eased restrictions on research analyst communications during the IPO process. In addition, several changes in legislation have been proposed, with many passing either the House or Senate, but not becoming law. Included in that is the Financial Choice Act, which recommended expanding the exclusion of research reports from the definition of an offer for or to sell securities under the Securities Act.

The Treasury Report recommends a complete overhaul of the rules related to research reports, including harmonizing the 2003 and 2004 enforcement settlements within those new rules.

Regulation A/A+ Amendments

Like research reports, multiple changes in legislation have been proposed, and passed either the House or Senate, including the Financial Choice Act, which would increase the limits for Regulation A to $75 million. Additionally, there have been many proponents, including myself, who advocate for allowing companies that are subject to the Exchange Act reporting requirements to use Regulation A. See HERE for a discussion on efforts in this regard.

Supporting Regulation A, the Treasury Report recommends expanding the eligibility to use Regulation A to include Exchange Act reporting companies and increasing the Tier 2 offering limits to $75 million.

Encouraging Private Funding

Being public is not the right choice for all companies, especially earlier-stage entities, and as such, the Treasury Report discusses the state of private equity and ways to encourage private funding and access to capital for these vital companies as well. In an effort to support private capital-raising efforts, the Report makes recommendations for the modification of the “accredited investor” definition, creating a regulatory structure for finders, and modifying rules for private equity funds, including allowing more investments by unaccredited investors under Rule 506.

Regulation of Finders

The regulation of finders, or lack thereof, has been a topic I have written about many times, and is one of the most deficient areas of guidance in the federal securities laws. I have been vocal about my recommendations, including that I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. For a review of the SEC Advisory Committee on Small and Emerging Companies recommendations related to finders, and a discussion of my own views, see HERE.

The Treasury Report recommends that the SEC, FINRA and states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions. The report generally suggests a “broker-dealer lite” structure; however, it makes no specific recommendations and anything broker-dealer-related will likely not resolve the issues or fix this broken area of the system.

Increase Eligible Investors in Regulation D Offerings

The definition of an accredited investor is another relevant topic to our private (and public) capital markets. On December 18, 2015, the SEC issued a report on the definition of an “accredited investor” and it is expected that new proposed rules amending the definition will be issued this year. For a review of the SEC report and more information on the background of the definition of an accredited investor, see HERE.

The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation. Generally, natural persons can qualify as an accredited investor if they have a net worth of at least $1 million, excluding their primary residence, or have income of at least $200,000 ($300,000 together with a spouse) for each year for the last two years with a reasonable expectation to continue such income in the current year. Certain legal entities with over $5 million in assets are accredited investors, while certain regulated entities such as banks, broker-dealers, registered investment companies, BDC’s, and insurance companies are automatically designated as accredited investors.

The Treasury Report recommends expanding the definition of an accredited investor to include additional sophisticated investors, including, for example, registered representatives working with broker-dealers, investment advisors, financial professionals, and investors that are advised as to the merits and risks by a licensed individual.

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« The CFTC And Cryptocurrencies The Senate Banking Committee’s Hearing On Cryptocurrencies »

The CFTC And Cryptocurrencies

Posted by Securities Attorney Laura Anthony | February 20, 2018 Tags: blockchain, CFTC, CFTC Chairman J. Christopher Giancarlo, CFTC Compliance Requirements, DLT/Blockchain and ICO’s, SEC Chairman Jay Clayton, The CFTC And Cryptocurrencies, Virtual Currencies, Virtual Currency

The SEC and U.S. Commodity Futures Trading Commission (CFTC) have been actively policing the crypto or virtual currency space. Both regulators have filed multiple enforcement actions against companies and individuals for improper activities including fraud. On January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo published a joint op-ed piece in the Wall Street Journal on the topic.

Backing up a little, on October 17, 2017, the LabCFTC office of the CFTC published “A CFTC Primer on Virtual Currencies” in which it defines virtual currencies and outlines the uses and risks of virtual currencies and the role of the CFTC. The CFTC first found that Bitcoin and other virtual currencies are 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.

The role of the CFTC is substantially similar to the SEC with a mission to “foster open, transparent, competitive and financially sound markets” and to “protect market users and their funds, consumers and the public from fraud, manipulation and abusive practices related to derivatives and other products subject to the Commodity Exchange Act (CEA).” The definition of a commodity under the CEA is as broad as the definition of a security under the Securities Act of 1933, including a physical commodity such as an agricultural product, a currency or interest rate or “all services, rights and interests in which the contracts for future delivery are presently or in the future dealt in” (i.e., futures, options and derivatives contracts).

Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets. At times the jurisdiction of the two regulators overlaps, such as related to swap transactions (see HERE). Furthermore, while there are no SEC licensed securities exchanges which trade virtual currencies or any tokens, there are several commodities exchanges that trade virtual currency products such as swaps and options, including the TeraExchange, North American Derivatives Exchange and LedgerX.

The Commodity Exchange Act would prohibit the trading of a virtual currency future, option or swap on a platform or facility not licensed by the CFTC. Moreover, the National Futures Association (NFA) is now requiring member commodity pool operators (CPO’s) and commodity trading advisors (CTA’s) to immediately notify the NFA if they operate a pool or manage an account that engaged in a transaction involving a virtual currency or virtual currency derivative.

The CFTC refers to the IRS’s definition of a “virtual currency” and in particular:

A virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments it operates like real currency but it does not have legal tender status in the U.S. Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as a convertible virtual currency. Bitcoin is one example of a convertible virtual currency.

I note that neither the CFTC’s definition of Bitcoin as a commodity, nor the IRS’s definition of a virtual currency, conflicts with the SEC’s position that most cryptocurrencies and initial cryptocurrency offerings today are securities requiring compliance with the federal 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. In fact, a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. For example, an offering of XYZ token for the purpose of raising capital to build a software or blockchain platform or community where XYZ token can be used as a currency would rightfully be considered a securities offering that needs to comply with the federal securities laws. However, when the XYZ token is issued and can be used as a form of currency, it would become a commodity. Furthermore, the bundling of a token securities offering to include options or futures contracts may implicate both SEC and CFTC compliance requirements.

The CFTC primer gives a little background on Bitcoin, which was created in 2008 by a person or group using the pseudonym “Satoshi Nakamoto” as an electric payment system based on cryptographic proof allowing any two parties to transact directly without the need for a trusted third party, such as a bank or credit card company. Bitcoin is partially anonymous, with individuals being identified by an alphanumeric address. Bitcoin runs on a blockchain-decentralized network of computers and uses open-source software and “miners” to validate transactions through solving complex algorithmic mathematical equations.

A virtual currency can be used as a store of value; however, virtual currencies are not a yield asset in that they do not generate dividends or interest. Virtual currencies can generally be traded with resulting capital gains or losses. The CFTC, like all regulators, points out the significant speculation and volatility risk. The CFTC reiterates the large incidents of fraud involving crypto marketplaces. Furthermore, there is a significant cybersecurity risk. If a “wallet” holding cryptosecurities is hacked, they are likely gone without a chance of recovery.

Although many virtual currencies, including Bitcoin, market themselves as a payment method, the ability to utilize Bitcoin and other virtual currencies for everyday goods and services has not yet come to fruition. In fact, the trend toward Bitcoin being a regularly accepted payment has seemed to have gone the other way, with payment processor Stripe, tech giant Microsoft and gaming platform Steam discontinuing Bitcoin support due to lengthy transaction times and increased transaction failure rates.

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.

To read about the SEC and CFTC joint statements and the Wall Street Journal op-ed article, see HERE.

The Author

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« The New Auditor Report The Treasury Department Report To The President On Capital Markets »

The New Auditor Report

Posted by Securities Attorney Laura Anthony | February 13, 2018 Tags: CAM, CAM Requirements, CAMs, PCAOB, SEC, The Auditor’s Report, The New Audit Report Rules, The New Auditor Report

In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. Among other additions, an audit report will need to include critical audit matters (CAMs) and disclosure the tenure of the auditor. The new rule and requirements related to audit reports are significant as the audit report is the document in which the auditor itself communicates to the public and investors.

The new standard will require auditors to describe CAMs that are communicated to a company’s audit committee. Critical audit matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.

The new audit report standard also adds information related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks.

The process in finalizing the rule has been lengthy, having begun in 2010 in response to investor- and public-initiated comments. Once proposed, the rule went through three rounds of public solicitation for comment. Of particular concern is whether the new requirements will result in increased nuisance shareholder litigation, costing the company and its investors, and whether it will result in a chill on auditor-company communications. In a statement related to the new auditor report, SEC Chairman Jay Clayton expressly addressed this concern, stating:

“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”

As an aside, as with any rule making, SEC rules and regulations can and do result in unintended consequences. This is an issue I’ve raised many times over the years in my blogs, including, for example, the multitude of differences between requirements for smaller reporting companies and emerging growth companies, a topic the SEC is now working on addressing and rectifying. It is great to see Chair Clayton discuss this phenomenon directly and for the rule itself to take measures to monitor and initiate changes based on implementation analysis.

There are certain carve-outs from some of the rule requirements, including the CAM requirements. In particular, the CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans; however, they do specifically apply to smaller reporting companies. Moreover, the rule requires extensive post-implementation review, in light of the potential for negative unintended consequences, and such review could result in changes to the rule itself and its implementation schedule.

The New Audit Report Rules

The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.

The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. A CAM is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”

For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.

The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.

Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed. The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.

The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.

In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.

All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.

The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.

The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.

Effective Dates

All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.

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« The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In The CFTC And Cryptocurrencies »

The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In

Posted by Securities Attorney Laura Anthony | February 6, 2018 Tags: CFTC, cryptocurrencies, SEC, The SEC And CFTC Joint Statements On Cryptocurrencies

On January 19, 2018 and again on January 25, 2018, the SEC and CFTC divisions of enforcement issued joint statements regarding cryptocurrencies. The January 19 statement was short and to the point, reading in total:

“When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.”

The January 25, 2018 statement was issued by SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo and was published as an op-ed piece in the Wall Street Journal. In summarizing the statements, I add my usual commentary and facts and information on this fast-moving marketplace.

Distributed ledger technology, or DLT, is the advancement that underpins an array of new financial products, including cryptocurrencies and digital payment services. Clearly the regulators understand the technological disruption, pointing out that “[S]ome have even compared it [DLT] to productivity-driving innovations such as the steam engine and personal computer.”

The regulators are careful not to discourage the technological advancement or investments themselves but rather are concerned that only those that are sophisticated and can afford a loss, participate. Likewise, unfortunately with every boom comes fraudsters, and investors have to ask the right questions and perform the right due diligence.

Like the dot-com era, of the hundreds (or thousands) of companies popping up in this space, few will survive and investments in those that do not, will be lost. The message from the regulators remains consistent, cautioning investors about the high risks with investments in this new space and stating that “[T]he CFTC and SEC, along with other federal and state regulators and criminal authorities, will continue to work together to bring transparency and integrity to these markets and, importantly, to deter and prosecute fraud and abuse.”

While the initial cryptocurrencies, like bitcoin and ether, were likened to a payment alternative to fiat currencies like the dollar and euro, these alternative currencies are very different. None are backed by a sovereign government, and they lack governance standards, accountability and oversight, reliable reporting of trading, or consistent reporting of price and other financial metrics.

Of course, this is an exciting era of development and Chairs Clayton and Giancarlo know that, stating:

“This is not a statement against investments in innovation. The willingness to pursue the commercialization of innovation is one of America’s great strengths. Together Americans embrace new technology and contribute resources to developing it. Through great human effort and competition, strong companies emerge. Some of the dot-com survivors are the among the world’s leading companies today. This longstanding, uniquely American characteristic is the envy of the world. Our regulatory efforts should embrace it.”

The SEC and CFTC are considering whether the historic approach to the regulation of currency transactions is appropriate for the cryptocurrency markets. Check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC. For example, Coinbase has money transmitting licenses from the majority of states. Gemini is a licensed trust company with the New York State of Financial Services. Furthermore, the Bank Secrecy Act and its anti-money laundering (AML) requirements apply to those in the business of accepting and transmitting, selling or storing cryptocurrencies.

Not a single cyptocurrency trading platform is currently registered by the SEC or CFTC. However, two CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms. In my next blog I will drill down on the CFTC’s regulatory role and position on cryptocurrencies including a discussion of its October 17, 2017 published article, “A CFTC Primer on Virtual Currencies.”

The SEC does not have jurisdiction over transactions involving currencies or commodities; however, where an offering of a cryptocurrency has characteristics of a securities offering, the SEC and state securities regulators have, and have exercised, jurisdiction. In addition to the many SEC enforcement proceedings I have written about, state regulators have likewise been very active in the enforcement arena against those offering cryptocurrency- or blockchain-related investments. The SEC is carefully monitoring the entire marketplace including issuers, broker-dealers, investment advisors and trading platforms. On January 18, 2018, the SEC issued a no-action letter prohibiting the registration under the Investment Company Act of 1940 of U.S. investment funds that desire to invest substantially in cryptocurrency and related products. I will provide further details on this letter in an upcoming blog.

As the boom has continued, many cryptocurrencies are simply being marketed for their potential increase in value on secondary trading platforms, again none of which are licensed by the SEC or CFTC. The utility side of the tokens (if any) has taken a back seat to the craze. Although a few trading platforms are licensed by state regulators as payment processors, many overseas are not licensed by any regulator whatsoever.

As the SEC has been repeating, the op-ed piece again clearly states that “federal securities laws apply regardless of whether the offered security—a purposefully broad and flexible term—is labeled a ‘coin’ or ‘utility token’ rather than a stock, bond or investment contract. Market participants, including lawyers, trading venues and financial services firms, should be aware that we are disturbed by many examples of form being elevated over substance, with form-based arguments depriving investors of mandatory protections.”

While attending the North American Bitcoin Conference in Miami a few weeks ago, I was amazed at the thousands of attendees and companies. I go to a lot of financial conferences and had never seen anything like this. I understand the concerns of the regulators and the need to issue constant warnings. While I met some extremely smart people and learned about great companies that could have hugely successful futures, many others were obviously trying to ride a boom, with nothing to offer. They lacked a strong management team, technological know-how, engineers and programmers, a real business, a real plan, or anything to support lasting value of the token issued in their ICO, or being touted for a future issuance. The sole opportunity for an investor was a potential increase in secondary trading value, which was being propped up with hundreds of thousands of dollars (raised in the ICO) of marketing, including crews of people paid to talk about the token on chat boards such as Telegram.

Like many practitioners, I am fascinated with the technology and disruption it will bring to many aspects of our lives including the arenas of corporate finance and trading markets, and have even invested.

International Organization of Securities Commissions Issues Warning on ICO’s

On January 18, 2018, the Board of the International Organization of Securities Commissions (“IOSCO”) issued a warning on ICO’s including the high risk associated with these speculative investments and concerns about fraud. The IOSCO is the leading international policy forum for securities regulators and is a recognized standard setter for securities regulation. The group’s members regulate more than 95% of the world’s securities markets in more than 115 jurisdictions.

The statement from IOSCO points out that ICO’s are not standardized and their legal and regulatory status depends on a facts and circumstances analysis. ICO’s are highly speculative and there is a chance that an entire investment will be lost. The warning continues: “[W]hile some operators are providing legitimate investment opportunities to fund projects or businesses, the increased targeting of ICOs to retail investors through online distribution channels by parties often located outside an investor’s home jurisdiction — which may not be subject to regulation or may be operating illegally in violation of existing laws — raises investor protection concerns.”

The IOSCO has provided its members with information on approaches to ICO’s and related due diligence. The IOSCO has also established an ICO Consultation Network with its members to continue the discussion.

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.

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

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« SEC Issues C&DI On Use Of Non-GAAP Measures The New Auditor Report »

SEC Issues C&DI On Use Of Non-GAAP Measures

Posted by Securities Attorney Laura Anthony | January 30, 2018 Tags: Definition of non-GAAP financial measure and exclusions, New C&DI, Refresher on Regulation G and Item 10(e) of Regulation S-K, Regulation G and Item 10(e) requirements

On October 17, 2017, the SEC issued two new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

My prior two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE and HERE.

GAAP continues to be criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number. I expect continued friction between the SEC’s enforcement of GAAP requirements and a company’s need to present non-GAAP numbers to satisfy the investment community.

New C&DI

The first of the new C&DI addresses whether forecasts provided to a financial advisor in relation to a business combination transaction would be considered non-GAAP financial measures requiring compliance with applicable rules. In particular, the SEC confirms that providing forecasts to a financial advisor in connection with a business combination transaction would not be considered non-GAAP financial measures.

Item 10(e)(5) of Regulation S-K and Rule 101(a)(3) of Regulation G provide that a non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, SEC rules, or pursuant to specific government regulations or SRO rules that are applicable to a company. Accordingly, financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (i) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (ii) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

Although the disclosure of projections to a financial advisor in a business combination transaction does not implicate rules related to non-GAAP financial measures, that same disclosure in a registration statement, proxy statement or tender offer statement would need to comply with Regulation G and Item 10(e) of Regulation S-K.

In the second new C&DI, the SEC addresses the limited exemptions from the non-GAAP rules for communications relating to business combination transactions. In particular, Rule 425 of the Securities Act requires that certain business combination communications, that would not be considered solicitation materials in other contexts, be filed with the SEC, generally as part of a registration statement on Form S-4, proxy statement or tender offer statement. Likewise, limited solicitations under Exchange Act Rule 14a-12 and 14d-2(b)(2) that are made prior to filing a proxy statement are exempted from the non-GAAP measure requirements.

Other than the limited exemptions set forth in the rules listed above, and communications to a financial advisor, business combination communications must comply with Regulation G and Item 10(e) of Regulation S-K related to non-GAAP financial measures, including a reconciliation to comparable GAAP numbers and the reasons for presenting the non-GAAP numbers.

Refresher on Regulation G and Item 10(e) of Regulation S-K

Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K.

Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

Definition of non-GAAP financial measure and exclusions

A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

Regulation G and Item 10(e) requirements

Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading.

As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.

« Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI) The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In »

Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI)

Posted by Securities Attorney Laura Anthony | January 23, 2018 Tags: Exemption for Limited Offerings and Sales of Securities Not Exceeding $5 Million, Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering, Filing of Notice of Sales (Form D), Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI), Regulation D, Rule 147, Rule 503, Rule 504, Rule 505, Rule 506

The SEC has been fine-tuning its Compliance and Disclosure Interpretations (C&DI), making multiple amendments, additions and deletions on September 20, 2017. The SEC made revisions to reflect changes to Rules 147 and 504, the repeal of Rule 505, as well as numerous non-substantive revisions throughout the C&DI to update for current rules and statutory references. Likewise, several C&DI have been removed that did not accurately reflect current rules.

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). The SEC created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC repealed the rarely used and now redundant Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A took effect on April 20, 2017. Amended Rule 504 took effect on January 20, 2017, and the repeal of Rule 505 was effective May 22, 2017. For a review of the rule changes, see my blog HERE.

This blog summarizes the substantive changes in the C&DI. Non-substantive changes were made to twenty-two C&DI, which the SEC marked with an asterisk (*) to indicate that they had been modified.

Regulation D

The SEC has made multiple changes to the C&DI related to Regulation D.

Rule 503 – Filing of Notice of Sales (Form D)

Rule 503 sets forth the requirements related to the filing of a Form D, notice of sales, with the SEC when completing an offering in reliance on Regulation D, including Rules 504 and 506. In 2009, the SEC issued a C&DI (Question 257.07) confirming that the filing of a Form D is not a condition to the availability of the exemptions under Rules 504 and 506.

All offers and sales of securities must comply with both federal and state securities laws, unless federal law specifically pre-empts state law compliance. The National Securities Markets Improvement Act of 1996 (“NSMIA”) amended Section 18 of the Securities Act to pre-empt state blue sky review of specified securities and offerings. The pre-empted securities are called “covered securities.” For more information on the NSMIA, see HERE and HERE.

The new C&DI (Question 257.08) bolsters the comfort level for issuers that fail to file a Form D (hopefully inadvertently) by confirming that the failure to file a Form D does not effect the Section 18 “covered security” status of securities issued under a Rule 506 offering.

Rule 504 – Exemption for Limited Offerings and Sales of Securities Not Exceeding $5 Million

The SEC has issued three new and withdrawn one C&DI related to Rule 504. Rule 504 provides an exemption from registration for offers and sales up to $5 million in securities in any twelve-month period. The purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions; furthermore, general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Rule 504, like Regulation A, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Rule 144 has bad actor disqualification provisions matching those provisions in Rule 506. For more information on bad actor disqualification provisions, see HERE.

Rule 504 offerings do not pre-empt state law and are, in essence, a deferral to the states for small offerings. Rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

The SEC has consistently viewed exempt offerings that involve general solicitation as public offerings. Accordingly, where a Rule 504 offering involves general solicitation or advertising, it would be considered a public offering.

One new C&DI (Question 258.03) confirms that a private fund which relies on either the Section 3(c)(1) or 3(c)(7) exemption from registration under the Investment Company Act of 1940 would not be able to make a public Rule 504 offering. The Investment Company Act exemptions in Sections 3(c)(1) and 3(c)(7) are not available to funds that conduct public offerings. If a private fund made a “public offering” of its securities, that private fund would no longer be able to rely on the applicable exclusion under Section 3(c)(1) or (7) and thus would be required to be registered under the Investment Company Act, unless another exclusion or exemption is available.

In the same C&DI, the SEC notes that a private fund could, however, rely on Rule 506(c) without losing its Investment Company Act exemption because Section 201(b)(2) specifically provides that offerings under Rule 506(c) are not considered “public offerings” under the federal securities laws. Interestingly, on November 17, 2016, the SEC issued a C&DI related to the integration of a 506(b) offering with a new 506(c) offering. Relying on Securities Act Rule 152, the SEC concluded that the two offerings would not integrate because the subsequent Rule 506(c) offering would be considered a “public offering.” See my blog HERE.

In new Question 258.05, the SEC confirms that the example for calculating aggregate offering price found in the instructions to Rule 504 does not contemplate integration of multiple offerings. Withdrawn Question 258.04 had also dealt with the calculation of the aggregate offering price.

In new Question 258.06, the SEC addresses the compliance date for the new Rule 504 bad actor disqualifications. That is, Rule 504 is not available to any issuer that is subject to disqualification under Rule 506(d) on or after January 20, 2017. On or after this date, issuers must determine if they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 504.

Rule 505

C&DI Questions 259.01 through 259.05 and 659.01 relating to Rule 505 have all been withdrawn consistent with the withdrawal of the Rule 505 exemption effective May 22, 2017.

Rule 506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering

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.

The SEC did not add any new C&DI on Rule 506 but did withdraw Question 260.02, which had addressed the now outdated preclusion of general solicitation or advertising for any Rule 506 offering.

Rule 147

For a complete summary of Rule 147, see HERE. The SEC has each added one and deleted one C&DI related to determining residence of a trust.

Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption. Rule 147, as amended is a safe harbor under Section 3(a)(11) of the Securities Act.

Rule 147 defines the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. The Rule specifies that if a trust is not a separate legal entity, it is deemed to be a resident of each state or territory in which its trustee is, or trustees are, resident.

The added C&DI (541.03) provides that where a family trust is not a separate legal entity and has two trustees residing in two separate states, an issuer may offer and sell securities to the trust, in reliance on Rule 147, as long as the Rule 147 offering is being conducted in one of the states in which a trustee resides.

The deleted C&DI (541.02) had provided that a trust could not be offered securities where the trust had a non-resident beneficiary that held a 50% interest in the trust.

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SEC and NASAA Statements on ICOs and More Enforcement Proceedings

Posted by Securities Attorney Laura Anthony | January 16, 2018 Tags: cryptocurrencies, DAO, ICO, ICOs, Initial Coin Offerings, NASAA, SEC, SEC and NASAA Statements on ICOs, SEC and NASAA Statements on ICOs and More Enforcement Proceedings

The message from the SEC is very clear: participants in initial coin offerings (ICO’s) and cryptocurrencies in general need to comply with the federal securities laws or they will be the subject of enforcement proceedings. This message spreads beyond companies and entities issuing cryptocurrencies, also including securities lawyers, accountants, consultants and secondary trading platforms. Moreover, the SEC is not the only watchdog. State securities regulators and the plaintiffs’ bar are both taking aim at the crypto marketplace. Several class actions have been filed recently against companies that have completed ICO’s.

After a period of silence, on July 25, 2017, the SEC issued a Section 21(a) Report on an investigation and related activities by the DAO, with concurrent statements by both the Divisions of Corporation Finance and Enforcement. On the same day, the SEC issued an Investor Bulletin related to ICO’s. For more on the Section 21(a) Report, statements and investor bulletin, see HERE. Since that time, the SEC has engaged in a steady flow of enforcement proceedings and statements on the subject.

The DAO report centered on a traditional analysis to determine whether a token is a security and thus whether an ICO is a securities offering. In particular, the nature of a digital asset (“coin” or “token”) must be examined to determine if it meets the definition of a security using established principles, including the Howey Test. See HERE for a discussion on the Howey Test. The report also pointed out that participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements, and that securities exchanges providing for trading must register unless an exemption applies.

On November 1, 2017, the SEC issued a warning to the public about the improper marketing of certain ICO’s, token offerings and investments, including promotions and endorsements by celebrities. Celebrities, like any other promoter, are subject to the provisions of Section 17(b) of the Securities Act, including the requirement to disclose the nature, scope, and amount of compensation received in exchange for the promotion. For more on Section 17(b) and securities promotion in general, see HERE.

On December 11, 2017, SEC Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings. In that statement, Clayton drilled down on the sudden rise of “non-security” ICO’s, now being referred to as “utility tokens,” clearly conveying the message that if a token has attributes of a security, it will be governed as a security. To make the message even clearer, also on December 11, 2017, the SEC halted the ICO by Munchee, Inc., disagreeing with Munchee’s statements and conclusions that its token was a “utility token” and not a security.

This was not the first ICO halt. On December 4, 2017, the SEC halted the ICO by PlexCorps, including outright fraud with the claims of an unregistered offering. The SEC has also taken aim at companies that are in the crypto space in general, having halting the trading of The Crypto Company on December 19, 2017 after a 2,700% stock price increase. This was not the first trading halt, either. Others include American Security Resources Corp, halted on August 24, 2017; First Bitcoin Capital, halted on August 23, 2017; CIAO Group, halted on August 9, 2017; and Sunshine Capital on June 7, 2017.

More recently, on January 5, 2018, the SEC halted the trading of UBI Blockchain Internet, Ltd. citing questions regarding the accuracy of information in SEC filings and concerns about market activity, which was the epitome of an unexplained stock surge.

On August 28, 2017, the SEC issued an investor alert warning about public companies making ICO-related claims. The alert specifically mentioned the trading suspensions and warned that ICO claims could be a sign of a pump-and-dump scheme.

On January 4, 2018, Chair Clayton issued another statement, this time joined by Commissioners Kara Stein and Michael Piwowar, commenting on the North American Securities Administrators Association (NASAA) statement made the same day. The NASAA is a group comprised of state securities regulators, which, among other functions, acts as a communication arm for the individual state regulators on important marketplace topics.

Jay Clayton’s December 11, 2017 Statement

Jay Clayton begins his December 11, 2017 statement with an acknowledgement of the “tales of fortunes made and dreamed to be made,” which is a perfect description of ICO mania. Keeping with the SEC theme under Clayton, he then addresses ICO considerations for Main Street investors. In addition to warning of fraud and misrepresentations, ICO’s and cryptocurrency trading is a national marketplace; invested funds may quickly move overseas. Furthermore, the SEC may not be able to gain jurisdiction or pursue bad actors or lost funds in other countries.

The fact is that as of today, no cryptocurrency offerings have been registered with the SEC. Although Jay Clayton doesn’t talk about what registration will really mean for an ICO, I note that, since registration is the process of ferreting out disclosures, it will force an entity issuing an ICO to be clear about the usefulness of its token, if any, and the risk factors not only associated with its token, but the marketplace as a whole. My firm is currently working on registration statements as well as private offering documents for ICO’s and blockchain technology entities and the complexity of this new industry and technology, and uncertainty associated with legalities (including not only securities matters, but the implication of swap and commodity transactions, tax ramifications, intellectual property matters, etc.) is confounding to even the best and brightest.

The importance of the involvement and efforts by market professionals is not lost on the SEC. In the beginning, many ICO’s, believing that this new investment vehicle was somehow not a security and therefore outside the parameters of the securities laws and SEC jurisdiction, forewent the advice of legal counsel and other professionals. Now that this belief has been rectified, in his statement, Jay Clayton reminds market professionals of their gatekeeping duties. Chair Clayton states, “[I] urge market professionals, including securities lawyers, accountants and consultants, to read closely the investigative report we released earlier this year (the “21(a) Report”) and review our subsequent enforcement actions.”

He continues: “[F]ollowing the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security….. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.” The bold emphasis was from the SEC, not added by me. The message could not be clearer.

Attorneys and other professionals are not the only groups that the SEC is taxing with gatekeeper responsibilities. Jay Clayton adds: “[I] also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of ‘scalping,’ ‘pump and dump’ and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.” Again, the bold emphasis is not mine. Although Jay Clayton does not indicate so, I am unaware of any properly licensed secondary market or exchange for the trading of cryptocurrencies at this time. TZero is properly licensed, but not up and functioning as of the date of this blog.

Jay Clayton’s statement is not all negative. He recognizes that ICO’s can be an effective method to raise capital and fund projects. He also recognizes that not all cryptocurrencies are securities. A specific example would be an in-app game with token purchases that can only be used to reach another level. However, Clayton points out that “[B]y and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

The Division of Enforcement has been instructed to vigorously police the ICO marketplace. Finally, the SEC encourages investors to conduct thorough due diligence before making an ICO investment. In that regard, he provides a list of basic questions that should be asked and considered before making any investment.

January 4, 2018 Statements by Chair Clayton and Commissioners Kara Stein and Michael Piwowar

On January 4, 2018, Chair Clayton, Commissioners Kara Stein and Michael Piwowar issued a statement commending the North American Securities Administrators Association’s (NASAA) own statement made the same day addressing concerns with ICO’s and cryptocurrencies. The NASAA is a group comprised of state securities regulators.

The SEC’s top brass specifically point out that cryptocurrencies are not, in fact, currencies in that they are not backed or regulated by sovereign governments and seem to be focused on a method of capital raising as opposed to mediums of exchange. Reiterating its other messaging, the SEC reminds the public that offerings and their participants must comply with the state and federal securities.

NASAA Statement on Cryptocurrencies and ICO’s

NASAA begins its statement with a consistent theme to the SEC, warning Main Street investors to be cautious about investments involving cryptocurrencies. NASAA, also like the SEC, encourages potential investors to conduct due diligence and ask questions before making an ICO (or any) investment.

NASAA includes a laundry list of risks and issues with ICO’s and crypto-related investments. NASAA points out that unlike FIAT or traditional currencies, cryptocurrencies have no physical form and typically are not backed by tangible assets (though I note that this is a void that is quickly being addressed by new tokens backed by physical assets and commodities).

Furthermore, cryptocurrencies are not insured, not controlled by a central bank or other governmental authority, are subject to very little if any regulation, and cannot be easily exchanged for other commodities. Cryptocurrencies are susceptible to breaches, hacking and other cybersecurity risks, including on both the ICO issuer side and the investor side through direct breaches into a wallet or other digital storage. ICO’s are a global investment vehicle and, as such, US regulators may have no ability to recover lost funds or pursue bad actors. Likewise, private civil proceedings could prove futile.

Moreover, the high volatility and high risk of cryptocurrency investments make them unsuitable for most investors. In both its statement and a very simple investor-directed animated video on the subject, NASAA clearly states that investors could lose all of their money in a crypto-related investment.

Regulators almost unanimously believe that cryptocurrencies involve a high risk of fraud. NASAA includes a list of obvious red flags, including guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy immediately, and unlicensed sellers.

NASAA now lists ICO’s and cryptocurrency-related investment products as an emerging investor threat for 2018.

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.

The Author

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

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The SEC’s 2017 Enforcement Priorities And Results

Posted by Securities Attorney Laura Anthony | January 9, 2018 Tags: 2017, SEC, The SEC's 2017 Enforcement Priorities And Results

No more broken windows! In a series of speeches by various top brass at the SEC followed by the publication of the SEC Enforcement Division 2017 Report on results and priorities, the SEC has confirmed both directly and through its actions that the era of “broken windows” enforcement is over. The broken windows policy was first shepherded by Mary Jo White in 2013 and was one in which the SEC committed to pursue infractions big and small and to investigate, review and monitor all activities. The idea was that small infractions lead to bigger infractions, and the securities markets have had the reputation that minor violations are overlooked, creating a culture where laws were treated as meaningless guidelines.

Michael Piwowar has been a critic of broken windows since its inception. In a speech to the Securities Enforcement Forum in 2014, Mr. Piwowar stated, “[I]f every rule is a priority, then no rule is a priority.” He continued, “[I]f you create an environment in which regulatory compliance is the most important objective for market participants, then we will have lost sight of the underlying purpose for having regulation in the first place. Rather than enabling vital and important economic activity, we will have unnecessarily shackled it – and our country will be far worse off from the absence of such activity.”

Given the power to make a change, Commissioner Michael Piwowar and Chair Jay Clayton have signaled an adjustment in enforcement priorities throughout the year. In February 2017, then acting Chair Michael Piwowar revoked the subpoena authority from SEC staff, leaving the Division of Enforcement with the sole authority to approve a formal order of investigation and issue subpoenas. Mr. Piwowar had been a vocal critic of both the staff subpoena power and the manner in which the power was created since its inception. He has also been a vocal critic of the SEC’s investigative power, believing it has too much power and too little oversight. For more on the SEC subpoena power, Mr. Piwowar’s views, and the early stage setting for the current enforcement priorities, see HERE.

In his October 4, 2017 testimony on the SEC’s Agenda, Operations and Budget before the Committee on Financial Services, Chair Jay Clayton reiterated his commitment to rooting out bad actors and fraud, including pump-and-dump schemes, insider trading, and serious reporting and disclosure violations. Certainly, a review of published enforcement proceedings has illustrated that commitment. Mr. Clayton also laid the groundwork for more focused enforcement, stating, “I have asked the Division of Enforcement to evaluate regularly whether we are focusing appropriately on retail investor fraud and investment professional misconduct, insider trading, market manipulation, accounting fraud and cyber matters. I believe our Main Street investors would want us to focus on these areas.”

In July 2017, Chair Clayton announced a top priority and philosophy of protecting “Main Street investors,” which buzzwords are now repeated often in SEC communications, including press releases and speeches.

On October 26, 2017, Steven Peikin, co-director of the SEC Division of Enforcement, confirmed the death knell for the broken windows policy. In a speech, Mr. Peiken told conference attendees that the SEC would “have to be selective and bring a few cases to send a broader message rather than seep the entire field.” Mr. Peiken also suggested stronger communication between the Division of Enforcement and investigative targets, and an environment that fosters cooperation. In that regard, the SEC should communicate the benefits of cooperation and specifically how a company can merit cooperation credit. In that regard, the SEC will again encourage self-reporting and remediation, a prior policy that lost its wind in the 2001 Enron crisis.

Clearly, the change is driven by more than philosophy. The SEC budget has effectively been frozen, and more money needs to be spent on cybersecurity matters than ever before. See HERE. The SEC Division of Enforcement could have at least 100 fewer investigators and supervisors over the next year, as those lost to attrition will not be replaced.

Mary Jo White’s policy of forcing admissions of guilt in enforcement settlements may also have reached its pinnacle. In June 2013, the SEC announced that it would require that a settling party admit wrongdoing as part of a settlement to act as a further deterrent and bolster public accountability. In addition to reputational damage, this policy had legal evidentiary significance that could be used in civil matters, including shareholder lawsuits. For more on this, see HERE.

In his October 2017 speech, Mr. Piekin talked about the admissions policy, stating, “I think when people resolve cases with the commission [and] neither admit nor deny but agree to all the points of relief, I don’t think most people in the world say, ‘Boy, they really got away with that.’” That doesn’t mean the policy will disappear, but it may revert to its prior reiteration, where only those with related criminal cases will be asked for a guilt admission.

Division of Enforcement Annual Report on Results and Priorities

On November 15, 2017, the Division of Enforcement issued its annual report (Annual Report) on results and priorities, reiterating the mission and focus on the protection of Main Street investors. The Annual Report cites five core principles, including: (i) focus on Main Street (retail) investors, including accounting fraud, sales of unsuitable products, pursuit of unsuitable trading strategies, pump-and-dump schemes and Ponzi schemes; (ii) focus on individual accountability to maximize deterrence and prevent recidivists from continuing improper activities; (iii) keeping pace with technological changes, including all cybersecurity matters; (iv) imposing sanctions that support enforcement goals; and (v) constantly assessing the allocation of resources.

The Annual Report reiterates initiatives announced earlier this year, including the new Cyber Unit and Retail Strategy Task Force (see HERE), while confirming its commitment to long-standing enforcement goals. The top current goals include risks posed by cyber-related misconduct; issues raised by the activities of investment advisers, broker-dealers, and other registrants; financial reporting and disclosure issues involving public companies; and insider trading and market abuse.

During fiscal year ended (FYE) September 2017, the SEC brought 754 enforcement proceedings, returned $1.07 billion to harmed investors and obtained judgment and orders for more than $3.789 billion in disgorgement and penalties. During FYE ended September 2016, the SEC brought 868 actions and obtained judgements and orders for more than $4 billion in disgorgement and penalties. For more on the 2016 report, see HERE.

Broken down by type of case, the most cases were brought related to issuer reporting violations including audit and accounting problems, followed by securities offerings, then investment advisor or investment company violations, then broker-dealer violations, followed by insider trading, then market manipulation. A number of cases were also brought for public finance abuse, FCPA violations and transfer agent issues.

Interestingly, the SEC suspended trading in 309 companies in FYE 2017, a 55% increase from 2016. Trading suspensions are generally related to market manipulation and microcap fraud, and are a very successful tool to stop these problems in their tracks. Asset freezes were pretty even in both years, with 35 court-ordered asset freezes in 2017 and 33 in 2017. Likewise, the imposition of bars and suspensions has remained a constant, with 625 in 2017 and 650 in 2016.

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