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

NASDAQ Issues Report Advocating for The U.S. Public Markets

Posted by Securities Attorney Laura Anthony | October 24, 2017 Tags: NASDAQ Issues Report Advocating for The U.S. Public Markets, SEC Disclosure Effectiveness Initiative, The NASDAQ Paper, The Promise of Market Reform: Reigniting American’s Economic Engine

Before SEC Commissioner Michael Piwowar’s May 16, 2017, speech at the SEC-NYU Dialogue on Securities Market Regulation regarding the U.S. IPO Market (see summary HERE), and SEC Chair Jay Clayton’s July 12, 2017, speech to the Economic Club of New York (see summary HERE), the topic of the U.S. IPO market had already gained significant market attention. Earlier this year, NASDAQ issued a paper titled “The Promise of Market Reform: Reigniting American’s Economic Engine” with its views and position on how to revitalize the U.S. equities and IPO market (the “NASDAQ Paper”). This blog summarizes the NASDAQ Paper.

The NASDAQ Paper begins with a statement by Adena Friedman, President and CEO of NASDAQ. The statement begins with a decidedly positive outlook, noting that “The U.S. equities markets exist to facilitate job creation and wealth creation for millions of people, ultimately driving economic growth for our country.” Ms. Friedman adds that “[E]xceptional market returns in recent years reflect the growing strength of the U.S. and global economy and continued confidence in the health of U.S. markets.”

However, on the other side she points out that there are structural issues that need to be addressed, noting that markets have become more complex and costly for companies that are already public or considering going public. The problem runs deep. Again quoting Ms. Friedman: “[I]f the volume of IPOs continues to fall and more companies choose to stay or go private, job creation and economic growth could suffer, and income inequality could worsen as average investors become increasingly shut out of the most attractive offerings.” In that regard, NASDAQ has issued its Paper setting out reforms that it advocates for to improve interest in the U.S. public markets.

The NASDAQ Paper

Following an Executive Summary, the NASDAQ Paper is broken down into three sections: (i) Reconstructing the Regulatory Framework; (ii) Modernizing Market Structure; and (iii) Promoting Long-Termism.

Executive Summary

Like Ms. Friedman’s statement, the executive summary at the beginning of the NASDAQ Paper touts the importance of robust U.S. public markets to our economy, a message I have reiterated in many blogs over the years. Citing the SEC’s own statistics, the NASDAQ Paper points out that since 1970, 92% of job creation has come from public companies and that the vast majority of Americans are invested in public companies either directly or indirectly through pension funds, mutual funds and other retirement accounts. Furthermore, index funds have gained in popularity, but for an index strategy to work, there needs to be a healthy selection of public companies to comprise these indexes and provide diversification and profitability.

Although many pension funds invest in private equity firms that in turn invest in private companies, these private investments are illiquid and hard to value. Accordingly, public markets remain and will continue to remain the investment of choice for U.S. retirement accounts.

However, with the necessary transparency of public companies comes greater obligations and compliance costs. Over the years the U.S. has continued to add layers of regulation such that the burdens of being public can outweigh the benefits. I note this is more so for larger companies that do not qualify as emerging growth or smaller public companies and are required to comply with even greater levels of disclosure, including compliance with Sarbanes-Oxley Act Section 404. For more on public company disclosure requirements, see HERE and HERE. A summary of the ongoing SEC Disclosure Effectiveness Initiative is at the end of this blog.

The NASDAQ Paper cites many reasons for the slowdown in the U.S. IPO market, including: (i) shareholder activists; (ii) frivolous shareholder lawsuits; (iii) pressure to prioritize short-term returns over long-term strategic growth; (iv) burdensome costs and headaches of the proxy process; and (v) irrelevant disclosure obligations. Moreover, the better companies have no problem finding private equity and often choose that route.

In addition to the direct causes for the slowdown, NASDAQ has three main concerns over the U.S. public markets, including: (i) complex regulations disincentivize market participation; (ii) a one-size-fits-all market structure does not work for small and emerging growth companies; and (iii) a culture in the investment community and media that prioritizes short-term return over long-term growth. NASDAQ offers its view and suggested solutions for each of these issues.

Reconstructing the Regulatory Framework

Although regulations and oversight are obviously a necessity, regulations which were put into place as a result of the financial crisis now need to be reviewed and particularly in relation to the burdens they impose on public companies and those considering entering the public markets. Moreover, years of layering of regulations, without a top-down view, has created unnecessary complexities for companies.

NASDAQ points to the proxy process as an area needing crucial regulatory reform. Although shareholders should have an ability to raise legitimate concerns, the proxy process is being used for nuisance value at a significant cost to companies. NASDAQ suggests that the SEC:

(i) Raise the minimum ownership amount and holding period to ensure that proposals have meaningful shareholder backing. Currently, the SEC rules allow a shareholder holding $2,000 or more of company stock for a period of one year or longer, to include issues in a company proxy statement, regardless of materiality, subject to the company’s ability to seek SEC no-action letter redress, which of course requires time and expense. For more on this process, see HERE. NASDAQ suggests increasing the minimum ownership to at least 1% of the company’s outstanding stock and increasing the minimum holding period to 3 years.

(ii) Update the SEC process for removing repetitive, unsuccessful proposals from proxies. NASDAQ backs the Financial Choice Act proposal, which would significantly increase the level of shareholder support a rejected proposal would need to have to be reintroduced at a future meeting. Moreover, the topics of shareholder proposals should be better identified to ensure that only matters that are meaningful to the shareholders are considered at annual meetings.

(iii) Create transparency and fairness in the proxy advisory industry. Due to the large number of proxies to consider each year, institutional investors rely on proxy advisory firms, which are unregulated and “rife with opacity, lack of accountability and conflicts of interest.” NASDAQ suggests that voting is often at the whim of these advisory firms, with no obligation to provide information related to their analysis, financial interests, or stock ownership (including long or short positions).

NASDAQ also advocates changes in corporate disclosure requirements. Although transparency is critically important, companies should have the flexibility to provide full disclosure that is shareholder-friendly (readable) and less burdensome on companies. I’ve included more information on the SEC’s Disclosure Effectiveness Initiative at the end of this blog. NASDAQ has strong views in this regard, and suggests the following changes:

(i) Offer flexibility on quarterly reporting. NASDAQ suggests allowing companies to file semiannual reports with material interim updates via press releases and Form 8-K’s.

(ii) Streamline quarterly reporting obligations for small and medium growth companies. NASDAQ suggests that “if companies report all key financial and business details in quarterly press releases, we should consider eliminating the archaic 10-Q form, which is duplicative and bureaucratic. We should also study options that allow for greater flexibility in reporting schedules, so that as long as companies are transparent with shareholders, they have the flexibility to report on a less-rigid structure. This would also promote our third goal of promoting long-termism.” In addition, NASDAQ questions the usefulness of XBRL, noting that many analysts use their own technology in any event.

(iii) Expand classifications for disclosure relief. In particular, NASDAQ suggests expanding the class of companies that will qualify as a “smaller reporting company” and “emerging growth company” to take advantage of the scaled-down disclosure requirements available to these companies.

(iv) Expand the ability to “test the waters” for emerging growth companies. For more information on test-the-waters provisions, see HERE and HERE.

(v) Allow all companies to file confidential draft registration statements. Since the time that NASDAQ issued its Paper, the SEC has, in fact, implemented this change. See HERE for more information.

(vi) Increase the definition of emerging growth company from the current $1,070,000,000 to $1.5 billion and eliminate the five-year phase-out period,

(vii) Harmonize the definitions and obligations of smaller reporting company with non-accelerated filer and emerging growth company. For more on the distinctions between these categories, see HERE. Also, for a summary of the current proposed changes to the definition of a smaller reporting company, see HERE.

(viii) Allow all companies to use shelf registrations regardless of size.

(ix) Roll back politically motivated disclosure requirements such that disclosures are only required that help investors evaluate a company’s financial performance and economic prospects. Examples of politically motivated disclosures include the conflict mineral disclosures and executive pay ratio.

(x) The SEC should complete its Disclosure Effectiveness Initiative to strip out unnecessary requirements and simplify the process all around.

NASDAQ suggests the need for comprehensive litigation reform. There has been a record rate of securities class actions, many of which are dismissed and are clearly filed for nuisance value. In fact, NASDAQ suggests, and I agree, that class actions have become a method of negotiation and ordinary standard business practice. However, the cost to companies to defend frivolous lawsuits is huge, as is the deterrent to entering the public arena. NASDAQ has several suggestions in this regard, including, for example: (i) ease the standards for imposing sanction on lawyers for bringing frivolous lawsuits; (ii) tighten the requirements for granting class certification; (iii) allow interlocutory appeals of decisions; (iv) require disclosure of third-party financing of the litigation; (v) limit plaintiffs’ legal fees; (vi) allow a plaintiff to amend its complaint only once; (vii) further codify the standards for pleading with respect to scienter and loss causation, and clarify the exclusive nature of federal jurisdiction over securities claims; (viii) increase the burden of proof; (ix) require the loser to pay the legal fees of the winner and require plaintiffs to post a bond to ensure this right; and (x) allow enforceable arbitration provisions for shareholder matters.

NASDAQ also supports tax reform and, in particular, is supportive of the current administration’s efforts to reduce corporate tax rates for U.S. companies as well as territorial taxation for foreign corporate earnings. The exchange also advocates for lower individual taxes specifically related to gains from investments in public companies. In particular, NASDAQ suggests:

(i) Exploring a system that would create a tax structure for individual investors that ties a low level of taxes on investments to the overall value of the account, rather than a higher dividends and capital gains tax on earnings within the account. Sweden introduced such a system in 2012, and since that time approximately 16% of the total Swedish population has taken advantage of this system and the number of Swedish IPO’s has doubled.

(ii) Expand the tax exemption on the sale of small business stock in the secondary market. The tax code currently has a narrow exemption that only benefits venture capitalists and private equity investors.

(iii) Enact a 100% dividends received deduction for holders of corporate stock, avoiding double taxation of corporate profits.

(iv) Eliminate the net investment income tax, which was enacted in 2013 and invokes a 3.8% surcharge on dividends and capital gains.

(v) Exclude dividends and capital gains from income for purposes of determining the phase-out of itemized deductions.

Modernizing Market Structure

The NASDAQ Paper states the obvious: the current market structure needs to be updated for technological advances. A particular problem is the illiquidity faced by small public companies, a problem which NASDAQ believes can be addressed through market reforms leveraging new technology. NASDAQ is particularly critical of Regulation NMS. NASDAQ specifically recommends:

(i) Strengthen markets for smaller companies. Small and medium companies face liquidity issues that also result in market volatility. When a buy or sell order is placed on a stock with low trading volume, it can create dramatic price movements which do not reflect underlying value. NASDSAQ suggests that the problem stems from fragmentation with trading spread among too many trading venues. Interestingly, 15 years ago, 90% of trading was on a single exchange, but today there are 12 exchanges and 50 or more trading venues. Although most OTC Market securities would not qualify for an exchange listing, even if they wanted to, NASDAQ cites the existence of this and other alternative trading systems as also causing a spread-out of liquidity. NASDAQ believes concentrating that disaggregated liquidity onto a single exchange, with limited exceptions, will allow investors to better source liquidity.

I can’t say I agree with NASDAQ on this one. The OTC Markets provides a much-needed source of capital raising and secondary market trading for small and emerging growth companies, where no other option exists. I am, and continue to be, an avid supporter of the OTC Markets and advocate for its recognition as a venture exchange. A legislatively supported venture market would improve the system dramatically. See my article HERE. I also note that the OTC Markets has a platform in place and a desire to be such a venture market. However, as of today, it has failed to receive the legislative support necessary to make the effective changes needed to the system.

(ii) Give issuers a choice to consolidate liquidity and improve trading quality. NASDAQ advocates reducing Unlisted Trading Privileges (UTP) but at the same time creating an exchange that small and medium companies can trade on. However, from my viewpoint such a route would reduce the number of publicly traded securities, which of course would increase supply and demand for traded securities, but would leave many small and emerging growth companies with no access to public capital or secondary markets.

NASDAQ is careful not to suggest eliminating off-exchange (OTC Markets) trading, noting that “[O]ff-exchange trading represents 38.4% of small and medium growth company trading volume today. While there are great benefits to consolidating on-exchange trading, there is also important value provided by off-exchange trading that merit consideration, especially block trades and price-improved trades. The network of off-exchange brokers also supports systemic resiliency for the trading of these securities.We want to work with the industry towards constructive solutions that balance on- and off- exchange activities.” However, it continues arguing in favor of consolidation. In reading the Paper, I wonder if NASDAQ is ultimately suggesting that OTC Markets be turned into a national exchange and run by NASDAQ itself.

(iii) Deploy intelligent tick sizes for small and medium growth companies. NASDAQ cites research that a one-size-fits-all approach to tick size is suboptimal for many (particularly small and medium growth) companies, which should trade in a suitable tick regime determined by their listing exchange. NASDAQ believes trading could be on sub-penny, penny, nickel or dime increments. For information on the SEC tick size pilot program, see HERE.

(iv) Cultivate innovative market-level solutions that improve the trading of small and medium growth companies. NASDAQ advocates eliminating or greatly reducing Regulation NMS. Regulation NMS (National Market System) is a set of rules and regulations governing fairness in price execution, quote displays and access to market data. NASDAQ believes that these rules are restrictive to the market as a whole and negatively impact the liquidity of lower-priced securities.

(v) Implement an intelligent rebate/fee structure that promotes liquidity and avoids market distortion. In this recommendation, NASDAQ is suggesting plans for incentivizing market making in less liquid stocks.

(vi) Ensure fair and reasonable pricing for participants in the context of limiting exchange competition. Of course, if competition is eliminated, there must be rules in place to ensure that “the house” doesn’t win all! (My words, not NASDAQ’s.)

Promoting Long-termism

Companies are under increasing pressure to realize short-term profits for shareholders to the detriment of sustainable long-term growth. NASDAQ particularly points the blame finger at activist investors. Furthermore, unlike many investor groups, NASDAQ supports dual class structures which allow the entrepreneurs and internal management to invest in a motivating fashion along with external investors. NASDAQ’s specific recommendations include:

(i) Address concerns regarding activist investors. As shareholder activism has grown, its definition and purpose have become more muddled. Activism is a term used as an investment strategy that may or may not have any benefit to the company and its other shareholders. In addition to a need for dialogue and research in this area, NASDAQ advocates for further transparency and disclosure around arrangements and motivations by activists, including conflicts of interest.

(ii) Equalize short interest transparency. Short interest disclosures should tie in with Section 13 long position disclosure requirements. The NASDAQ Paper hits the nail on the head: “the asymmetry of information between long investors and those with short positions deprives companies of insights into trading activity and limits their ability to engage with investors and it deprives investors of information necessary to make meaningful investment decisions.”

(iii) Continue to support a dual class structure. Each public company, and their entrepreneurs and innovators, should have the flexibility to determine the best class structure for that company.

(iv) Encourage, rather than mandate, ESG disclosure. ESG stands for environmental, social and governance disclosures.

Further Reading on the SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. Although the rate of changes has slowed down since the election and change in SEC control regime, I expect it to pick up again. In an upcoming blog, I will be writing about the SEC’s announced Regulatory Flexibility Agenda. The Agenda lists regulations the SEC expects to propose or finalize in the next 12 months. This year’s Agenda only includes 33 rules (last year’s contained 62), at least 8 of which are related to disclosure requirements.

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. See my blog HERE on the Item 601 rule changes.

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

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

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

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

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

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

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

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.

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

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« SEC Chief Accountant Speaks On Initial Coin Offerings ( ICO’s) SEC Proposes Rules to Modernize and Simplify Disclosures »

SEC Chief Accountant Speaks On Initial Coin Offerings ( ICO’s)

Posted by Securities Attorney Laura Anthony | October 17, 2017 Tags: blockchain, cryptocurrencies, digital coins, Distributed Ledger Technology, DLT, ICO by the DAO, ICOs, SEC Chief Accountant Speaks On Initial Coin Offerings, secondary token trading

On September 11, 2017, the SEC Chief Accountant, Wesley R. Bricker, gave a speech before the AICPA National Conference on Banks & Savings Institutions. The bulk of the speech was similar to Mr. Bricker’s June 2017 speech before the 36th Annual SEC and Financial Reporting Institute Conference, summarized HERE. However, one topic that was new, and interesting enough to spark this blog, was related to initial coin offerings (ICO’s). Note that offers and sales of digital coins, cryptocurrencies or tokens using distributed ledger technology (DLT) or blockchain have become widely known as ICO’s.

As the capital markets become more and more focused on all things blockchain, including ICO’s, secondary token trading, and disruptive changes made possible by distributed ledger technology (DLT), which is inevitably transforming capital market processes, the SEC is fronting a wave of questions and concerns on the subject. On July 25, 2017, the SEC issued a report on an investigation related to an ICO by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report. On the same day, the SEC issued an Investor Bulletin related to ICO’s. (See summary of the report, statement and investor bulletin HERE).

Almost all divisions and committees of the SEC are and will be impacted by DLT and ICO’s and are working diligently to address the technology and the public markets’ wave of interest. In August 2017 the SEC suspended the trading in a slew of bitcoin-based companies questioning the accuracy of publicly reported information and press releases. On September 20, 2017, the SEC’s Investor Advisory Committee announced the agenda for its next meeting to be held on October 12, the first item on which is blockchain and other distributed ledger technology and its implications for securities markets.

FINRA is likewise as attentive to DLT and its far-reaching implications. On July 13, 2017, FINRA held a Blockchain Symposium including participation by the Office of the Comptroller of Currency, the US Commodity Futures Trading Commission (CFTC), the Federal Reserve Board and the SEC. Earlier in the year, FINRA published a report on the technology and its potential impacts on broker-dealers and the markets in general. See HERE for a summary.

Although outside of my practice area, the Internal Revenue Service is stepping up efforts to make sure taxes are reported and paid for trading profits and other taxable income related to cryptocurrencies. In that regard, the IRS has contracted with a company that provides software that analyzes and tracks bitcoin transactions.

Mr. Bricker’s Remarks on ICO’s

Mr. Bricker begins by talking about the SEC report on the DAO investigation, stating that “[T]he report makes clear that the federal securities laws apply to those who offer and sell securities in the U.S., regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, whether those securities are purchased using U.S. dollars or virtual currencies, or whether they are distributed in certificated form or through distributed ledger technology.”

All offers and sales of securities in the U.S. must either be registered with the SEC or must qualify for an exemption. The SEC’s registration requirements include the filing of audited financial statements. In addition, I note that many exemptions likewise require the disclosure of either audited or unaudited financial statements. Furthermore, the basic antifraud principles encompassed in Rule 10b-5 of the Securities Exchange Act of 1934 and Section 17(a) of the Securities Act of 1933, require full and fair disclosure, which includes financial information about the issuer.

Mr. Bricker confirms the basics that U.S. accounting principles apply to ICO’s as they do with any other offerings. Issuing companies should review guidance related to the presentation and disclosure of financial statements, consolidation, translation, assets, liabilities, revenue, expenses and ownership.

Mr. Bricker lists questions that both issuers and holders should consider:

Issuers:

What are the necessary financial statement filing requirements?

Are there liabilities requiring recognition or disclosure?

Are there previously recognized assets that require de-recognition?

Are there revenues or expenses requiring recognition or deferral?

Is there a transaction with owners, resulting in debt or equity classification and possibly compensation expense?

Are there implications for the provision for income taxes?

Holders:

Does specialized accounting guidance (such as for investment companies) apply to the holder’s financial statement presentation?

What are the characteristics of the coin or token in considering whether, how, and at what value the transaction should affect the holder’s financial statements?

What is the nature of the holder’s involvement in considering whether the issuer’s activities should be consolidated or accounted for under the equity method?

A new wave of ICO’s

Since the SEC issued its report on the DAO, my office has been actively involved with clients and potential clients interested in structuring ICO’s which comply with the federal (and state) securities laws. Although I have yet to see a registered ICO, several are now utilizing 506(b) or 506(c) to complete their offerings. For instance, the recent $285 million Filecoin ICO was completed in reliance on Rule 506(c) and included such institutional investors as Sequoia Capital, Andreessen Horowitz and Union Square Ventures. Other similar offerings have been and continue to be launched on platforms such as CoinList (which is partnered with AngelList) and now more traditional securities offering platforms such as Start Engine. I am certain the number of securities ICO’s relying on traditional securities offering registration or exemption rules and regulations will continue to increase dramatically.

The Author

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

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« Updates On Regulation A+ NASDAQ Issues Report Advocating for The U.S. Public Markets »

Updates On Regulation A+

Posted by Securities Attorney Laura Anthony | October 10, 2017 Tags: Improving Access to Capital Act, Summary of Regulation A, Updates On Regulation A+

On September 14, 2017, the SEC issued three new Compliance and Disclosure Interpretations (C&DI) to provide guidance related to the filing of a Form 8-A in conjunction with a Tier 2 Regulation A offering. The new guidance addresses the timing of financial statements and subsequent reporting requirements under the Securities Exchange Act of 1934 (“Exchange Act”).

Furthermore, earlier in September, the House passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A, a change the entire marketplace is advocating for.

As I do with each blog on Regulation A, I have included an ongoing commentary, practice tips, and thoughts on Regulation A+, and a summary of the Regulation A+ rules, including interpretations and guidance up to the date of this blog.

New CD&I Guidance

As a reminder, Tier 2 issuers that have used the S-1 format for their Form 1-A filing are permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements and to register with a national exchange. The Form 8-A must be filed within 5 days of qualification of the Form 1-A by the SEC. A Form 8-A is a simple Exchange Act registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC. Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. A form 8-A can also be used as a short-form registration to list on a national exchange under Section 12(b) of the Exchange Act.

On March 31, 2017, the SEC issued initial guidance on the timing of the filing of the Form 8-A for an exchange listing. In order to be able to file a Form 8-A as part of the Regulation A+ process, in addition to utilizing Form S-1 format in the Regulation A+ offering circular, a company must file the Form 8-A concurrent with qualification of the offering circular. Registration under 12(g) occurs automatically; however, Registration under 12(b) requires that the applicable national securities exchange certify the registration within five calendar days. As with any SEC filings based on calendar days, where the fifth day falls on a Saturday, Sunday or federal holiday, the certification may be received on the next business day.

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

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

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

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

Improving Access to Capital Act

The Improving Access to Capital Act is a short Act with only two sections. First the Act requires that companies subject to the Exchange Act reporting requirements not be ineligible to utilize Regulation A. As noted below, Regulation A is written to include a list of ineligible issuers. The Act would remove reporting companies from that list. Second the Act provides that Exchange Act reports will satisfy the Tier 2 reporting requirements.

The Act was passed with a 403-3 vote by the House and will next be presented to the Senate. I am hopeful that this much-needed change will come to fruition.

The Final Rules – Summary of Regulation A

I’ve written about Regulation A+ on numerous occasions, including detailing the history and intent of the rules. Title IV of the JOBS Act, which was signed into law on April 5, 2012, set out the framework for the new Regulation A and required the SEC to adopt specific rules to implement the new provisions. The new rules came into effect on June 19, 2015. For a refresher on such history and intent, see my blog HERE. Importantly, as I point out in that blog and others I have written on the subject, Tier 2 of Regulation A preempts state blue sky law.

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

However, as I will discuss below, this does not include preemption of state law related to broker-dealer registration. Five states (Florida, New York, Texas, Arizona and North Dakota) do not have “issuer exemptions” for public offerings such as a Regulation A offering. Companies completing a Regulation A offering without a broker-dealer will need to register as an “issuer dealer” in those states.

Two Tiers of Offerings

Regulation A is now divided into two offering paths, referred to as Tier 1 and Tier 2. Tier 1 remains substantially the same as the old pre-JOBS Act Regulation A but with a higher offering limit and allowing for more marketing and testing the waters. A Tier 1 offering allows for sales of up to $20 million in any 12-month period. Since Tier 1 does not preempt state law, it is really only useful for offerings that are limited to one but no more than a small handful of states. Tier 1 does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements. Tier 1 cannot be used for an initial going public transaction.

Both Tier I and Tier 2 offerings contain minimum basic requirements, including issuer eligibility provisions and disclosure requirements. Resales of securities by selling security holders are limited to no more than 30% (including affiliate selling shareholders) of a total particular offering for all Regulation A offerings. For offerings up to $20 million, an issuer can elect to proceed under either Tier 1 or Tier 2. Both tiers will allow companies to submit draft offering statements for non-public SEC staff review before a public filing, permit continued use of solicitation materials after the filing of the offering statement and use the EDGAR system for filings.

Tier 2 allows a company to file an offering circular with the SEC to raise up $50 million in a 12-month period. Tier 2 preempts state blue sky law. A company may elect to either provide the disclosure in the new Form 1-A or the disclosure in a traditional Form S-1 when conducting a Tier 2 offering. The Form S-1 format is a precondition to being able to file a Form 8-A to register under the Exchange Act. Either way, the SEC review process is a little shorter, and a company can market in a way that it cannot with a traditional IPO. Regulation A has specific company eligibility requirements, investor qualifications and associated per-investor investment limits.

Also, the process is not inexpensive. Attorneys’ fees, accounting and audit fees and, of course, marketing expenses all add up. A company needs to be organized and ready before engaging in any offering process, and especially so for a public offering process. Even though a lot of attorneys, myself included, will provide a flat fee for the process, that flat fee is dependent on certain assumptions, including the level of organization of the company.

Eligibility Requirements

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

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

Companies currently subject to the reporting requirements of the Exchange Act;

Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s;

Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents; or assets consisting of any amount of cash and cash equivalents and nominal other assets. Accordingly, a start-up business or minimally operating business may utilize Regulation A;

Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;

Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years;

Issuers that became subject to Regulation A reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and

Issuers that are disqualified under the Rule 262 “bad actor” provisions

A company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A. A company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to use Regulation A. A wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued.

Unfortunately, in what is clearly a legislative miss, companies that are already publicly reporting – that is, are already required to file reports with the SEC – are not eligible. OTC Markets has petitioned the SEC to eliminate this eligibility criteria, and pretty well everyone in the industry supports a change here, but for now it remains. One of the top recommendations by the SEC Government-Business Forum on Small Business Capital Formation has also been to expand Regulation A to allow reporting issuers to utilize the process. For more information on the OTC Markets’ petition and discussion of the reasons that a change is needed in this regard, see my blog HERE. Also, as discussed at the beginning of this blog, the House has now passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A.

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

Eligible Securities

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

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

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

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

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

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

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

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

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

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

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

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

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

Continuous or Delayed Offerings

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

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

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

Additional Tier 2 Requirements; Ability to List on an Exchange

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

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

A company completing a Tier 2 offering may file a Form 8-A concurrently with the qualification of the Form 1-A (i.e., no later than 5 days following qualification), to register under the Exchange Act, and may make immediate application to a national securities exchange. A Form 8-A is a simple (generally 2-page) registration form used instead of a Form 10 for companies that have already filed the substantive Form 10 information with the SEC (generally through an S-1). The Form 8-A will only be allowed if it is filed within five (5) days of the qualification of the Form 1-A or a post-qualification amendment to the initial qualified Form 1-A. An issuer could not qualify a Form 1-A, wait a year or two, and then file a Form 8-A. In that case, they would need to use the longer Form 10.

Where the securities will be listed on a national exchange, the accredited investor limitations will not apply. When the Form 8-A is for registration with a national securities exchange under Section 12(b) of the Exchange Act, the national exchange must certify the Form 8-A within five (5) business days of its filing.

Upon filing a Form 8-A, the company will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A reporting will automatically be suspended.

A company that reports under the scaled-down Regulation A requirements is not considered to be subject to the Exchange Act reporting requirements, and therefore its shareholders will need to satisfy the longer one-year holding period under Rule 144.

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

A company that reports under Regulation A may apply to trade on any of the three OTC Markets tiers of quotation (Pink, OTCQB or OTCQX).

Integration

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

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

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

Offering Statement – General

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

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

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

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

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

Offering Statement – Non-Public (Confidential) Submission

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

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

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

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

Offering Statement – Form and Content

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

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

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

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

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

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

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

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

Offering Price

All Regulation A offerings must be at a fixed price. That is, no offerings may be made “at the market” or for other than a fixed price.

Ongoing Reporting

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

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

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

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

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

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

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

A company that completes a Tier 2 offering and files a form 8-A may immediately apply for trading on a national exchange such as the NASDAQ or NYSE American. In 2017, several Regulation A issuers have begun trading on both exchanges.

Freely Tradable Securities

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

Since neither Tier 1 nor Tier 2 Regulation A issuers are subject to the Exchange Act reporting requirements (unless a Form 8-A is filed), the Rule 144 holding period for shareholders is the longer 12 months and such shareholders would not be able to rely on Rule 144 at all if the company has been a shell company at any time in its history. For more information on Rule 144 as relates to shell companies, see HERE.

Treatment under Section 12(g)

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

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

The issuer utilizes an SEC-registered transfer agent. Such transfer agent must be engaged at the time the company is relying on the exemption from Exchange Act registration;

The issuer remains subject to the Tier 2 reporting obligations;

The issuer is current in its Tier 2 reporting obligations, including the filing of an annual and semiannual report; and

The issuer has a public float of less than $75 million as of the last business day of its most recently completed semiannual period or, if no public float, had annual revenues of less than $50 million as of its most recently completed fiscal year-end.

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

State Law Preemption

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

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

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

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

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

Broker-Dealer Placement

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

Regulation A – Private or Public Offering?

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

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

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

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

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

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

Also, effective July 10, 2016, the OTCQB amended their rules to allow a Tier 2 reporting entity to qualify to apply for and trade on the OTCQB; however, unless the issuer has filed a Form 8-A or Form 10, they will not be considered “subject to the Exchange Act reporting requirements” for purposes of benefiting from the shorter 6-month Rule 144 holding period.

Practice Tip on Registration Rights Contracts

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

Further Thoughts

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

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

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

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SEC Provides Regulatory Relief To Hurricane Victims

Posted by Securities Attorney Laura Anthony | October 3, 2017 Tags: Form ADV Filing Deadline, Form ADV Filing Requirements, SEC Provides Regulatory Relief To Hurricane Victims

On September 28, 2017, the SEC announced interim final temporary rules (“Exemptive Order”) to provide relief to publicly trading companies, investment companies, accountants, transfer agents, municipal advisors and others affected the Hurricanes Harvey, Irma and Maria. In addition to the interim rules, the SEC urges others not covered by the relief but affected in their ability to provide information to the SEC or shareholders to contact the SEC to seek relief on a case-by-case basis.

Interim Final Temporary Rules

Generally the due date for Exchange Act reports for companies relying on the Exemptive Order shall be October 10, 2017 for those affected by Hurricane Harvey, October 19, 2017 for those affected by Hurricane Irma, and November 2, 2017 for those affected by Hurricane Irma. As such, companies with such extended due dates may also file an additional extension on Form 12b-25 on those dates, and benefit from an additional five days for a Form 10-Q and 15 days for a Form 10-K. As long as the subject report is filed within the time specified in the 12b-25, such company will still be considered timely and current in its reporting requirements.

The filing extensions apply to all Exchange Act reports, including under Sections 13(a) such as Forms 10-Q, 10-K and 8-K; 13(d), (f) and (g) for reports of ownership in excess of 5%; Section 14 proxy, information, and tender offer filing; Section 15(d) filings, including Forms 10-Q, 10-K and 8-K; and 16(a), Regulations 13A, 13D-G, 14A, 14C and 15D, and Exchange Act Rules 13f-1, 14f-1 and 16a-3.

Where the company is seeking relief from a requirement to deliver a report or information to shareholders, such as proxy or tender offer information under Section 14 of the Exchange Act, in addition to the time periods, the company must show that the shareholders had a mailing address located in the zip codes affected by Hurricanes Harvey, Irma or Maria and that mail service was suspended.

For purposes of the eligibility to use Form S-3, a company relying on the Exemptive Order will be considered current and timely in its Exchange Act filing requirement during the relief period, if such company was current and timely prior to the first day of the period specified in the Order. As a reminder, among other requirements, to qualify to use an S-3 registration statement a company must have filed all Exchange Act reports in a timely manner, including Form 8-K, within the prior 12 months. Any delayed reports need to be filed by October 10, 2017 for those affected by Hurricane Harvey, October 19, 2017 for those affected by Hurricane Irma and November 2, 2017 for those affected by Hurricane Irma.

For purposes of Form S-8 eligibility and the current information requirements under Rule 144(c), a company relying on the Exemptive Order will be considered current in its Exchange Act filing requirements if such company was current and timely prior to the first day of the period specified in the Order. Again, any delayed reports need to be filed by October 10, 2017 for those affected by Hurricane Harvey, October 19, 2017 for those affected by Hurricane Irma and November 2, 2017 for those affected by Hurricane Irma.

Registered transfer agents either in areas affected by the Hurricanes, or unable to provide services to security holders in the affected areas, were also granted relief. Registered transfer agents unable to provide services under Sections 17A and 17(f) of the Exchange Act are granted temporary exemptive relief from compliance from August 25, 2017 through November 2, 2017 if: (i) they notify the SEC in writing by November 2, 2017 that they are relying on the Exemptive Order; (ii) the notification provides a statement of the reasons why, in good faith, the transfer agent was unable to comply with the rules; (iii) if the transfer agent knows or believes that the books and records it is required to maintain were lost, destroyed or materially damaged, the extent of such loss, the affected issuers, and steps taken to rectify the damage; (iv) if the transfer agent knows or believes that funds or securities belonging to either an issuer or security holder that were within its possession were lost, destroyed or materially damaged, the extent of such loss and steps taken to rectify the damage; and (v) the transfer agent must take steps to protect remaining books, records, funds and securities.

The Exemptive Order also allows independent auditors to provide books and records to issuer clients to assist in the reconstruction of accounting records, without infringing on such auditors’ independence. In particular, Exchange Act rules and Regulation S-X prohibit an independent auditor from “maintaining or preparing the audit client’s accounting records” or “preparing or originating source data underlying the audit client’s financial statements.” Relief under the Exemptive Order is conditioned upon limiting services by the independent auditor to reconstruction of previously existing accounting records that were lost or destroyed as a result of the hurricanes and that such services cease as soon as the audit client’s lost or destroyed records are reconstructed, its financial systems are fully operational and the client can effect an orderly and efficient transition to management or other service provider. In addition, the company’s audit committee must specifically approve the auditor’s services.

During the period from August 25, 2017 to November 1, 2017, a registered open-end investment company and a registered unit investment trust will be considered to have satisfied the requirements of Section 5(b)(2) of the Securities Act to deliver a summary or a statutory prospectus to an investor, provided that: (1) the sale of shares to the investor was not an initial purchase by the investor of shares of the company or unit investment trust; (2) the investor’s mailing address for delivery, as listed in the records of the company or unit investment trust, has a ZIP code for which the common carrier has suspended mail service, as a result of Hurricanes Harvey, Irma, Maria, of the type or class customarily used by the company or unit investment trust, to deliver summary or statutory prospectuses; and (3) the company, or unit investment trust, or other person promptly delivers the summary or statutory prospectus, either (a) if requested by the investor, or (b) by the earlier (i) of November 2, 2017 or (ii) the resumption of the applicable mail service. The same dates and parameters apply to registered investment advisers for the delivery of written disclosure statements to advisory clients.

A registered investment advisor affected by Hurricane Harvey will be considered to have satisfied their Form ADV filing requirements under the Advisors Act, if: (i) their Form ADV filing deadline was between August 25, 2017 and October 6, 2017; and (ii) they filed by October, 10, 2017.

A registered investment advisor affected by Hurricane Irma will be considered to have satisfied their Form ADV filing requirements under the Advisors Act, if: (i) their Form ADV filing deadline was between September 6, 2017 and October 18, 2017; and (ii) they filed by October, 19, 2017.

A registered investment advisor affected by Hurricane Maria will be considered to have satisfied their Form ADV filing requirements under the Advisors Act, if: (i) their Form ADV filing deadline was between September 20, 2017 and November 1, 2017; and (ii) they filed by November 2, 2017.

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« The SEC Provides Further Guidance On Financial Statement Requirements In Registration Statements Updates On Regulation A+ »

The SEC Provides Further Guidance On Financial Statement Requirements In Registration Statements

Posted by Securities Attorney Laura Anthony | September 26, 2017 Tags: Background on Section 71003 of the FAST Act, Financial Statement Requirements for Companies Other than an Emerging Growth Company, Financial Statement Requirements for Emerging Growth Companies, Financial Statement Requirements In Registration Statements, Guidance On Financial Statement Requirements In Registration Statements, Section 71003 of the FAST Act

On August 17, 2017, the SEC issued guidance on financial statement requirements for confidential and public registration statement filings by both emerging growth companies (EGC) and non-emerging growth companies. The new Compliance and Disclosure Interpretations (C&DI’s) follow the SEC’s decision to permit all companies to submit draft registration statements, on a confidential basis (see HERE). The newest guidance is in accord with the SEC’s announced policy to take active measures to promote the U.S. IPO market and small business capital-raise initiatives.

Earlier in the summer, the SEC expanded the JOBS Act benefit available to emerging growth companies, to be able to file confidential draft registration statements, to all companies. Confidential draft submissions are now available for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting.

Title I of the JOBS Act initially allowed for confidential draft submissions of registration statements by emerging growth companies but did not include any other companies, such as smaller reporting companies. Regulation A+ as enacted on June 19, 2015, also allows for confidential submissions of an offering circular by companies completing their first Regulation A+ offering.

The new C&DI’s expand certain FAST Act benefits also only statutorily available to emerging growth companies, to all companies. Like the earlier expansion of the JOBS Act benefit, the new extension of rights was made by staff policy and not a formal rule change.

Background on Section 71003 of the FAST Act

Section 71003 of the FAST Act allows an EGC that is filing a registration statement under either Form S-1 or F-1 to omit financial information for historical periods that would otherwise be required to be included, if it reasonably believes the omitted information will not be included in the final effective registration statement used in the offering, and if such final effective registration statement includes all up-to-date financial information that is required as of the offering date. As directed by the FAST Act, the SEC revised the instructions to Forms S-1 and F-1 to reflect the new law.

The Section 71003 provisions do not allow for the omission of stub period financial statements if that stub period will ultimately be included in a longer stub period or year-end audit before the registration statement goes effective. In a C&DI under the prior SEC administration, the SEC clarified that the FAST Act only allows the exclusion of historical information that will no longer be included in the final effective offering. The C&DI clarifies that “Interim financial information ‘relates’ to both the interim period and to any longer period (either interim or annual) into which it has been or will be included.” For example, an issuer could not omit first-quarter financial information if that first quarter will ultimately be included as part of a second- or third-quarter stub period or year-end audit.

An SEC C&DI clarified that Section 71003 allows for the exclusion of financial statements for entities other than the issuer if those financial statements will not be included in the final effective registration statement. For example, if the EGC has acquired a business, it may omit that acquired business’ historical financial information as well. In a C&DI, the SEC confirms that: “Section 71003 of the FAST Act is not by its terms limited to financial statements of the issuer. Thus, the issuer could omit financial statements of, for example, an acquired business required by Rule 3-05 of Regulation S-X if the issuer reasonably believes those financial statements will not be required at the time of the offering. This situation could occur when an issuer updates its registration statement to include its 2015 annual financial statements prior to the offering and, after that update, the acquired business has been part of the issuer’s financial statements for a sufficient amount of time to obviate the need for separate financial statements.”

As a reminder, an EGC is defined as an issuer with less than $1,070,000,000 in total annual gross revenues during its most recently completed fiscal year. If an issuer qualifies as an EGC on the first day of its fiscal year, it maintains that status until the earliest of the last day of the fiscal year of the issuer during which it has total annual gross revenues of $1,070,000,000 or more; the last day of its fiscal year following the fifth anniversary of the first sale of its common equity securities pursuant to an effective registration statement; the date on which the issuer has, during the previous 3-year period, issued more than $1,070,000,000 in non-convertible debt; or the date on which the issuer is deemed to be a “large accelerated filer.”

NEW CD&I

Financial Statement Requirements for Emerging Growth Companies

Using staff policy, the SEC will not require an EGC to include interim financial information in its draft registration statements, that it reasonably believes it will not be required to present separately at the time of the contemplated offering. For example, if an EGC with a calendar fiscal year-end submits a draft registration statement in November 2017, but does not expect to launch the offering until April 2018, after the full 2017 audit would be required, such EGC could omit the 2015 annual financial statements and stub period information for both 2016 and 2017. That is, since only full-year audits for 2016 and 2017, and no stub period statements for nine months ended 2016 and 2017, would be included in the final effective registration statement, neither the stub periods nor the 2015 statements would need to be included in the draft registration.

Financial Statement Requirements for Companies Other than an Emerging Growth Company

The SEC has extended the benefit of Section 71003 of the FAST Act to companies that do not qualify as an EGC to allow for the omission of historical financial statements in its confidential draft registration statements, that it reasonably believes will not be required to be included at the time it files its registration statement publicly.

A company must publicly file its registration statement and all nonpublic draft submissions at least 15 days prior to any road show, and in the absence of a road show, at least 15 days prior to the requested effective date of the registration statement.

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« SEC Monitors Impact of Hurricanes On Capital Markets SEC Provides Regulatory Relief To Hurricane Victims »

SEC Monitors Impact of Hurricanes On Capital Markets

Posted by Securities Attorney Laura Anthony | September 19, 2017 Tags: Capital Markets, Hurricanes, Impact of Hurricanes On Capital Markets, SEC

As I wrote this blog I continued to have no power at my home after one week, though thankfully it has returned by publication date. Living in South Florida, our firm has felt and seen the devastating impact of Hurricane Irma on the state and send our thoughts and wishes to all affected by both Irma and Hurricane Harvey in Texas.

On September 13, 2017, the SEC issued a press release confirming that it is closely monitoring the effects of both Irma and Harvey on the capital markets. In particular, the SEC is working to make sure that investors have access to their securities accounts and evaluating the need for extending filing deadlines for reporting companies. Furthermore, the SEC is watching for and will keep investors updated via alerts on storm-related scams.

Despite the announcement that the SEC is monitoring the markets and considering extending filing deadlines, no specific broad-based relief has been granted. As has been done historically, I believe the SEC will grant filing deadline extensions to those companies that request such relief and demonstrate they are in an affected area and that the specific report cannot be completed in a timely manner without undue hardship.

Companies seeking an extension for a filing should contact the SEC Division of Corporation Finance at 202-551-3500 or via online submission at www.sec.gov/forms/corp_fin_interpretive.

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« SEC Announces Regulatory Agenda The SEC Provides Further Guidance On Financial Statement Requirements In Registration Statements »

SEC Announces Regulatory Agenda

Posted by Securities Attorney Laura Anthony | September 12, 2017 Tags: SEC, SEC Announces Regulatory Agenda, SEC Disclosure Effectiveness Initiative, SEC Disclosure Effectiveness Initiatives, SEC Flex Regulatory Agenda

In July 2017 the SEC posted its latest version of its semi-annual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The agenda is as interesting for what’s on it, as for what isn’t. The semi-annual list only contains 33 legislative action items that the SEC intends to propose or finalize in the next 12 months. The fall 2016 list contained 62 items. As further discussed in this blog, the list does not include proposals on executive compensation, or many other Dodd-Frank mandated rules.

In the preamble to the list it indicates that it was completed in March, when Michael Piwowar was acting Chair of the SEC. Chair Jay Clayton and now Commissioner Michael Piwowar have been publicly like-minded, with a goal of directing the SEC towards assisting in small and emerging business growth and capital raise activities, while remaining tough on fraud. A summary of Chair Clayton’s first public speech as head of the SEC can be read HERE and a summary of Commissioner Piwowar’s words on the U.S. IPO market can be read HERE.

The Unified Agenda of Regulatory and Deregulatory Actions

The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, though the fall edition contains statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year.

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

Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives. Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action. The SEC is not the only agency with a reduced Agenda. In total, agencies withdrew 469 actions that were initially proposed in the fall 2016 Agenda. Agencies moved 391 actions to either long-term or inactive. There are only 58 proposed economically significant regulations, about half from last year. Also, adding transparency for those of us who like to stay up on these matters, for the first time, the agencies will post and make public their list of “inactive” rules.

SEC Flex Regulatory Agenda

As mentioned, in the preamble to the list it indicates that it was completed in March, when Michael Piwowar was acting Chair of the SEC, and reflects his priorities. The preamble to the newest agenda is short. The fall 2017 agenda will reflect the priorities of Chair Jay Clayton and contains more information, including “The Regulatory Plan” of the SEC with a statement of regulatory priorities for the coming year.

The newest agenda is in line with the SEC’s new leader’s promise of support to small and emerging companies. It is also in line with the current administration’s lack of support for Dodd-Frank. The list does not include proposed regulatory actions related to pay for performance (see HERE), executive compensation clawback (see HERE), hedging (see HERE), universal proxies (see HERE), and clawbacks of incentive compensation at financial institutions, although many of these items remain on the “long-term actions” schedule.

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

Interesting items in the final rule stage include disclosure update and simplification (again see summary at end of this blog), simplification of disclosure requirements for emerging-growth companies and forward incorporation by reference on Form S-1 for smaller reporting companies (see HERE), Form 10-K summary, amendments to smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems.

Items of interest in the proposed rule stage include amendments to the interactive data (XBRL) program, amendments to financial disclosures about entities other than the registrant (see HERE), business and financial disclosure required by Regulation S-K (see end of this blog for the most recent summary on Regulation S-K changes), reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), implementation of FAST Act report recommendations (see HERE), and concept release on possible audit committee disclosures.

Also interesting is the many items that appeared on the proposed rule list in fall 2016 that have now been moved to “long-term actions.” Items moved from proposed to long-term include registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, personalized investment advice standard of conduct, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, commission guidance on definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

Other items on the long-term action list include pay versus performance, amendments to Regulation D, Form D and Rule 156, hedging disclosures, several securities-based swaps regulatory actions, exchange traded products, and disclosures of payments by resource extraction issuers.

Further Reading on the SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC’s ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. Although the rate of changes has slowed down since the election and change in SEC control regime, I expect it to pick up again. In an upcoming blog, I will be writing about the SEC’s announced Regulatory Flexibility Agenda. The Agenda lists regulations the SEC expects to propose or finalize in the next 12 months. This year’s Agenda only incudes 33 rules (last year’s contained 62), at least 8 of which are related to disclosure requirements.

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

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

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« OTCQB Sets New Requirements For Change Of Control Events SEC Monitors Impact of Hurricanes On Capital Markets »

OTCQB Sets New Requirements For Change Of Control Events

Posted by Securities Attorney Laura Anthony | September 5, 2017 Tags: Change Of Control Events, OTC Markets, OTCQB, OTCQB Sets New Requirements For Change Of Control Events

On June 30, 2017, the OTC Markets Group published amendments to the OTCQB standards related to the processing and reporting of change in control events. The new rules went into effect on July 31, 2017.

OTC Markets has been initiating a series of changes related to the OTCQB including amending the qualification requirements to allow quotation by companies that follow its alternative reporting standard (“Alternative Reporting Standard”) which went effective on May 18, 2017. For a review of the new qualification changes, see my blog HERE.

Highlights of Changes

The OTCQB has added a new Section 2.4 to the OTCQB Standards published by OTC Markets. The OTCQB Standards include a comprehensive summary of admission and eligibility requirements, application processes, initial and ongoing disclosure requirements, continued eligibility requirements, fees and removal processes.

Section 2 of the OTCQB Standards set forth the continued OTCQB Eligibility requirements, and includes the new Section 2.4 related to change in control events.

A “change in control event” is defined to mean a transaction resulting in: (i) a change in the majority ownership or effective control of a company; (ii) material changes to the company’s management team or board of directors; or (iii) in conjunction with either of the above, a material change in the nature of the company’s business operations.

Under Section 2.4, a company will be responsible for notifying OTC Markets upon the completion of a transaction resulting in a change of control. Regardless of notification, OTC Markets may also make a discretionary determination that a change of control event has occurred.

Upon a change of control event a company will be required to submit a OTCQB Change in Control Notification together with a new OTCQB Application and application fee ($2,500) within 20 calendar days. OTC Markets will review the notice and application and may request additional information. The failure to respond or fully comply with such requests may result in removal from the OTCQB.

Furthermore, immediately following a change in control event, a company would be required to file a new OTCQB Certification and updated company profile page.

I note that under the current Section 2.2(7)(d), a company is already required to make certain filings and disclosures to OTC Markets upon a change of control. In particular, all companies must file interim disclosures in the event the company undergoes a reverse merger or change of control and make new updated certifications and disclosure related to the new business and control persons.

Refresher on OTCQB Standards

The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink. The OTC Pink, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. The OTCQB is considered the venture-market tier designed for entrepreneurial and development-stage U.S. and international companies. To apply to the OTCQB, a company must submit a completed application and quotation agreement and pay the application fee.

Eligibility Requirements

To be eligible to be quoted on the OTCQB, all companies will be required to:

Meet a minimum closing bid price on OTC Markets of $.01 for each of the last 30 calendar days and as of the day the OTCQB application is approved;

In the event that there is no prior public market and a 15c2-11 application has been submitted to FINRA by a market maker, OTC Markets can waive the bid requirement at its sole discretion;

In the event that a company is a seasoned public issuer that completed a reverse stock split within 6 months prior to applying to the OTCQB, the company must have a post-reverse-split minimum bid price of $.01 at the close of business on each of the 5 consecutive trading days immediately before applying to the OTCQB;

In the event the company is moving to the OTCQB from the OTCQX, it must have a minimum closing bid price of $.01 for at least one (1) of the 30 calendar days immediately preceding;

Companies may not be subject to bankruptcy or reorganization proceedings immediately preceding the company’s application;

Either be subject to the reporting requirements of the Securities Exchange Act of 1934 and be current in such reporting obligations, be a Tier 2 Regulation A reporting company and be current in such reporting obligations, or, if an international issuer, be eligible to rely on the registration exemption found in Exchange Act Rule 12g-2(b) and be current and compliant in such requirements or be a bank current in its reporting obligations to its bank regulator, or be current in the OTC Markets Alternative Reporting Standards;

Have U.S. GAAP audited financials prepared by a PCAOB qualified auditor, including an audit opinion that is not adverse, disclaimed or qualified. International reporting companies may have audited financial statements prepared in accordance with IFRS;

Be duly organized, validly existing and in good standing under the laws of each jurisdiction in which it is organized and does business;

Submit an application and pay an application and annual fee;

Maintain a current and accurate company profile on the OTC Markets website;

Use an SEC registered transfer agent and authorize the transfer agent to provide information to OTC Markets about the company’s securities, including but not limited to shares authorized, shares issued and outstanding, and share issuance history; and

Submit an OTCQB Annual Certification confirming the accuracy of the current company profile and providing information on officers, directors and controlling shareholders.

For companies that are relying on the Alternative Reporting Standard (i.e., not reporting to the SEC), meet minimum corporate governance requirements, including (i) have a board of directors that includes at least two independent directors; and (ii) have an audit committee comprised of a majority of independent directors. A company may request the ability to phase in compliance with this requirement if: (a) at least one member of the board of directors and audit committee are independent at the time of the application; and (b) at least two members of the board and a majority of the audit committee are independent within the later of 90 days after the company begins trading on the OTCQB or by the time of the company’s next annual meeting and in no event later than one year from joining the OTCQB.

All companies are required to post their initial disclosure on the OTC Markets website and make an initial certification. The initial disclosure includes:

Confirmation that the company is current in its SEC reporting obligations, whether subject to the Exchange Act reporting requirements or Regulation A+ reporting requirements, and has filed all reports with the SEC, that all financial statements have been prepared in accordance with U.S. GAAP, and that the auditor opinion is not adverse, disclaimed or qualified;

Bank Reporting Companies must have filed all financial reports required to be filed with their banking regulator for the prior two years, including audited financial statements;

International Companies – (i) Companies subject to the Exchange Act reporting requirements must be current in such reports; (ii) A company that is not an SEC Reporting company must be current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and shall have posted in English through the OTC Disclosure & News Service or an Integrated Newswire, the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b) for the preceding 24 months (or from inception if less than 24 months); and all financial statements have been prepared in accordance with U.S. GAAP and that the auditor opinion is not adverse, disclaimed or qualified;

Alternative Reporting Companies must have filed, through the OTC Disclosure and News Services, an information and disclosure statement meeting the requirements of the OTCQX and OTCQB disclosure guidelines; and

Verification that the company profile is current, complete and accurate.

In addition, all companies will be required to file an initial and annual certification on the OTC Markets website, signed by the CEO and/or CFO, stating:

The company’s reporting standing (i.e., whether SEC reporting, Regulation A+ reporting, Alternative Standards Reporting, bank reporting or international reporting) and briefly describing the registration status of the company;

If the company is an international company and relying on 12g3-2(b), that it is current in such obligations;

That the company is current in its reporting obligations to its regulator and that such information is available either on EDGAR or the OTC Markets website;

That the company profile on the OTC Markets website is current and complete and includes the total shares outstanding, authorized and in the public float as of that date;

That the company is duly organized, validly existing and in good standing under the laws of each state or jurisdiction in which the company is organized and conducts business;

States the law firm and/or attorneys that assist the company in preparing its annual report or 10-K;

Identifies any third-party providers engaged by the company, its officers, directors or controlling shareholders, during the prior fiscal year and up to the date of the certification, to provide investor relations services, public relations services, stock promotion services or related services;

Confirms the total shares authorized, outstanding and in the public float as of that date; and

Names and shareholdings of all officers and directors and shareholders that beneficially own 5% or more of the total outstanding shares, including beneficial ownership of entity shareholders.

An application to OTCQB can be delayed or denied at OTC Markets’ sole discretion if they determine that admission would be likely to impair the reputation or integrity of OTC Markets group or be detrimental to the interests of investors.

Requirements for Bank Reporting Companies

Bank reporting companies must meet all the same requirements as all other OTCQB companies except for the SEC reporting requirements. Instead, bank reporting companies are required to post their previous two years’ and ongoing yearly disclosures that were and are filed with the company’s bank regulator, on the OTC Markets website.

International Companies

In addition to the same requirements for all issuers as set forth above, foreign issuers must be listed on a Qualified Foreign Exchange and be compliant with SEC Rule 12g3-2(b). Moreover, a foreign entity must submit a letter of introduction from a qualified OTCQB Sponsor which states that the OTCQB Sponsor has a reasonable belief that the company is in compliance with SEC Rule 12g3-2(b), is listed on a Qualified Foreign Exchange, and has posted required disclosure on the OTC Markets website. A foreign entity must post two years’ historical and ongoing quarterly and annual reports, in English, on the OTC Markets website which comply with SEC Rule 12g3-2(b). I am a qualified OTCQB Sponsor and assist multiple international companies with this process.

Application Review Process

OTC Markets will review all applications and may request additional information on any of the information submitted. In addition, OTC Markets can require that a company provide a further undertaking, such as submission of personal information forms for any executive officer, director or 5%-or-greater beneficial owner. OTC Markets can request that third parties provide confirmations or information as well. OTC Markets can, and likely will, conduct independent due diligence including through the review of publicly available information.

OTC Markets can deny an application if it determines, upon its sole and absolute discretion, that the admission of the company would be likely to impair the reputation or integrity of OTC Markets or be detrimental to the interests of investors.

Upon approval of an application, the company’s securities will be designated as OTCQB on the OTC Markets websites, market data products and broker-dealer platforms.

Ongoing Requirements

All companies are required to remain in compliance with the OTCQB standards, including the ongoing disclosure obligations;

S. OTCQB companies will be required to remain current and timely in their SEC reporting obligations, including either Exchange Act reports, Regulation A+ reports or Alternative Reporting Standard and including all audited financial statement requirements;

A foreign company that is not an SEC Reporting Company must remain current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and in any event shall, on an ongoing basis, post in English through the OTC Disclosure & News Service or an Integrated Newswire the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b);

Banks must remain current in their banking reporting requirements and file copies of their reports on the OTC Markets website no later than 45 days following the end of a quarter or 90 days following the end of the fiscal year;

All OTC Markets postings and reports must be filed within 45 days following the end of a quarter or 90 days following the end of the fiscal year for US Exchange Act issuers and Alternative Reporting Standard filers, as required by Regulation A+ for Regulation A+ reporting issuers, and immediately after their submission to their primary regulator for international companies; where applicable, file a notice of late filing allowing for 5 extra days on a quarterly report and 15 extra days on an annual or semiannual report;

All OTCQB companies will be required to post annual certifications on the OTC Markets website signed by either the CEO or CFO no later than 30 days following the company’s annual report due date;

All companies are required to comply with all federal, state, and international securities laws and must cooperate with all securities regulatory agencies;

Must pay the annual fee within 30 days of prior to the beginning of each new annual service period;

All companies must respond to OTC Markets inquiries and requests;

All companies must maintain an updated verified company profile on the OTC Markets website and must submit a Company Update Form at least once every six months;

OTCQB is a recognized securities manual for purposes of blue sky secondary market exceptions. A precondition to relying upon the manuals exemption is the maintenance of current updated disclosure information as required by OTC Markets;

All companies must make a press release and possibly other public disclosure (such as a Form 8-K) to inform the public of any news or information which might be reasonably expected to materially affect the market of its securities;

All companies must file interim disclosures in the event the company undergoes a reverse merger or change of control and make new updated certifications and disclosure related to the new business and control persons;

In the event that OTC Markets determines, upon its sole discretion, that a company is the subject of promotional activities that encourage trading, OYC Markets may require the company to provide additional public information related to shareholdings of officers, directors and control persons and confirmation of shares outstanding, and any share issuance in the prior two years. OTC Markets may also require submission of a Personal Information Form for any executive officer, director or 5%-or-greater shareholder.

Not be subject to bankruptcy or reorganization proceedings;

Be duly organized and in good standing under the laws of each jurisdiction in which the company is organized or does business;

Companies relying on the Alternative Reporting Standard must comply with the ongoing corporate governance requirements subject to a notice and one-year grace period if the company falls into noncompliance;

All OTCQB companies must meet the minimum bid price of $.01 per share at the close of business of at least one of the previous thirty (30) consecutive calendar days; in the event that the price falls below $.01, the company will begin a grace period of 90 calendar days to maintain a closing bid price of $.01 for ten consecutive trading days; and

Officers and directors of the company are responsible for compliance with the ongoing requirements and the content of all information. Entities that do not meet the requirements of either OTCQX or OTCQB will be quoted on the OTC Pink.

Fees

Newly applying entities must pay an initial application fee of $2,500, which fee is waived for existing OTCQB entities. All OTCQB companies will be required to pay an annual fee of $10,000. Fees are nonrefundable.

Removal/Suspension from OTCQB

A company may be removed from the OTCQB if, at any time, it fails to meet the eligibility and continued quotation requirements subject to a notice and opportunity to cure. Companies that are delinquent in filing and reporting requirements are subject to a 45-day cure period. Companies with a bid price deficiency shall have a 90-day cure period. However, in the event the company’s bid price falls below $0.001 at any time for five consecutive trading days, the company will be immediately removed from the OTCQB. All other deficiencies are subject to a 30-day cure period. OTC Markets may provide additional cure periods, but in no event may audited financial statements be older than 18 months.

In addition, OTC Markets Group may remove the company’s securities from trading on OTCQB immediately and at any time, without notice, if OTC Markets Group, upon its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.

In addition, OTC Markets can temporarily suspend trading on the OTCQB pending investigation or further due diligence review.

A company may voluntarily withdraw from the OTCQB with 24 hours’ notice.

The Author

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

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« FINRA Issues New Guidance On Communications With The Public, Including Social Media SEC Announces Regulatory Agenda »

FINRA Issues New Guidance On Communications With The Public, Including Social Media

Posted by Securities Attorney Laura Anthony | August 22, 2017 Tags: Finra, FINRA Rule 2210, Regulatory Notice 17-18

In April 2017 FINRA issued Regulatory Notice 17-18 providing additional guidance on the use of social media and digital communications by member firms and persons associated with member firms. The guidance specifically relates to FINRA Rule 2210 – Communications with the Public, and supplements previously issued guidance in Regulatory Notices 10-06 and 11-39, published in 2011. The new guidance is in the form of FAQ’s and concentrates on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

I have previously written about the SEC’s guidance on social media use by companies, including as a method for communications with investors and the public. The most recent blog is HERE and includes hyperlinks to prior blogs, including a three-part summary of the SEC Guidance on Social Media and Websites for Company Announcements and Communications.

Brief Overview of Rule 2210

FINRA Rule 2210 governs communications by FINRA member firms and associated persons, including: (i) institutional communications – including any written or electronic communication, distributed or made available only to institutional investors such as banks, insurance companies and investment companies; (ii) retail communications – including any written or electronic communication distributed or made available to more than 25 retail investors within any 30-calendar-day period; and (iii) correspondence. The Rule also sets forth requirements related to approval, review and recordkeeping of communications; filing requirements and review procedures and content standards.

The Rule’s general content standards apply to all communications and are meant to ensure that communications are fair, balanced and not misleading. Communications to retail customers or potential customers have the highest standards. The communication rules focus on the recipient and not the type of product (IPO, private, debt, etc.) that might be being discussed.

Retail Communications

Subject to certain exemptions, an appropriately qualified registered principal of the member firm must approve each and every retail communication before the earlier of its first use, or its filing with FINRA’s Advertising Regulation Department. However, this requirement does not apply where another member firm has used the same communication and received approval from FINRA as to its content. In other words, member firms can piggyback on each other’s advertising and communication approvals.

The requirement also does not apply to: (i) certain communications excepted from the definition of a research report or debt research report unless the communication makes a financial or investment recommendation; (ii) any retail communication that is posted on an online interactive electronic forum; and (iii) retail communication that does not make any financial or investment recommendation or otherwise promote a product or service of the member firm.

Correspondence

All correspondence must be subject to general supervision and review requirements.

Institutional Communications

Members must establish written procedures that are appropriate to their business, size, structure, and customers for the review by an appropriately qualified registered principal of institutional communications used by the member and its associated persons. The procedures must be reasonably designed to ensure that institutional communications comply with applicable standards. When the procedures do not require review of all institutional communications prior to first use or distribution, they must include provisions for the education and training of associated persons as to the firm’s procedures, documentation of the education and training, and surveillance and follow-up to ensure that the procedures are implemented and adhered to.

Recordkeeping

As required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

Records must include: (i) a copy of the communication and the dates of first and last use; (ii) the name of any principal who approved the communication and the date of approval; (iii) if the communication was not approved, the name of the person who prepared or distributed it; (iv) information on the source of any statistical table, chart, graph or other illustration; (v) where the firm or representative is relying on another member’s approval, the name of the member and a copy of the review letter and approval from FINRA; and (vi) for any retail communication that includes or incorporates a performance ranking or performance comparison of a registered investment company, a copy of the ranking or performance used in the retail communication.

Filing Requirements and Review Procedures

For the first year as a licensed broker-dealer, a firm must file all retail communications with FINRA’s Advertising Regulation Department at least 10 days prior to its first use. If a communication is a free writing prospectus that has been filed with the SEC, it can be filed with FINRA within 10 days of its first use, instead of prior. FINRA can also impose a filing requirement on any firm at any time if it determines that the firm has departed from the standards in Rule 2210.

Retail communications concerning registered investment companies, which include or incorporate performance rankings or comparisons, must always be filed at least 10 business days prior to use. Likewise, retail communications recommending a specific registered investment company, concerning a direct participation program, concerning collateralized mortgages or concerning derivatives or indexes must all be filed with FINRA at least 10 business days prior to their first use.

If a member has filed a draft version or “storyboard” of a television or video retail communication pursuant to a filing requirement, then the member also must file the final filmed version within 10 business days of first use or broadcast.

Certain retail communications are excluded from the filing requirements, including: (i) communications based on a template that has previously been filed with FINRA and approved for use either without material change, or changes limited to updated statistical and other information; (ii) retail communications that do not make any financial or investment recommendation or otherwise promote a product or service of the member; (iii) retail communications that do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker; (iv) retail communications that do no more than identify the member or offer a specific security at a stated price; (v) offering documents, reports or free writing prospectus that have been filed with the SEC or a state or offering documents for exempt offerings; (vi) tombstone communications identifying a firm’s participation in an offering; (vii) press releases that are made available only to members of the media; (viii) republications of unaffiliated third-party articles or reports that the firm has neither adopted nor become entangled with; (ix) correspondence; (x) institutional communications; (xi) communications that refer to types of investments solely as part of a listing of products or services offered by the member; (xii) retail communications that are posted on an online interactive electronic forum; (xiii) press releases issued by closed-end investment companies that are listed on the New York Stock Exchange; (xiv) research reports on exchange traded securities.

FINRA may grant exemptions to the filing requirements for good cause. All filings must be approved by a registered principal within the firm prior to submitting to FINRA.

Content Standards

Rule 2210 focuses on antifraud issues. In particular, the Rule provides that “All member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” The next section continues: “No member may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication. No member may publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.”

Information may only be placed in a footnote if it is still clear. Members must ensure that statements are not misleading and that they provide balanced treatment of risks and potential benefits. FINRA requires that firms consider their audience in creating content, and such content must be audience-appropriate. Communications cannot exaggerate and may not predict or project performance.

There are specific requirements for content in communications. For example, a member firm must prominently include the name of the member firm, fictional names, and relationships between parties listed in the communication. There are specific requirements regarding communications related to tax-free or tax-exempt products and disclosures of fees and expenses for investment management companies and pooled funds.

Testimonials and Recommendations

Rule 2210 governs the use of testimonials about a member firm and the use of recommendations by a member firm. Each requires a reasonable basis and must be rendered by a person with the knowledge and experience to form a valid opinion. Retail communications involving recommendations about a product or service by a member firm have additional technical requirements.

BrokerCheck

All communications must contain a prominent reference and hyperlink to BrokerCheck.

New Guidance

FINRA Regulatory Notice 17-18 provides additional guidance on the use of social media and digital communications by member firms and associated persons through FAQ’s designed to supplement previously issued guidance on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

Recordkeeping

As noted above, and as required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

The new guidance confirms that the record retention requirements apply to communications made through text messaging or a chat service or app. Prior to allowing text or chat communications, a firm must ensure that it has the ability to retain the content of the communications.

Third-party Posts; Adoption or Entanglement

Generally speaking, posts by customers or other third parties on social media or any website established by a firm or its personnel do not constitute communications with the public by the firm or its associated persons under Rule 2210. Accordingly, these posts do not require pre-use approval by a principal in the firm, and as a practical matter, a firm could not require third parties to seek such approval. However, if the firm or associated person paid for the preparation of the content or otherwise caused it to be prepared and posted, the firm would be responsible for its content under FINRA’s “entanglement” theory. Moreover, if the firm or associated person explicitly or implicitly endorses or approves the third-party content, it would also be responsible for its content under FINRA’s theory of “adoption” of content. Where a firm or associated person is responsible for the content, it must comply with all the requirements of Rule 2210.

The new guidance clarifies that a firm or registered representative can contact a third party to correct factual information, such as the spelling of a name, an incorrect address or website, where the firm was completely unaffiliated with the publisher and not involved in the publications content, without such correction resulting in entanglement or endorsement.

Hyperlinks to Third-party Sites

A firm is responsible for links to a third-party site if that firm has adopted or become entangled with the content. A firm would be deemed to have adopted content that it explicitly or implicitly endorses or approved and would be deemed to be entangled in content where it has participated in the development of such content. A member firm may not establish a link to any third-party site that the firm knows or has reason to know contains false or misleading content and may not include a link on its website if there are any red flags that indicate the linked site contains false or misleading content.

The new guidance clarifies that by sharing or linking to third-party content, the member firm has adopted that content and is responsible for its content to the same extent it is for firm-generated communications. Where the shared or linked content itself has additional links to other content, the firm must do a facts-and-circumstances analysis to determine if it would also be responsible for that additional content. The firm would not be deemed to have adopted the content in the links in the shared content, solely by sharing or linking.

In general, if a firm shares or links to content that in turn links to other content over which the firm has no influence or control, the firm would not have adopted the other content. On the other hand, if a firm shares or links to content that in turn links to other content over which the firm has influence or control, the firm would then have adopted that other content. In addition, if the firm shares or links to content that itself serves primarily as a vehicle for links, the firm would be responsible for the content in the links.

The new guidance also clarifies that whether a firm has adopted the content of an independent third-party website or any section of the website through the use of a link is fact dependent. Two factors are critical to the analysis: (i) whether the link is “ongoing” and (ii) whether the firm has influence or control over the content of the third-party site.

Where the link is “ongoing” the firm would not have adopted the content. “Ongoing” means that: (i) the link is continuously available to investors who visit the firm’s site; (ii) investors have access to the linked site whether or not it contains favorable material about the firm; and (iii) the linked site could be updated or changed by the independent third party and investors would still be able to use the link. As an example, some firms link to regulatory agencies such as FINRA or the SEC.

However, if the firm has influence or control over the third-party site, the firm would be entangled with its content and thus responsible under Rule 2210.

Personal Communications

Personal communications are not subject to Rule 2210. Moreover, if an associated person shares or links to content that the member firm made available, which is not related to its products or services, the communication is likewise not subject to Rule 2210. Examples given in the FINRA notice include information about the firm’s sponsorship of a charitable event, a human interest article, or an employment opportunity.

Native Advertising

Native advertising is defined as content that bears a similarity to the news feature articles, product reviews, entertainment and other material that surrounds it online. Native advertising can appear to be a genuine news article or product review at first glance. FINRA clarifies that native advertising is not inherently misleading and can be used as long as it complies with Rule 2210, including that the firm ensures that the communication is fair, balanced and not misleading. Native advertising must prominently disclose the firm’s name, accurately reflect any relationship with the firm and any other entity or individual named in the advertisement, and state whether mentioned products or services are offered by the firm.

Where a member firm arranges for or pays for third-party native advertising, such as content in a blog or posts by an influencer, the firm would be responsible for its content under the entanglement theory. As provided in an earlier Regulatory Notice, if a firm or representative has paid for the publication, production or distribution of any communication that appears to be a magazine, article or interview, then the communication must be clearly identified as an advertisement. Firms should clearly identify as advertisements any communications that take the form of comments or posts by influencers and include the broker-dealer’s name as well as any other information required for compliance with Rule 2210.

Testimonials and Endorsements

Many social networking sites, such as LinkedIn, allow individuals to post opinions or provide comments regarding a person’s professional capabilities. FINRA allows registered representatives and associated persons to utilize social networking platforms for business-related purposes as long as the account is supervised and retained by the member firm. FINRA does not include unsolicited third-party opinions or comments posted on a social network to be communications of the firm or representative for purposes of Rule 2210. However, if the firm or representative likes or shares content, they have adopted the content and become subject to the communication rules, including prohibitions on misleading or incomplete statements or claims, the testimonial requirements, and the supervision and recordkeeping rules.

Testimonials are governed by Rule 2210 and in particular:

(A) If any testimonial in a communication concerns a technical aspect of investing, the person making the testimonial must have the knowledge and experience to form a valid opinion.

(B) Retail communications or correspondence providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose the following: (i) the fact that the testimonial may not be representative of the experience of other customers; (ii) the fact that the testimonial is no guarantee of future performance or success; and (iii) if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial.

Testimonials are subject to the general Rule 2210 standards as well, including that they not be false, misleading, exaggerated or promissory. The disclosures that must be required can be included via a clearly marked and labeled hyperlink. Also, investment advisors are prohibited from directly or indirectly publishing, circulating or distributing testimonials.

BrokerCheck

Effective June 6, 2016, Rule 2210 requires each of a firm’s websites to include a readily apparent reference and hyperlink to BrokerCheck on (i) the initial web page that the firm intends to be viewed by retail investors, and (ii) any other web page that includes a professional profile of one or more registered persons who conduct business with retail investors. The reference and hyperlink are not required to be included in communications appearing on a third-party website, including social media sites, or in email or text messages.

The new guidance clarifies that the reference and hyperlink to BrokerCheck would not need to be included in an app created by a firm. However, if the app accesses and displays the firm’s website, the link must be readily apparent when the page is displayed through the app.

The Author

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

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« SEC Issues Report on Initial Coin Offerings (ICO’s) OTCQB Sets New Requirements For Change Of Control Events »

SEC Issues Report on Initial Coin Offerings (ICO’s)

Posted by Securities Attorney Laura Anthony | August 15, 2017 Tags: cryptocurrencies, cryptocurrency securities, Initial Coin Offerings, SEC, SEC Issues Report on Initial Coin Offerings (ICO's)

On July 25, 2017, the SEC issued a report on an investigation related to an initial coin offering (ICO) by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report (the “Report”). On the same day, the SEC issued an Investor Bulletin related to ICO’s. Offers and sales of digital coins, cryptocurrencies or tokens using distributed ledger technology (DLT) or blockchain have become widely known as ICO’s. For an introduction on DLT and blockchain, see HERE.

The basis of the report is that offers and sales of digital assets, including cryptocurrencies, are subject to the federal (and state) securities laws. From the highest level, the nature of a digital asset must be examined to determine if it meets the definition of a security using established principles (see HERE). In addition, all offers and sales of securities must either be registered with the SEC or there must be an available exemption from such registration. This statement applies to cryptocurrency securities in the same manner it applies to all other securities. In addition, 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. Securities exchanges providing for trading must register unless an exemption applies.

Despite the SEC findings, it declined to pursue an enforcement action but rather used the opportunity to inform the public on its views and, in particular, that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In the press release announcing the investigative findings, SEC Chair Jay Clayton stated, “[T]he SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”

This is not the first time the SEC has addressed registration and exemption requirements associated with cryptocurrencies. There have been several other cases. For example, in December 2014 the SEC settled charges against BTC Virtual Stock Exchange and LTC Global Virtual Stock Exchange related to violations of both the broker-dealer registration requirements and the securities offer and sale registration requirements. For more information on that case, see HERE.

This blog will summarize the SEC Report of Investigation, statements by the Divisions of Corporation Finance and Enforcement and the Investor Bulletin on Initial Coin Offerings.

SEC Report of Investigation on an ICO

On July 25, 2017, the SEC issued its Report on an investigation into an ICO and related activities by the DAO, an unincorporated entity, Slock.it UG (“Slock.it”), a German corporation, and various principals and participants. As mentioned earlier, although the report provides a platform for which the SEC can educate the marketplace, it did not pursue enforcement actions against the targets of the investigation.

The “DAO” stands for a decentralized autonomous organization, or a virtual network embodied in computer code on a on a DLT or blockchain. The DAO was created by Slock.it to sell tokens to investors, which proceeds would be used to fund for-profit projects. The token holders would share in the profits and, as such, had an expectation of a return on investment. The DAO tokens were also transferable and available for secondary trading on different web-based platforms. After the ICO, but before projects were funded, the DAO was hacked and approximately one-third of its assets stolen. Fortunately the DAO was able to come up with a plan that caused the return of ETGH raised from the DAO back to their original Ethereum address and thus return investments to the original investors.

The SEC opened an investigation as to whether the offer and sale of the DAO Tokens invoked federal securities laws, whether the DAO Tokens were securities and whether the platforms for the secondary trading of the Tokens required registration as a securities exchange. The answer to each of these questions, under the facts and circumstances presented, was in the affirmative. Since the DAO had not yet commenced operations, the SEC did not review whether the DAO was acting as an “investment company” under the Investment Company Act of 1940, but noted that had they begun operations, such an analysis would have been appropriate.

The Report begins with the conclusion. Whether or not a particular transaction involves the offer and sale of a security depends on an analysis of the facts and circumstances, regardless of terminology or technology used or employed. All persons or entities that use a Decentralized Autonomous Organization (DAO Entity), DLT or other blockchain-based technology as a means to raise capital in the U.S. are subject to the U.S. federal securities laws. All securities offered and sold in the U.S. must be registered or must qualify for an exemption from registration. Moreover, any entities or platforms that allow for the secondary trading of securities must either be registered as a national securities exchange or operate pursuant to a registration exemption. The automation of functions, computer code, smart contracts, and decentralization does not change the obligations under the federal securities laws.

Background and Facts

In a one-month period from April 30, 2016, through May 28, 2016, the DAO offered and sold 1.15 billion DAO Tokens in exchange for 12 million Ether (“ETH”) valued at approximately $150 million USD. ETH is a virtual currency. The Financial Action Task Force defines a “virtual currency” as:

a digital representation of value that can be digitally traded and functions as: (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. It is not issued or guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency. Virtual currency is distinguished from fiat currency (a.k.a. “real currency,” “real money,” or “national currency”), which is the coin and paper money of a country that is designated as its legal tender; circulates; and is customarily used and accepted as a medium of exchange in the issuing country. It is distinct from e-money, which is a digital representation of fiat currency used to electronically transfer value denominated in fiat currency.

The DAO itself was created by the founders of Slock.it as a type of alternative corporation with all corporate functions and governance automated using blockchain and smart contracts. The DAO was the “first generation” of its kind. Participants sent in ETH in exchange for DAO Tokens. DAO Token holders could vote on projects to be used with the DAO assets (ETH, which could be exchanged for fiat currency and other physical or digital assets) and participate in rewards such as profit distributions and dividends. The entire DAO was intended to be autonomous such that project proposals were in the form of smart contracts and voting administered by computer code. The DAO code was launched on the Ethereum blockchain.

The DAO promoted itself through a website which described its purpose (“[T]o blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code”), how it operated, its source code, and a link to buy the DAO Tokens. The DAO was also promoted through media attention and numerous social media channels.

Anyone was eligible to purchase DAO Tokens as long as they paid in ETH and there were no limitations on the number of DAO Tokens offered for sale or the number that could be purchased by any purchaser. There were no parameters set on the accreditation or sophistication level of a purchaser. Anyone with ETH and an ETH blockchain address could participate. All ETH from DAO Token sales were aggregated in the DAO’s Ethereum blockchain address.

Only DAO Token holders could submit proposed projects in which the DAO might participate, and each proposal would have to involve a smart contract and comply with the preset DAO Token holders voting code. Projects would be approved by a majority vote of DAO Token holders. Before being submitted for a vote, projects were to be reviewed by human curators. Although beyond the scope of this blog, there appeared to be many issues with the system, including the programming for voting.

The DAO Tokens were unrestricted and there were several platforms that allowed for the immediate secondary trading of the DAO Tokens. The secondary market trading platforms were registered with the Federal Crimes Enforcement Network (FinCEN) as Money Services Businesses. For more on FinCEN, see HERE. The DAO Tokens were in fact actively traded on various platforms.

SEC Regulatory Analysis

Section 5 of the Securities Act of 1933, as amended (“Securities Act”) requires the registration of all offers and sales of securities unless there is an available exemption. The registration provisions are based on “full and fair disclosure” of all material information for an investor to make an informed investment decision, including detailed information about the issuer’s financial condition, identity and background of management and the price and amount of securities to be offered.

Section 5 of the Securities Act, like many provisions in the securities laws, is written in the inclusive, such that all offers and sales are covered unless an exemption is available pursuant to statute or case law. Section 5 states that “unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities in interstate commerce.” A violation of Section 5 does not require intent.

The SEC begins its analysis of the DAO Tokens by reference to the definitions of a security found in both Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Securities Exchange Act. Both definitions include the term “investment contract,” which has been famously defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. For an in-depth discussion on the definition of a security in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (the “Howey Test”), see HERE.

Under the Howey Test, whether an investment instrument is a security requires a substance-over-form analysis. The Howey Test defines an investment contract as follows:

“… an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party…. Such a definition… permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security…. It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

Applying the Howey Test, courts have interpreted a security to include such diverse items as citrus groves, warehouse receipts, chinchillas, minks, diamonds, bullion, pay phones, real estate and equipment, and condominium units, when they were offered or sold under circumstances involving the investment of money and an expectation of a return through the efforts of others.

Applying the Howey Test to the DAO Tokens, the SEC notes that “money” need not include cash, but rather can be anything of value. A contribution of ETH is an investment as considered by the Howey Test. Investors in the DAO were investing in a common enterprise with the expectation of profits, including dividends and increased value. The SEC also found that the profits were to be derived from the efforts of others, including Slock.it, its founders and the DAO curators.

In its analysis of whether the DAO was a security, the SEC spent the most discussion on the “from the efforts of others” factor. Presumably this is because the DAO was established as an autonomous organization with participants voting on all projects. However, the Slock.it team, through its curators, and management of the DAO website and participation in online forums, “led investors to believe that they could be relied on to provide the significant managerial efforts required to make the DAO a success.” Moreover, in fact, the curators and Slock.it team did exercise significant control over proposals and operations of the DAO and were responsible for stopping the hacking attack and coming up with a plan to rectify the situation.

The SEC also noted that the DAO Token holders voting rights were limited. The DAO Token holders could only vote within the rules (code) established by the Slock.it management team. The SEC points to case law related to multi-level marketing schemes which were securities despite the labor put forth by the investors because the promoter dictated the terms and controlled the scheme itself. The SEC stated that “[T]he voting rights afforded DAO Token holders did not provide them with meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote for contracts was a largely perfunctory one; and (2) DAO Token holders were widely dispersed and limited in their ability to communicate with one another.” Furthermore, the SEC questioned the level of disclosure on projects, believing that such disclosure was not “full and fair” such as to allow an informed investment decision.

Upon concluding that the DAO Tokens were securities, the SEC also concluded that the DAO needed to register their issuance, or satisfy a registration exemption, regardless of whether the DAO was incorporated or an unincorporated organization. Issuers, like securities, are broadly defined to include any sponsor or organization that is primarily responsible for the success or failure of the venture. Participants in an offering are also subject to Section 5 obligations and liability. Accordingly, this included the Slock.it founders and principals.

The secondary trading platforms also required registration, or the availability of an exemption, under the federal securities laws. Section 5 of the Exchange Act makes it unlawful for any broker, dealer or exchange to directly or indirectly affect any transaction in a security or report such transaction unless the exchange is registered as a national exchange or exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood …”

The functions of a stock exchange generally include: (i) bringing together orders for securities of multiple buyers and sellers; and (ii) using established, non-discretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. A frequent exemption to the definition of an exchange is an Alternative Trading System (ATS) that complies with Regulation ATS. Regulation ATS requires, among others, registration as a broker-dealer. The OTC Markets is an ATS, as is t0 Technologies. The platforms that traded the DAO Tokens fit within the definition of an exchange and did not satisfy any available registration exemptions.

Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on the DAO

On the same day that the SEC issued its investigative Report, the Divisions of Corporation Finance and Enforcement issued a statement on the Report. Off the top I notice that the SEC, under Chair Jay Clayton, Commissioner Michael Piwowar and the numerous new executive members, has a decidedly more positive attitude towards business and capital raising overall, than the prior regime. I also notice, through review of enforcement proceedings, that the new regime has not been deterred at all from its mission to detect and prosecute fraud, including micro-cap and penny-stock-related schemes.

To begin its statement, the Divisions noted that DLT, blockchain and other emerging technologies have the potential to influence and improve capital markets and the financial services industry. The Divisions “welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities,” and are “hopeful that innovation in this area will facilitate fair and efficient capital raisings for small businesses.” However, new technologies also offer new opportunities for misconduct and abuse.

The Divisions reiterate the SEC Report’s assertion that an offer and sale of securities must comply with the federal securities laws and that determining whether a particular investment opportunity involves a security involves a facts and circumstances analysis, including economic realities and underlying structure, regardless of the terminology or technology used.

Noting that the SEC Report had found that the DAO Tokens were securities, the Divisions caution sponsors and other participants in offerings of digital or other novel forms of value to consider whether they involve a security and thus their obligations under the federal securities laws, including registration or meeting the qualifications for a registration exemption. Market participants that operate a web or other platform that facilitates transactions in securities must also consider whether they need to be registered as a broker-dealer or an exchange, or if there is an available exemption.

Although the Divisions statement does not mention it, keeping in line with the fundamental view that basic securities laws apply, a web platform that meets the criteria set out in Section 4(b) of the Securities Act, as created by the JOBS Act, should qualify for a broker-dealer exemption when hosting digital coin or token offerings. See HERE for details on this exemption.

Furthermore, the Divisions caution that sponsors and other market participants should consider whether their business model results in an entity that needs to be registered as an investment company and whether anyone providing advice about an investment in the security could be an investment advisor.

The Divisions also caution against bad actors and fraud, again using the same principles and tenets that have always applied to economies. Investors should watch for red flags, including deals that sound too good to be true, promises of high returns with little or no risk, high-pressure sales tactics, and working with unregistered or unlicensed persons.

A fundamental message that I always try to deliver is that anyone engaging in any activity that could invoke the securities laws, should consult with competent securities counsel. The Divisions statement relays the same message, and in particular, that “market participants who are employing new technologies to form investment vehicles or distribute investment opportunities to consult with securities counsel to aid in their analysis of these issues.” The SEC staff also encourages direct communication with the SEC and has set up an email address for communications related to these matters.

Investor Bulletin on Initial Coin Offerings

In addition to its Report and statement of the Divisions of Corporation Finance and Enforcement, on July 25, 2017, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin on Initial Coin Offerings (ICO’s). The Investor Bulletin is written in a simple format and helps to inform the public on the basics of ICO’s.

As noted throughout this blog, virtual coins or tokens are created using DLT or blockchain and can be sold in exchange for other virtual coins (such as Bitcoin or Ethereum) or for fiat currency such as U.S. dollars. Generally tokens sold entitle the purchaser to some return on investment or participation in a project and also may be resold or traded on secondary markets, such as virtual currency exchanges. The Investor Bulletin informs the public that these virtual coin or token offerings can invoke the federal securities laws.

The Investor Bulletin provides some basic information on blockchain and virtual currencies. In particular, taken from the Investor Bulletin:

What is a blockchain?

A blockchain is an electronic distributed ledger or list of entries – much like a stock ledger – that is maintained by various participants in a network of computers. Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure. Some examples of blockchain are the Bitcoin and Ethereum blockchains, which are used to create and track transactions in Bitcoin and Ether, respectively.

What is a virtual currency or virtual token or coin?

A virtual currency is a digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value. Virtual tokens or coins may represent other rights, as well. Accordingly, in certain cases, the tokens or coins will be securities and may not be lawfully sold without registration with the SEC or pursuant to an exemption from registration.

What is a virtual currency exchange?

A virtual currency exchange is a person or entity that exchanges virtual currency for fiat currency, funds, or other forms of virtual currency. Virtual currency exchanges typically charge fees for these services. Secondary market trading of virtual tokens or coins may also occur on an exchange. These exchanges may not be registered securities exchanges or alternative trading systems regulated under the federal securities laws. Accordingly, in purchasing and selling virtual coins and tokens, you may not have the same protections that would apply in the case of stocks listed on an exchange.

Who issues virtual tokens or coins?

Virtual tokens or coins may be issued by a virtual organization or other capital-raising entity. A virtual organization is an organization embodied in computer code and executed on a distributed ledger or blockchain. The code, often called a “smart contract,” serves to automate certain functions of the organization, which may include the issuance of certain virtual coins or tokens. The DAO, which was a decentralized autonomous organization, is an example of a virtual organization.

The Investor Bulletin continues with warnings to potential investors, including to be aware that the federal securities laws require either registration or an exemption from registration for an offer and sale of securities. The Investor Bulletin points potential investors to the EDGAR database to find registration statements, and reminds investors that exemptions usually are limited to accredited investors.

Further, the Investor Bulletin discusses disclosure obligations and sets forth key information that an investor should be informed of, such as use of proceeds, management and business plans.

The Investor Bulletin points out that even if there has been a fraud or theft, their rights may be limited do to the nature of ICO’s in general, including that they can be autonomous, the inability to trace money, the international scope of offerings, that there is no central controlling authority and that there is no method to freeze or secure virtual currency. Finally, the Investor Bulletin points to the usual red flags, including “guaranteed” high returns or low risk, unsolicited offers, sounds too good to be true, buying pressure, no net worth or other investor requirements and unlicensed sellers.

The Author

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