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

The SEC Has Issued New Guidance Related To Foreign Private Issuers

Posted by Securities Attorney Laura Anthony | March 14, 2017 Tags: American Depository Receipts, American Depository Receipts (ADRs), C&DI Related to use of Form 20-F, Definition of Foreign Private Issuer, F-series registration statement, Foreign Private Issuers, Form 20-F annual report, Form 6-K, India as an Emerging Market, OTC Markets, Qualified Foreign Exchange, Refresher Overview for Foreign Private Issuers, SEC

On December 8, 2016, the SEC issued 35 new compliance and disclosure interpretations (C&DI) including five related to the use of Form 20-F by foreign private issuers and seven related to the definition of a foreign private issuer.

C&DI Related to use of Form 20-F

In the first of the five new C&DI, the SEC confirms that under certain circumstances the subsidiary of a foreign private issuer may use an F-series registration statement to register securities that are guaranteed by the parent company, even if the subsidiary itself does not qualify as a foreign private issuer. In addition, the subsidiary may use Form 20-F for its annual report. To qualify, the parent and subsidiary must file consolidated financial statements or be eligible to present narrative disclosure under Rule 3-10 of Regulation S-X.

Likewise in the second of the new C&DI, the SEC confirms that an F-series registration statement may be used to register securities to be issued by the parent and guaranteed by the subsidiary. When a parent foreign private issuer issues securities guaranteed or co-issued by one or more subsidiaries that do not themselves qualify as a foreign private issuer, the parent and subsidiary may use an F-series registration statement when they are eligible to present condensed consolidating financial information or narrative disclosure.

In the third C&DI the SEC clarifies the deadline for filing a Form 20-F annual report. In particular, the Form 20-F is due 4 months to the day from the end of a company’s fiscal year-end. For example, if a company’s fiscal year-end is February 20, the Form 20-F due date would be June 20.

In the fourth C&DI, the SEC confirms that a wholly owned subsidiary can omit certain information from its Form 20-F annual report in the same manner that a wholly owned subsidiary of a U.S. company can omit information in its Form 10-K. The subsidiary would need to include a prominent statement on its cover page that it meets the requirements to and is providing reduced disclosure.

The requirements to be able to provide reduced disclosure, for both 20-F and 10-K filers, include: (i) all of the company’s equity securities are owned, either directly or indirectly, by a single entity which is subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”); (ii) such parent entity is current in its reporting requirements; (iii) the parent company specifically names the subsidiary in its description of its business; (iv) during the preceding 36 calendar months and any subsequent period of days, there has not been any material default in the payment of principal, interest or any other material default with respect to any indebtedness of the parent or its subsidiaries; and (v) there has not been any material default in the payment of rentals under material long-term leases.

The disclosure that may be omitted by a qualifying subsidiary includes: (i) selected financial data; (ii) operating and financial review prospects; (iii) the list of subsidiaries exhibit; (iv) information required by Item 6.A, Directors and Senior Management, Item 6.B, Compensation, 6.D, Employees, Item 6.E, Share Ownership, Item 7, Major Shareholders and Related Party Transactions, Item 16A, Audit Committee Financial Expert, and Item 16B, Code of Ethics; and (v) Item 4 Information on the company as long as such information is included in the parent company’s filings.

In the final new C&DI, the SEC confirms that a foreign private issuer may incorporate by reference into a Form 20-F annual report information that had previously been filed with the SEC in another report, such as a Form 6-K.

C&DI Related to Definition of Foreign Private Issuer

The first of the new guidance on the definition of a foreign private issuer relates to determining whether 50% or more of a company’s outstanding securities are directly or indirectly owned by U.S. residents when a company has multiple classes of voting stock with different voting rights. In such a case a company may either (i) calculate voting power on a combined basis; or (ii) make a determination based on the number of voting securities. A company must apply its methodology on a consistent basis.

The second C&DI provides guidance on determining whether an individual is a U.S. resident. In particular, the SEC confirms that a permanent residence with a green card would be considered a U.S. resident. A company may also consider any relevant facts including tax residency, nationality, mailing address, physical presence, the location of a significant portion of their financial and legal relationships and immigration status. The application of facts must be consistently applied to all shareholders.

The third C&DI clarifies the determination of citizenship and residency of directors and officers. A company must consider the citizenship and residency of all individual directors and officers separately and not count them as a single group. In the fourth C&DI, the SEC addresses the determination where a company has two boards of directors. In that case, the company should examine the board that most closely undertakes functions that U.S.-style boards of directors would. Where such determination cannot be made or where both boards provide these functions, both boards should be aggregated and citizenship and residency examined for both.

In the fifth C&DI the SEC confirms that a company can use the geographic segment information in its balance sheet to determine if more than 50% of its assets are located outside the U.S. A company may also use any other reasonable methodology as long as it is used consistently.

In the sixth C&DI the SEC provides guidance for determining whether a business is principally administered in the U.S. As with the theme of the other guidance, the SEC gives the company guidance to exercise reasonable discretion consistently. A company must assess the location from which its officers, partners, or managers primarily direct, control and coordinate the company business and activities.

In the seventh new C&DI the SEC confirms that holding meetings of shareholders or the board of directors on occasion, will not necessarily result in a conclusion that the company is principally administered in the U.S.

In another new C&DI the SEC confirms that all securities-trading markets in countries that are part of the European Union may be considered a single foreign jurisdiction for purposes of applying the trading market definition for purposes of determining the trading of foreign securities.

Refresher Overview for Foreign Private Issuers

Definition of Foreign Private Issuer

Both the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934, as amended (“Exchange Act”) contain definitions of a “foreign private issuer.” Generally, if a company does not meet the definition of a foreign private issuer, it is subject to the same registration and reporting requirements as any U.S. company.

The determination of foreign private issuer status is not just dependent on the country of domicile, though a U.S. company can never qualify regardless of the location of its operations, assets, management and subsidiaries. There are generally two tests of qualification as a foreign private issuer, as follows: (i) relative degree of U.S. share ownership; and (ii) level of U.S. business contacts.

As with many securities law definitions, the overall definition of foreign private issuer starts with an all-encompassing “any foreign issuer” and then carves out exceptions from there. In particular, a foreign private issuer is any foreign issuer, except one that meets the following as of the last day of its second fiscal quarter:

(i) a foreign government;

(ii) more than 50% of its voting securities are directly or indirectly held by U.S. residents; and any of the following: (a) the majority of the executive officers or directors are U.S. citizens or residents; (b) more than 50% of the assets are in the U.S.; or (c) the principal business is in the U.S. Principal business location is determined by considering the company’s principal business segments or operations, its board and shareholder meetings, its headquarters, and its most influential key executives.

That is, if less than 50% of a foreign company’s shareholders are located in the U.S., it qualifies as a foreign private issuer. If more than 50% of the record shareholders are in the U.S., the company must further consider the location of its officers and directors, assets and business operations.

Registration and Ongoing Reporting Obligations

Like U.S. companies, when a foreign company desires to sell securities to U.S. investors, such offers and sales must either be registered or there must be an available Securities Act exemption from registration. The registration and exemption rules available to foreign private issuers are the same as those for U.S. domestic companies, including, for example, Regulation D (with the primarily used Rules 506(b) and 506(c)) and Regulation S) and resale restrictions and exemptions such as under Section 4(a)(1) and Rule 144.

When offers and sales are registered, the foreign company becomes subject to ongoing reporting requirements. Subject to the exemption under Exchange Act Rule 12g3-2(b) discussed at the end of this blog, when a foreign company desires to trade on a U.S. exchange or the OTC Markets, it must register a class of securities under either Section 12(b) or 12(g) of the Exchange Act. Likewise, when a foreign company’s worldwide assets and worldwide/U.S. shareholder base reaches a certain level ($10 million in assets; total shareholders of 2,000 or greater or 500 unaccredited with U.S. shareholders being 300 or more), it is required to register with the SEC under Section 12(g) of the Exchange Act.

The SEC has adopted several rules applicable only to foreign private issuers and maintains an Office of International Corporate Finance to review filings and assist in registration and reporting questions. Of particular significance:

(i) Foreign private issuers may prepare financial statements using either US GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to US GAAP;

(ii) Foreign private issuers are exempt from the Section 14 proxy rules;

(iii) Insiders of foreign private issuers are exempt from the Section 16 reporting requirements and short swing trading prohibitions; however, they must comply with Section 13 (for a review of Sections 13 and 16, see my blog HERE);

(iv) Foreign private issuers are exempt from Regulation FD;

(v) Foreign private issuers may use separate registration and reporting forms and are not required to file quarterly reports (for example, Form F-1 registration statement and Forms 20-F and 6-K for annual and periodic reports); and

(vi) Foreign private issuers have a separate exemption from the Section 12(g) registration requirements (Rule 12g3-2(b)) allowing the trading of securities on the OTC Markets without being subject to the SEC reporting requirement.

Although a foreign private issuer may voluntarily register and report using the same forms and rules applicable to U.S. issuers, they may also opt to use special forms and rules specifically designed for and only available to foreign companies. Form 20-F is the primary disclosure document and Exchange Act registration form for foreign private issuers and is analogous to both an annual report on Form 10-K and an Exchange Act registration statement on Form 10. A Form F-1 is the general registration form for the offer and sale of securities under the Securities Act and, like Form S-1, is the form to be used when the company does not qualify for the use of any other registration form.

A Form F-3 is analogous to a Form S-3. A Form F-3 allows incorporation by reference of an annual and other SEC reports. To qualify to use a Form F-3, the foreign company must, among other requirements that are substantially similar to S-3, have been subject to the Exchange Act reporting requirements for at least 12 months and have filed all reports in a timely manner during that time. The company must have filed at least one annual report on Form 20-F. A Form F-4 is used for business combinations and exchange offers, and a Form F-6 is used for American Depository Receipts (ADR). Also, under certain circumstances, a foreign private issuer can submit a registration statement on a confidential basis.

Once registered, a foreign private issuer must file periodic reports. A Form 20-F is used for an annual report and is due within four months of fiscal year-end. Quarterly reports are not required. A Form 6-K is used for periodic reports and captures: (i) the information that would be required to be filed in a Form 8-K; (ii) information the company makes or is required to make public under the laws of its country of domicile; and (iii) information it files or is required to file with a U.S. and foreign stock exchange.

As noted above, a foreign private issuer may elect to use either U.S. GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to U.S. GAAP in the preparation and presentation of its financial statements. Regardless of the accounting standard used, the audit firm must be registered with the PCAOB.

All filings with the SEC must be made in English. Where a document or contract is being translated from a different language, the SEC has rules to ensure that the translation is fair and accurate.

The SEC rules do not have scaled disclosure requirements for foreign private issuers. That is, all companies, regardless of size, must report the same information. A foreign private issuer that would qualify as a smaller reporting company or emerging growth company should consider whether it should use and be subject to the regular U.S. reporting requirements and registration and reporting forms. The company should also consider that no foreign private issuer is required to provide a Compensation Discussion & Analysis (CD&I). If the foreign company opts to be subject to the regular U.S. reporting requirements, it must also use U.S. GAAP for its financial statements. For further discussions on general reporting requirements and rules related to smaller reporting and emerging growth companies, see my blogs HERE and HERE and related to ongoing proposed changes HERE, which includes multiple related links under the “further background” subsection.

Deregistration

The deregistration rules for a foreign private issuer are different from those for domestic companies. A foreign private issuer may deregister if: (i) the average daily volume of trading of its securities in the U.S. for a recent 12-month period is less than 5% of the worldwide average daily trading volume; or (ii) the company has fewer than 300 shareholders worldwide. In addition, the company must: (i) have been reporting for at least one year and have filed at least one annual report and be current in all reports; (ii) must not have registered securities for sale in the last 12 months; and (iii) must have maintained a listing of securities in its primary trading markets for at least 12 months prior to deregistration.

American Depository Receipts (ADRs)

An ADR is a certificate that evidences ownership of American Depository Shares (ADS) which, in turn, reflect a specified interest in a foreign company’s shares. Technically the ADR is a certificate reflecting ownership of an ADS, but in practice market participants just use the term ADR to reflect both. An ADR trades in U.S. dollars and clears through the U.S. DTC, thus avoiding foreign currency issuers. ADR’s are issued by a U.S. bank which, in turn, either directly or indirectly through a relationship with a foreign custodian bank, holds a deposit of the underlying foreign company’s shares. ADR securities must either be subject to the Exchange Act reporting requirements or be exempt under Rule 12g3-2(b). ADR’s are always registered on Form F-6.

OTC Markets

OTC Markets allows for the listing and trading of foreign entities on the OTCQX and OTCQB that do not meet the definition of a foreign private issuer as long as such company has its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days subject to OTC Markets’ ability to waive such requirement upon application. If the company does not meet the definition of foreign private issuer, it still must fully comply with Exchange Act Rule 12g3-2(b). For details on the OTCQX listing requirements for international companies, see my blog HERE and for listing requirements for OTCQB companies, including international issuers, see HERE.

India as an Emerging Market

India is widely considered the world’s fastest-growing major economy. The small- and micro-cap industry has been eyeing India as an emerging market for the U.S. public marketplace for several years now. In my practice alone, I have been approached by several groups that see the U.S. public markets as offering incredible potential to the exploding Indian start-up and emerging growth sector. Taking advantage of this opportunity, however, was stifled by strict Indian laws prohibiting or limiting foreign investment into Indian companies. In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian-owned and -domiciled companies, opening up the country to foreign investment, including by U.S. shareholders.

The new rules allow for up to 100% foreign investment in certain sectors. U.S. investors who already invest heavily in Indian-based defense, aviation, pharmaceutical and technology companies will see even greater opportunity in these sectors, which will now allow up to 100% foreign investment. Although certain sectors, including defense, will still require advance government approval for foreign investment, most sectors will receive automatic approval. U.S. public companies will now be free to invest in and acquire Indian-based subsidiaries. Likewise, more India-based companies will be able to trade on U.S. public markets, attracting U.S. shareholders and the benefits of market liquidity and public company valuations.

Indian companies are slowly starting to take advantage of reverse-merger transactions with U.S. public companies. In July 2016, online travel agency Yatra Online, Inc., entered into a reverse-merger agreement with Terrapin 3 Acquisition Corp, a U.S. SPAC. The transaction is expected to close in October 2016. Yatra is structured under a U.S. holding company with operations in India though an India-domiciled subsidiary.

Last year Vidocon d2h became the first India-based company to go public via reverse merger when it completed a reverse merger with a U.S. NASDAQ SPAC. In January, 2016 Bangalore-based Strand Life Sciences Pvt. Ltd. became the second India-based reverse merger when it went public in the U.S. in a transaction with a NASDAQ company.

In addition, U.S.-based public companies, venture capital and private equity firms, and hedge funds and family offices have been investing heavily in the Indian start-up and emerging growth boom. Yatra and Strand Life had both received several rounds of U.S. private funding before entering into their reverse merger agreements. NASDAQ-listed firm Ctrip.com International recently invested $180 million into another India-based online travel company, MakeMyTrip.

India’s Mumbai/Bombay Stock Exchange is already a Qualified Foreign Exchange for purposes of meeting the standards to trade on the U.S. OTCQX International. For details on all OTCQX listing requirements, including for international companies, see my blog HERE and related directly to international companies including Rule 12g3-2(b), see HERE. At least 5 companies currently trade on the OTCQX, with their principal market being in India.

Exchange Act Rule 12g3-2(b)

Exchange Act Rule 12g3-2(b) permits foreign private issuers to have their equity securities traded on the U.S. over-the-counter market without registration under Section 12 of the Exchange Act (and therefore without being subject to the Exchange Act reporting requirements). The rule is automatic for foreign issuers that meet its requirements. A foreign issuer may not rely on the rule if it is otherwise subject to the Exchange Act reporting requirements.

The rule provides that an issuer is not required to be subject to the Exchange Act reporting requirements if:

the issuer currently maintains a listing of its securities on one or more exchanges in a foreign jurisdiction which is the primary trading market for such securities; and
the issuer has published, in English, on its website or through an electronic information delivery system generally available to the public in its primary trading market (such as the OTC Market Group website), information that, since the first day of its most recently completed fiscal year, it (a) has made public or been required to make public pursuant to the laws of its country of domicile; (b) has filed or been required to file with the principal stock exchange in its primary trading market and which has been made public by that exchange; and (c) has distributed or been required to distribute to its security holders.

Primary Trading Market means that at least 55 percent of the trading in the subject class of securities on a worldwide basis took place in, on or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer’s most recently completed fiscal year.

In order to maintain the Rule 12g3-2(b) exemption, the issuer must continue to publish the required information on an ongoing basis and for each fiscal year. The information required to be published electronically is information that is material to an investment decision regarding the subject securities, such as information concerning:

(i) Results of operations or financial condition;

(ii) Changes in business;

(iii) Acquisitions or dispositions of assets;

(iv) The issuance, redemption or acquisition of securities;

(v) Changes in management or control;

(vi) The granting of options or the payment of other remuneration to directors or officers; and

(vii) Transactions with directors, officers or principal security holders.

At a minimum, a foreign private issuer shall electronically publish English translations of the following documents:

(i) Its annual report, including or accompanied by annual financial statements;

(ii) Interim reports that include financial statements;

(iii) Press releases; and

(iv) All other communications and documents distributed directly to security holders of each class of securities to which the exemption relates.

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The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.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 Announces Examination Priorities For 2017 SEC Completes Inflation Adjustment To Civil Penalties »

SEC Announces Examination Priorities For 2017

Posted by Securities Attorney Laura Anthony | March 7, 2017

On January 12, 2017, the SEC announced its Office of Compliance Inspections and Examinations (OCIE) priorities for 2017. The OCIE examines and reviews a wide variety of financial institutions, including investment advisors, investment companies, broker-dealers, transfer agents, clearing agencies and national securities exchanges. The OCIE examination goals are to promote compliance, prevent fraud, identify risk and inform policy.

The priorities this year have a primary focus on (i) protecting retail investors, especially those saving for retirement; (ii) assessing market-wide risks; and (iii) new forms of technology, including automated investments advice.

The SEC shares its annual examination priorities as a heads-up and to encourage industry participants to conduct independent reviews and make efforts for increased compliance, prior to an SEC examination, investigation or potential enforcement proceeding. Moreover, the SEC chooses its priority list in conjunction with discussions with all divisions of the SEC and other market regulators and identifies what it believes are the areas that present heightened risk to investors and market integrity.

A. Retail Investors

Retail investors are being offered products and services that were formally only available to institutional investors. A wide range of products that have traditionally been alternative or institutional products, such as private funds, illiquid investments and structured products, are now available to the retail investor. In addition, as investors are more dependent than ever on their own investments for retirement, financial services firms have increased their services in the area of planning for retirement and the SEC intends to examine this area of service. The SEC will examine whether information, advice, products and services are being offered in a manner consistent with laws, rules and regulations.

The focus of examinations in this area will be on:

Electronic Investment Advice – Investors are increasingly able to obtain investment advice through automated or digital platforms. The SEC will examine registered investment advisors (RIA’s) and broker-dealers that offer these services, including “robo-advisors” that offer advice online or through other electronic platforms. The SEC will focus on the firms’ compliance programs, marketing, formulation of investment recommendations, data protection, and conflict of interest disclosures.

Wrap Fee Programs – The SEC will expand its review of RIA’s and broker-dealers that offer a single bundled fee for advisory and brokerage services, usually referred to as a “wrap fee program.” In particular, the SEC will review whether the RIA’s are meeting their fiduciary duties and contractual obligations to the clients. Areas of concern are wrap account suitability, effectiveness of disclosures, conflicts of interest, and brokerage practices, including best execution and trading away.

Exchange Traded Funds (“ETF’s”) – The SEC will examine ETF’s for compliance with securities laws, including exemptions under the Exchange Act of 1934 and Investment Company Act of 1940. The SEC will also focus on unit creation, redemption process, sales practices and disclosures and the suitability of broker-dealers’ recommendations to purchase ETF’s with a niche strategy.

Never-before-examined Investment Advisors – The SEC will expand its review of never-before-examined investment advisors and will, in particular, try to examine more newly registered advisors and advisors that have been registered for a long period of time without examination.

Recidivist Representatives and their Employers – The SEC will use analytics to track individuals with a history of misconduct and will also examine the firms that employ these people.

Multi-branch Advisors – The use of a multi-branch model provides unique challenges in fashioning compliance programs and oversight procedures.

Share Class Selection – The SEC will examine factors affecting recommendations to invest in or remain invested in a particular share class of a mutual fund, including conflict-of-interest issues. The SEC will examine whether recommendations are being improperly made for share classes with higher loads or distribution fees.

B.Focusing on Senior Investors and Retirement Investments

The SEC continues to focus on retirement accounts and senior investors. Specific areas of priority include:

ReTIRE – The SEC will continue to focus on its ReTIRE initiative, which focuses on investment advisors and broker-dealers that offer services to retirement accounts. The priority this year is on recommendations and sales of variable insurance products and the sales and management of target date funds.

Public Pension Advisors – The OCIE will examine investment advisors to state pension plans, municipalities and other government entities, including particular risks to these advisors such as pay to play and undisclosed gifts and entertainment practices.

Senior Investors – The OCIE will evaluate how firms manage interactions with senior investors, including the ability to identify financial exploitation. Examinations will focus on supervisory programs and controls related to products and services directed at senior investors.

C.Assessing Market-wide Risks

The SEC continues to review structural risks and trends that involve multiple firms and industries, including:

Money Market Funds – The SEC will review money market funds to ensure compliance with the new redemption rules and changes to Form PF which came into effect in October 2016.

Payment for Order Flow – The SEC will examine broker-dealers with a retail client base to ensure compliance with the duty of best execution when routing customer orders.

Clearing Agencies – The SEC will continue annual clearing agency reviews.

FINRA – The SEC intends to enhance its oversight of FINRA with respect to its goal of protecting investors and market integrity. The SEC will also review the quality of FINRA’s examination of broker-dealers.

Regulation Systems Compliance and Integrity (SCI) – The SEC will continue to review compliance with Regulation SCI. See my blog HERE.

Cybersecurity – The SEC will review cybersecurity compliance procedures and controls. See my blog HERE.

Anti-Money Laundering (“AML”) – The SEC will examine clearing and introducing firms’ AML programs and specifically those of firms that have not filed suspicious activity reports or have filed such reports late. The SEC will also examine programs that allow customers to deposit and withdraw cash and/or provide non-U.S. customers with direct access to the markets.

D.Other Areas of Examination

In addition to the primary focus discussed above, the SEC will prioritize the following additional areas for examination:

Transfer Agents – The SEC views transfer agents as an important gatekeeper to prevent Section 5 and other violations as well as preventing fraud. The SEC intends to allocate more resources to examine transfer agents and particularly those involved with microcap securities and private offerings.

Municipal Advisors – The SEC will conduct examinations of newly registered municipal advisors.

Private Fund Advisors – The SEC will examine private fund advisors, focusing on conflicts of interest and disclosure of conflicts.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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« The SEC Has Proposed The Use Of Universal Proxy Cards The SEC Has Issued New Guidance Related To Foreign Private Issuers »

The SEC Has Proposed The Use Of Universal Proxy Cards

Posted by Securities Attorney Laura Anthony | February 28, 2017 Tags: Proxy Rules, SEC, SEC Proposed Rule, Section 14 of the Exchange Act, Section 14 proxy requirements, The SEC Has Proposed The Use Of Universal Proxy Cards, Universal Proxy Cards

The SEC has seen a huge exodus of key officials and employees since the recent change in administration, and the ultimate effect of these changes on pending or proposed rule making remains to be seen. However, some proposed rules, whether published or still in drafting process, will remain largely unaffected by the political changes. This could be one of them. In particular, on October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. The proposed card would include the names of both the company and opposed nominees. The SEC also proposed amendments to the rules related to the disclosure of voting options and standards for the election of directors.

Currently where there is a contested election of directors, shareholders likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e. all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned the second would cancel out and replace the first under state corporate law.

Shareholders can always appear in person and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. In an effort to provide the same voting rights to shareholders utilizing a proxy card instead of in person appearance, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.

Opposition to the proposed rule is concerned that it will give more power to shareholder activists groups and encourage additional proxy contests ultimately damaging the corporation that pays the price, both directly and indirectly, by such adversarial processes.

In an era of strong shareholder activism, the regulation of a company’s obligation in the face of a shareholder proposal has been complex, populated with a slew of no-action letters, SEC guidance through C&DI, and court rulings. In October 2015, the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years (see my blog HERE) and on the same day the SEC issued specific guidance related to merger and acquisition transactions (see my blog HERE).

SEC Proposed Rule

Introduction and Background

Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Company’s subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. Private companies, and companies that voluntarily file reports with the SEC (called ’33 Act companies) are not subject to the Section 14 proxy requirements. The SEC views its regulatory authority over the proxy process as “preventing the recurrence of abuses which have frustrated the free exercise of the voting right of stockholders.”

Currently shareholders that appear in person for a meeting, can vote from any of the choices for a director. However, shareholders voting by proxy, which is the vast majority (as high as 99.9%) can only choose from the candidates on the proxy card provided by the party soliciting such vote. In a contested election a shareholder will receive two separate proxy cards and solicitations, one from the company and one from the opposition. Under state law, a shareholder cannot submit two separate proxy cards as the second cancels out and replaces the first.

Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally in a contested election the opposing candidates will not agree presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.

As mentioned, shareholders appearing in person can vote for any duly nominated directors, regardless of whether supported by a company or the opposition. However, in today’s world shareholders rarely appear in person. Besides the time and expense of traveling to and appearing at a meeting, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition.

In 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e. those prepared by the company) to get those names.

In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. As a response, the SEC issued the new rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.

In its rule release the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”

Companies have a concern that dissident board representation can be counter-productive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve. The SEC rule release solicits comments on this point.

Moreover, there is a concern that shareholders could be confused as to which candidates are endorsed by who, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.

Proposed Amendments

In order to provide for the use of universal proxy cards, the SEC has proposed amendments to the proxy rules related to the solicitation of proxies, the preparation and use of proxy cards and the dissemination of information about all director nominees in a contested election. In particular the proposed rules:

Revise the consent required of a bona fide nominee such that a consent for nomination with include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
Eliminates the short slate rule for companies other than funds and BDC’s as the rule would no longer have an effect or be necessary;
Requires the use of universal proxy cards in all non-exempt solicitations in connection with contested elections. The universal proxy card would not be required where the election of directors is uncontested. There may be cases where shareholder proposals are contested by a company in which case a shareholder would still receive two proxy cards, however, in such case, all director nominees must be included in each groups proxy cards.
Requires dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
Requires companies to provide dissidents with notice of the names of the company’s nominees;
Provides for a filing deadline for the dissidents’ definitive proxy statement;
Requires dissidents to solicit the holders of shares representing at least a majority of the voting power of shares entitled to vote on the election of directors;
Prescribes requirements for the universal proxy cards, including form, content and disclosures;
Makes changes to the form of proxy including requiring an “against” and “abstain” voting option; and
Makes changes to the proxy statement disclosure to require a better explanation of the effect of a “withhold” vote in an election.

The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:

Due Date	Action Required
No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [proposed Rule 14a-19(b)(1)]	Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees.
No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [proposed Rule 14a- 19(d)]	Registrant must notify the dissident of the names of the registrant’s nominees.
No later than 20 business days before the record date for the meeting. [current Rule 14a-13]	Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners.
By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [proposed Rule 14a-19(a)(2)]	Dissident must file its definitive proxy statement with the Commission.

The proposed new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« SEC Issues White Paper On Penny Stock Risks SEC Announces Examination Priorities For 2017 »

SEC Issues White Paper On Penny Stock Risks

Posted by Securities Attorney Laura Anthony | February 21, 2017 Tags: micro-cap, OTC Markets, OTC Pink, OTCBB, OTCQB, OTCQX, SEC

On December 16, 2016, the SEC announced several new settled enforcement proceedings against market participants including issuers, attorneys and a transfer agent, related to penny stock fraud. On the same day the SEC issued a new white paper detailing the risks associated with investing in penny stocks. This blog summarizes the SEC white paper.

As I have written about on numerous occasions, the prevention of micro-cap fraud is and will always be a primary focus of the SEC and other securities regulators. In fact, the SEC will go to great lengths to investigate and ultimately prosecute micro-cap fraud. See my blog HERE regarding the recent somewhat scandalous case involving Guy Gentile.

Introduction

The SEC Division of Economic and Risk Analysis published a white paper on the risks and consequences of investing in stocks quoted in the micro-cap markets versus those listed on a national securities exchange. The paper reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns.

The white paper notes that the incidence of and amount of negative returns, as well as alleged market manipulation increase with the fewer disclosure-related requirements associated with the company. The white paper, on the whole, is very negative towards OTC Markets securities. However, off the top, I think the white paper is skewed unfairly against OTC Markets securities when it should target those lower-tier securities that do not provide disclosures to the public.

This blog will summarize the white paper, including many of its facts and figures, but will find issue with its framework. The white paper does not give fair distinction to the higher OTCQX tier of OTC Markets. In fact, “OTCQX” only appears twice in the entire white paper, both in a footnote that purports to list the OTCQX requirements, but fails to mention the quantitative requirements, including that the security not be a penny stock as defined by the federal securities laws. The shortened “QX” does appear 13 times in the white paper, providing some factual and statistical information such as market size and trading patterns, but again, ignores the meaningful distinction related to the penny stock definition. For a review of the OTCQX tier of OTC Markets and its listing requirements, see my blog HERE.

It is axiomatic that the vast majority of new jobs are created by small and emerging companies and that these companies are critical to the economic well being of the United States. See, for example, my blog on the SEC report on the definition of accredited investor HERE and its study on private placements HERE.

According to both Bloomberg and Forbes, 8 out of 10 new businesses fail within 18 months and that number jumps to 96% in the first 10 years. However, despite that failure rate, it is indisputable that we need entrepreneurs to continue forming new businesses and access supportive capital, to have a healthy economy.

Likewise, it is axiomatic to all micro-cap market participants that those companies that fail to provide meaningful disclosure to the public, are more likely to result in investment losses. Those companies are also more likely to engage in market manipulation and other securities law violations. However, those companies that do provide meaningful disclosure to the public, whether through SEC reporting or alternatively to the OTC Markets, and especially those companies that trade on the OTCQX, are the very small and emerging companies that are necessary and vital to our healthy economy. They may be the 8 out of 10 or the 96%, but some will also be the 2 out of 10 and 4% – and all are necessary.

Also, the fact is that bank financing is not readily available for these companies, and they have no choice but to try to access capital through the public. That public wants an exit strategy and that exit strategy tends to be the public markets. Where the companies are small and immature in their business life cycle, the OTC Markets provide that secondary trading market. In discussing this aspect of the economies of these small public companies, they are more positively referred to by the SEC as “venture” companies and the trading market as a “venture exchange” (see my blog HERE).

Many times when a company ceases to provide disclosure or information to the public and remains dark for a period of time, its business operations have failed, it has gone private, or otherwise has been abandoned. These companies continue to trade, and sometimes with high volume with no public information. The SEC makes an effort to eliminate these companies through its Operation Shell-Expel (see HERE), but unfortunately many remain and new ones are added all the time as the 8-out-of-10 cycle continues.

Although all penny stocks are risky, and are undeniably the highest-risk investments, grouping all OTC Markets into the white paper, in the fashion that the SEC has done, strikes me as fundamentally unfair. Throughout my summary of the SEC White Paper, I provide thoughts and commentary.

SEC White Paper

The SEC White Paper begins with an introduction on some high-level differences between an exchange traded security and one on the OTC Markets. One of the biggest distinctions is that the majority of ownership and trading of an exchange listed security is by institutional investors, whereas the majority of ownership and trading on the OTC Markets is by individuals. The SEC points out that institutions tend to be more proactive in research and shareholder activism, creating a check on corporate governance. As an aside, these institutions are also more sophisticated and able to assert greater influence and power over a company than an individual small shareholder.

The SEC quickly highlights the negative literature on OTC Markets securities, including that they have poor liquidity, generate negative and volatile returns and are often subject to market manipulation, including by the dissemination of false and misleading information. Although OTC securities offer the opportunity to invest in early-stage companies that may grow to be larger successful ones, the number that do exceed is small (such as the 2 out of 10 in my summary above).

One portion of the white paper’s information I find interesting is that despite the risks, OTC Markets continue to grow and investor demands for these stocks continues to rise. The SEC offers two hypotheses for this. The first is that OTC investors are simply gambling for the big return, just as they do with the lottery. The second is that OTC Markets investors simply make bad investment decisions. However, the report does admit that little is known about the characteristics of OTC investors and that this is likely the first comprehensive study trying to determine those demographics. Personally, I also think that many OTC Markets investors are day traders and that although a particular stock may go down over time, those day traders are taking advantage of the small intraday price changes to make a profit.

The SEC reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative, with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns, and are also worse for elderly and retired investors and those with lower levels of income and education. The SEC white paper purports to be the first study of its kind that examines investor outcomes around stock promotions and level of disclosure.

I would suggest that the exact same results (i.e., lower returns on less transparent investments and those engaged in improper promotional campaigns and lower returns for the elderly and lower income and education demographic) would be found for any investments in any studied market and are not unique to OTC Markets securities. To be clear, I don’t think the correlation is necessarily improper activity, though that could be the case especially when looking at some stock promotions. Companies that provide less disclosure may have less capital and financial resources to further their business plan and, as such, are far riskier investments. Also, companies that provide less disclosure may be less interested in furthering the public aspect of their business. Even if the underlying business is sound, if they are not providing public disclosure, the stock price and liquidity are unlikely to reflect the underlying business, which could result in poor investor returns.

The SEC white paper continues with a three-part discussion: (i) OTC Market structure and size; (ii) review of academic literature; and (iii) analysis of OTC investor demographics and outcomes.

OTC Market Structure and Size

The SEC white paper describes the basic makeup of OTC Markets including its three tiers of OTC Pink, OTCQB and OTCQX. I’ve written about these market tiers many times. For a review of the three tiers, see my blog HERE, though I note that both the OTCQB and OTCQX have updated their listing standards since that blog was written. The OTC Pink remains unchanged. For the most current listing standards on the OTCQX see HERE and for the OTCQB see HERE.

The SEC white paper also references the OTCBB, which technically still exists, but has fewer than 400 listed securities and does not have a readily accessible quote page.

The SEC white paper has a lot of information on the market size and its growth over the years. Without getting into a lot of facts and figures, I note that the OTC Markets grew by 47% from 2012 through 2015, with $238 billion of trading in 2015. There are approximately 10,000 securities quoted on OTC Markets, as compared to approximately 2,700 on NASDAQ, of which only approximately 675 are micro-cap companies.

The OTC Markets monthly newsletter gives a complete review and breakdown of the size of OTC Markets. For the one month of December 31, 2016, the following is the number of traded securities and volume:

Monthly Trade Summary – December 2016

Market Designations	Number of Securities*	Monthly $ Volume	Monthly $ Volume per Security	2016 $ Volume*

OTCQX	461	$3,844,835,942	$8,340,208	$36,847,879,435
OTCQB	933	$3,249,939,872	$3,483,322	$13,638,584,206
Pink	8,234	$14,648,939,577	$1,779,079	$142,411,521,245
Total	9,628	$21,743,715,392	$2,258,383	$192,897,984,887

Literature Review

The SEC white paper continues with a summary of recent academic research and analysis including on OTC Markets securities’ liquidity, returns, market manipulation, transition to an exchange and investor participation.

Liquidity refers to the ability of shareholders to quickly buy and sell securities near the market price without substantial price impact. Where there is a lack of liquidity, it is difficult to sell. Also, low-volume stocks tend to have wider price fluctuations and bid-ask spreads, and are more expensive for dealers to hold in inventory. OTC Markets securities are less liquid than those listed on a national exchange such as the NYSE MKT or NASDAQ. Research also shows that there tends to be lower liquidity with less transparency and disclosure. None of this is surprising, though many of us that work in the OTC Markets space have seen the anomaly of a company with no information, and likely no underlying business or management, trading on heavy volume.

The returns on OTC Markets securities are also very different than exchange traded securities. Returns on OTC Markets are often negative, volatile and skewed (the lottery factor). Where the majority of trades have negative returns, there is the incidence of extremely high, lottery-like returns on some of the securities. This, again, is not surprising. OTC Markets-traded companies tend to be smaller companies and thus would naturally have a smaller market capitalization and smaller returns as well as the potential for larger upside.

Again, returns on companies that provide less transparency and public information tend to be lower. Interestingly, another hypothesis as to why returns are lower is the short-sale constraints on OTC Market securities. Many OTC Market securities are ineligible for margin (and thus short sales), and locating shares for borrow can be challenging. Those that are margin-eligible usually have a very high carry interest and per-share transaction cost for short sales. The argument is that short sales create an equilibrium and thus help reflect a truer stock price such that the stock will be less vulnerable to negative price adjustments. However, unfortunately, sophisticated traders can open offshore accounts that will allow for short selling of OTC Market securities, opening those same securities up to manipulation by those investors.

OTC Markets securities are relatively often the target of market manipulation, including outright fraudulent disclosures and pump-and-dump schemes. Generally these schemes are conducted in the trading of those companies that are less transparent in disclosures. A market manipulation scheme can involve the dissemination of false information followed by taking advantage of the price changes that result. The scheme can be perpetrated by the company and its insiders, or by unaffiliated investors. Examples include spam and email campaigns, rumors and false information in Internet chat rooms or forums, and false “analyst reports.” Research shows these schemes are effective – that is, the price increases while the stock is being touted and falls when the campaign is over.

Obviously not all increases in stock prices are a result of improper behavior. OTC Markets stocks react to legitimate news and growth as well. In fact, the majority of extreme increases in trading price and volume are the result of changes in company fundamentals and not market manipulation. Moreover, not investor relations and stock promotion is perfectly legal and can be completely legitimate. It is when false or misleading information is being disseminated, or targeted marketing aimed at vulnerable investor groups is used, that it is problematic. The key is recognizing the difference, which generally involves transparency from companies that provide steady, consistent disclosure with apparent credible information.

Many OTC investors are hoping to “bet” on the company that will grow and move to an exchange where it is likely the stock price will increase substantially, as will liquidity. The SEC white paper gives dismal statistics on the rates of graduation. However, it does note that the rate of movement to an exchange is much higher for OTCQX or OTCQB (9%) than OTC Pink companies (less than 1%). The SEC white paper also suggests that companies that graduate to an exchange from the OTC Markets underperform those companies that go public onto an exchange in the first instance.

The last area that the SEC white paper discusses in this section is investor participation and, in particular, why that investor participation continues to grow year over year. The SEC white paper gives two hypotheses, the first being that investors are drawn by the opportunity for lottery-like payoff and the second is that investors are “duped about the stock return probabilities.” Although this sounds harsh, the white paper is not actually referring to market manipulation, but rather suggests that all OTC investors, including the most sophisticated, make poor estimates on return probabilities. No reason for this is offered.

Studies show that although investors frequently lose small investments in OTC stocks, they also occasionally receive an extremely large return. As such, the SEC white paper suggests that these investors are really just gamblers. I’m sure that oftentimes is correct.

Data Analysis and Investor Demographics

The Division of Economic and Risk Analysis studied a sampling of trades for specific securities and time periods which included information on the issuer, trade and investor. The purpose of the review was to determine a relationship between investor returns on the one hand and stock promotions, company transparency and investor demographics on the other hand. However, the information used for the analysis is admittedly biased in that such information was taken from the SEC enforcement files for the year 2014. Since one or more parties to the trades were the subject of enforcement proceedings, this information would not be indicative of the usual OTC company.

The SEC white paper comes to the conclusion that there is a positive correlation between losses and market manipulation and lack of transparency. As discussed above, this is not surprising and is actually quite logical. The white paper also found a positive correlation between losses and elderly, lower-income and poorly educated investors.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« What Does The SEC Do And What Is Its Purpose? The SEC Has Proposed The Use Of Universal Proxy Cards »

What Does The SEC Do And What Is Its Purpose?

Posted by Securities Attorney Laura Anthony | February 14, 2017 Tags: SEC, What Does The SEC Do?, what is the sec, what is the sec and what does it do, what is the securities and exchange commision, what is the securities and exchange commission sec

As I write about the myriad of constantly changing and progressing securities law-related policies, rules, regulations, guidance and issues, I am reminded that sometimes it is important to go back and explain certain key facts to lay a proper foundation for an understanding of the topics which layer on this foundation. In this blog, I am doing just that by explaining what the Securities and Exchange Commission (SEC) is and its purpose. Most of information in this blog comes from the SEC website, which is an extremely useful resource for practitioners, issuers, investors and all market participants.

Introduction

The mission of the SEC is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. Although each mission should be a priority, the reality is that the focus of the SEC changes based on its Chair and Commissioners and political pressure. Outgoing Chair Mary Jo White viewed the SEC enforcement division and task of investor protection as her top priority. Jay Clayton will likely shift the top priority to capital formation.

In addition to regulating and overseeing the processes involved in capital formation (registration and exemptions), the SEC regulates the market participants themselves, including securities exchanges, brokers and dealers, investment advisors, investment companies, issuers and investors, and civilly enforces the law as to each of these participants. Related to securities exchanges, brokers and dealers and investment advisors, the SEC is primarily concerned with disclosure, fair dealing and protecting against fraud. The SEC brings hundreds of enforcement proceedings each year. For a review of the SEC 2016 enforcement results, see my blog HERE.

The federal securities laws are based on the premise that all investors, whether large institutions or private individuals, should have access to disclosure and information about an investment both before they buy it and during the time they hold the investment. The public company reporting requirements are designed to provide meaningful, comparable information and data about public companies so that investors can conduct due diligence and make an analysis as to whether to buy, sell or hold a particular security.

In order to be effective in its mission in an ever-changing global economy, the SEC must stay connected with market participants and their needs, and be abreast of, and utilize, technological advances. Moreover, the SEC considers the education of investors as a key component to its mission. Educated investors make better decisions. The majority of leads and ultimate evidence on wrongdoing come from investors themselves and, as such, better educated investors provide a more useful resource for enforcement.

History

The SEC was formed as a response to the stock market crash of October 1929 and the following period of the Great Depression. First, Congress passed the Securities Act of 1933, which was designed to regulate disclosure and truth in the purchase and sale of securities. Second, Congress passed the Securities Exchange Act of 1934, which created the SEC and was designed to regulate the people who sell and trade securities, including public companies, brokers, dealers and exchanges. Joseph Kennedy, John F. Kennedy’s father, was the first Chairman of the SEC.

Organization

The SEC is controlled by five commissioners appointed by the president. Each commissioner serves a five-year term and the terms are staggered as to the individual commissioners. One of the commissioners is designated as the chairman by the president. By law, and in an effort to ensure bipartisan policies, no more than three of the commissioners can belong to the same political party.

The SEC is divided into five divisions and 23 offices, all of which are headquartered in Washington, D.C., although there are 11 regional offices throughout the country. A brief summary of each division follows.

Divisions

Division of Corporation Finance

The Division of Corporation Finance (CorpFin) oversees disclosure documents filed by companies with the SEC, including, for example, registration statements on Form S-1, 1-A or Form 10, SEC reports on Forms 10-Q, 10-K and 8-K, and proxy materials related to annual and special shareholder meetings. CorpFin routinely reviews the documents filed with the SEC and may provide comments on the filings. For information on responding to SEC comments, see my blog HERE.

CorpFin provides administrative interpretations and guidance on the federal securities laws for the public and makes specific recommendations to the SEC for rule implementation and changes. In addition to the more formal written no-action letter process, CorpFin maintains staff that is available to answer calls by potential issuers and investors to provide guidance and interpretations on the federal securities laws, including related to whether a particular offering would qualify for an exemption from the registration requirements. CorpFin also works with the Office of Chief Accountant to monitor accounting activities, including the Financial Accounting Standards Board (FASB), which formulates generally accepted accounting principles (GAAP).

Division of Enforcement

The Division of Enforcement conducts investigations and brings civil and administrative proceedings on behalf of the SEC to enforce the federal securities laws. The Division of Enforcement is not itself a criminal prosecutory authority but does work with law enforcement agencies such as the Department of Justice and Attorney General offices around the U.S. to recommend and assist with criminal cases.

All SEC investigations are private. Once an investigation is completed, the SEC will decide to take no action, pursue a civil complaint or pursue an administrative proceeding. Matters that may result in civil or administrative proceedings are often settled first. Although this firm does not represent clients in enforcement proceedings, I have written about the topic in general on numerous occasions. For further reading on enforcement penalties, see HERE. Related to the SEC Whistleblower program, see HERE. For reading related to the SEC’s efforts to prevent microcap fraud, see HERE.

Division of Trading and Markets

The Division of Trading and Markets is responsible for the SEC’s role of maintaining fair, orderly and efficient markets. In executing its duties, the Division provides daily oversight of major market participants, including the securities exchanges, broker-dealers, self-regulatory organizations including FINRA and the MSRB, clearing agencies, transfer agents, securities information processors and credit rating agencies. This Division also oversees the Securities Investor Protection Corporation (SIPC), which provides insurance against loss in customer accounts due to the bankruptcy or other overall failure of brokerage firms. SIPC does not ensure against individual losses from market declines or negligent or fraudulent broker conduct.

The Division of Trading and Markets also assists with financial integrity programs for broker-dealers, reviewing rules proposed by self-regulatory organizations, drafting and proposing rules and interpretations related to market operations and surveilling the markets.

Division of Investment Management

The Division of Investment Management helps oversee the investment management industry, including mutual funds, fund managers, analysts and investment advisors. The Division of Investment Management is responsible for both investor protection and promoting capital formation in the industry balancing between disclosure by funds and limiting regulatory costs that ultimately reduce gains.

The Division of Investment Management assists the SEC in promulgating and interpreting laws and regulations in the investment management industry, responds to no-action letter and exemptive relief requests, reviews investment company and investment advisor filings with the SEC, and assists in enforcement proceedings.

Division of Economic and Risk Analysis

The Division of Economic and Risk Analysis helps with all aspects of the SEC’s mission through its economic analysis and data analytics. This Division interacts with all other divisions and offices of the SEC, providing economic and risk analyses related to policymaking, rulemaking, enforcement and examinations. The Division also provides advance risk assessments as to litigation, examinations, registrants reviews and general economic support.

Offices of the SEC

The SEC has several offices that perform functions related to the SEC’s overall mission, including, but not limited to, the Office of General Counsel, the Office of the Chief Accountant, the Office of Compliance Inspections and Examinations, the Office of Investor Education and Advocacy, the Office of Credit Ratings, the Office of International Affairs, the Office of Municipal Securities, the Office of Ethics Counsel, the Office of the Investor Advocate, the Office of Women and Minority Inclusion, the Office of the Chief Operating Officer, the Office of Legislative and Intergovernmental Affairs, the Office of Public Affairs, the Office of the Secretary, the Office of Equal Employment Opportunity, the Office of the Inspector General and the Office of Administrative Law Judges, a few of which deserve explanation.

The General Counsel, as part of the Office of the General Counsel, is appointed by the Chairman, is the chief legal officer of the SEC and provides legal advice and counsel to all divisions, other offices, commissioners and the Chairman on all matters within the SEC’s jurisdiction. The General Counsel office also represents the SEC in all civil and administrative litigation matters.

The Chief Accountant, as part of the Office of the Chief Accountant, is also appointed by the Chairman and advises the SEC on all accounting and auditing matters, including approving PCAOB auditing rules. In addition, the Office of the Chief Accountant assists the SEC in establishing accounting principles and overseeing the private sector accounting standards-setting process. The Chief Accountant liaises with FASB, which in turn establishes GAAP. It also liaises with the PCAOB, the International Accounting Standards Board and the American Institute of Certified Public Accountants.

The Office of Investor Education and Advocacy responds to questions, complaints and suggestions from the public. The Office also publishes information and holds seminars and other outreach educational programs to educate the public on the securities laws and their rights.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« House Passes Creating Financial Prosperity For Business And Investors Act SEC Issues White Paper On Penny Stock Risks »

House Passes Creating Financial Prosperity For Business And Investors Act

Posted by Securities Attorney Laura Anthony | February 7, 2017 Tags: Accelerating Access to Capital Act Accelerating Access to Capital Act, Capital Markets Improvement Act of 2016 Capital Markets Improvement Act of 2016, Crowdfunding SPV, Financial Choice Act, Hous, House Passes Creating Financial Prosperity For Business And Investors Act, Remove term: Title II: The SEC Small Business Advocate Act (H.R. 3784) Title II: The SEC Small Business Advocate Act (H.R. 3784), Remove term: Title IV: The Fix Crowdfunding Act (H.R. 4855) Title IV: The Fix Crowdfunding Act (H.R. 4855), Special Purchase Vehicle (SPV), SPV Structure, Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168), Title III: The Supporting America’s Innovators Act (H.R. 4854), Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187), Title VI: The U.S. Territories Investor Protection Act (H.R. 5322), U.S. House of Representatives

ABA Journal’s 10th Annual Blawg 100

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On December 5, 2016, the U.S. House of Representatives passed the Creating Financial Prosperity for Businesses and Investors Act (H.R. 6427) (the “Act”), continuing the House’s pro-business legislation spree. The Act is actually comprised of six smaller acts, all of which have previously been considered and passed by the House in 2016. The Act is comprised of: (i) Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168); (ii) Title II: The SEC Small Business Advocate Act (H.R. 3784); (iii) Title III: The Supporting American’s Innovators Act (H.R. 4854); (iv) Title IV: The Fix Crowdfunding Act (H.R. 4855); (v) Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187); and (vi) Title VI: The U.S. Territories Investor Protection Act (H.R. 5322).

Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168)

This Act requires the SEC to respond to the findings and recommendations of the SEC’s annual Government-Business Forum on Small Business Capital Formation, which forum I attended in 2016 and found very interesting and productive. The Act would require the SEC to respond to recommendations by issuing a public statement evaluating the finding or recommendation and indicating what action the SEC intends to take as a result. Currently, the SEC is required to hold the annual Government-Business Forum to review the current status of problems and programs related to small business capital formation. The SEC is also required to prepare summaries of the Forum and any findings made by the Forum but is not required to comment or take a position on same.

The SEC is already legally required to review and respond to findings of the Investor Advisory Committee but currently is not required to take this additional step related to the small business forum. As with the Investor Advisory Committee, the SEC’s action on recommendations could be simply to review the matter further, conduct a study, consider or propose a rule change, or the SEC could state that it is taking no action at all. The Act does not limit, direct or require any particular response, just that a response be made. This Act was originally passed as part of the Financial Choice Act.

Title II: The SEC Small Business Advocate Act (H.R. 3784)

This legislation establishes the Office for Small Business Capital Formation within the SEC to assist small businesses and their investors in resolving problems and to provide a forum to identify issues and propose changes to statutes, regulations and rules to benefit small businesses and their investors and generally facilitate capital formation. The SEC would be required to review and respond to any recommendations by the committee. However, like similar rules, including the proposed H.R. 4168, the SEC’s response could be to review the matter further, conduct a study, consider or propose a rule change, or the SEC could state that it is taking no action at all.

The new Office for Small Business Capital Formation would be responsible for planning and holding the annual Government-Business Forum on Small Business Capital Formation. The new office would also analyze the effects of new and proposed rules on small businesses. The purpose would be to create an office in the SEC that would advocate for rule and policy changes on behalf of small businesses and their investors. In order to give the office independence in its role, the office would provide its reports directly to various committees of Congress without review or oversight by the SEC itself.

The legislation also establishes the SEC Small Business Advisory Committee to provide the SEC with advice on rules, regulations and policies related to capital formation, securities trading, public reporting and corporate governance for emerging, privately held and smaller reporting companies with less than $250 million in public float. This new SEC Small Business Advisory Committee would essentially replace the voluntarily created SEC Advisory Committee on Small and Emerging Companies. The Advisory Committee on Small and Emerging Companies was last renewed by the SEC Chair and Commissioners on September 24, 2015 for a period of two years and accordingly, unless renewed again, will dissolve later this year.

As a reminder, the Advisory Committee on Small and Emerging Companies was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

The SEC would have the same mandate to review and respond to recommendations by the new committee. My prior blog discussing this act is HERE.

Title III: The Supporting America’s Innovators Act (H.R. 4854)

This legislation creates a new small “qualifying venture capital fund” under the Investment Company Act of 1940 and increases the current registration exemption under Section 3(c)(1) of the Investment Company Act to allow for up to 250 investors in such qualifying venture capital fund. Currently Section 3(c)(1) of the Investment Company Act exempts pooled funds, such as hedge funds, from registering under the Act as long as they have fewer than 100 equity holders. There is no limit on the amount of invested capital in a fund to qualify for the 3(c)(1) exemption. H.R. 4854 would create a new class of pooled fund, called a “qualifying venture capital fund,” which would be defined as any venture fund with $10 million or less of invested capital and allow up to 250 investors in such fund.

Title IV: The Fix Crowdfunding Act (H.R. 4855)

From the time the SEC published the final Regulation Crowdfunding rules and regulations on October 30, 2015, the regulatory framework has met with wide criticism, including that the process is too costly considering the $1 million raise limitation. The most commonly repeated issues with the current structure include: (i) the $1 million annual minimum is too low to adequately meet small business funding needs; (ii) companies cannot “test the waters” in advance of or at the initial stages of an offering; and (iii) companies cannot currently use a Special Purchase Vehicle (SPV) in a crowdfunding offering. The Fix Crowdfunding Act only addresses one of these three complaints.

The Fix Crowdfunding Act would also allow for the use of special purpose vehicles (SPV’s) in the fundraising process. The Act would allow for SPV’s by amending the Investment Company Act of 1940 to add a newly defined “crowdfunding vehicle” which is limited by its organizational and charter documents to one that acquires, holds and disposes of securities of a single issuing company in one or more crowdfunding transactions conducted under Section 4(a)(6) and Regulation Crowdfunding.

In addition, the newly defined “crowdfunding vehicle” would need to meet the following requirements: (i) have only one class of securities; (ii) neither the vehicle nor any person associated with the vehicle can receive any compensation in connection with the purchase, holding or sale of securities of the investment target; (iii) the vehicle can only purchase securities issued in a transaction under Section 4(a)(6) and Regulation Crowdfunding; (iv) both the crowdfunding vehicle and investment target must remain current in their respective disclosure obligations under Regulation Crowdfunding; and (v) the crowdfunding vehicle must be advised by either a state or federally registered investment advisor (RIA).

A crowdfunding SPV will be exempt from the current per-investor investment limits under Regulation Crowdfunding (i.e., (a) if either annual income or net worth is less than $100,000, the investment limitation is the greater of $2,000 or 5% of the lesser of annual income or net worth; or (b) if both annual income and net worth are equal to or greater than $100,000, the investment limitation is 10% of the lesser of annual income or net worth). However, investments into the crowdfunding SPV would remain subject to the per-investor limitations.

It is thought that an SPV structure helps protect the smaller investors by allowing them to pool funds together with larger investors in an entity that offers separate protections than the offering company itself. The SPV structure has become prevalent in Rule 506(c) offerings where the company is utilizing a platform to advertise and attract investors. However, under Rule 506(c), which is limited to accredited investors, it has not been problematic for SPV’s to stay within the current exemptions to registration under the Investment Company Act of 1940 by having fewer than 100 investors.

The Fix Crowdfunding Act also modifies the current exemption from the Exchange Act Section 12(g) registration requirements under Regulation Crowdfunding. The Exchange Act and Regulation Crowdfunding currently provide that security holders who acquired their securities in a crowdfunded offering are not counted for purposes of the registration threshold, provided that the issuer is current in its required annual reports and has engaged a transfer agent for its securities. The Fix Crowdfunding Act would remove the annual report and transfer agent conditions if the issuer had a public float for the last semi-annual period of less than $75 million, or if the public float is zero for such period annual revenues of less than $50 million in the most recently completed fiscal year.

One of my colleagues in the world of corporate finance, Dara Albright, wrote a great letter to Representative McHenry supporting the Fix Crowdfunding Act. Ms. Albright’s letter can be read HERE.

Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187)

This legislation amends the definition of “accredited investor” under the Securities Act of 1933 to include: (i) persons whose individual net worth, together with their spouse, exceeds $1,000,000, adjusted for inflation, excluding the value of their primary residence; (ii) persons with an individual income greater than $200,000, or $300,000 for joint income, both adjusted for inflation; (iii) any person currently licensed or registered as a broker or investment adviser by the SEC, FINRA, an equivalent SRO, or state securities regulator; and (iv) persons whom the SEC determines have demonstrable education or job experience to qualify as having professional subject-matter knowledge related to a particular investment (FINRA or an equivalent self-regulatory organization must verify the person’s education or job experience).

My prior blog discussing this act is HERE.

Title VI: The U.S. Territories Investor Protection Act (H.R. 5322)

This legislation amends the Investment Company Act to terminate an exemption for investment companies located in Puerto Rico, the Virgin Islands and other territories of the United States. Currently an exemption applies for entities located in these territories that limits sales of securities to residents of the particular territory in which they operate. The Act contains a three-year phase-in safe harbor.

Other 2016 House Legislation

Earlier in 2016 I wrote about: (i) H.R. 1675 – the Capital Markets Improvement Act of 2016, which has 5 smaller acts embedded therein; (ii) H.R. 3784, establishing the Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee within the SEC; and (iii) H.R. 2187, proposing an amendment to the definition of accredited investor. See my blog HERE.

In early July, the House passed H.R. 2995, an appropriations bill for the federal budget for the fiscal year beginning October 1. No further action has been taken. The 259-page bill, which is described as “making appropriations for financing services and general government for the fiscal year ending September 30, 2017, and for other purposes” (“House Appropriation Bill”), contains numerous provisions reducing or eliminating funding for key aspects of SEC enforcement and regulatory provisions. My discussion on this provision can be read as part of my blog on the Financial Choice Act, a link to which is below.

On September 8, 2016, the House passed the Accelerating Access to Capital Act. Unlike many of the House bills that passed in 2016, this one gained national attention, including an article in the Wall Street Journal. The Accelerating Access to Capital Act is actually comprised of three bills: (i) H.R. 4850 – the Micro Offering Safe Harbor Act; (ii) H.R. 4852 – the Private Placement Improvement Act; and (iii) H.R. 2357 – the Accelerating Access to Capital Act. See my blog HERE.

On September 13, 2016, the House passed the Financial Choice Act, which is an extreme anti-regulation act that would dramatically change the current SEC regime and dismantle a large portion of the Dodd-Frank Act. Read my blog on the Financial Choice Act HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers What Does The SEC Do And What Is Its Purpose? »

SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers

Posted by Securities Attorney Laura Anthony | January 31, 2017 Tags: C&DI, Five-Day Tender Offer, SEC, Should I accept a Tender Offer, Tender Offer Example, Tender Offer Private Company, Tender Offer Process, Tender Offer Rules, Tender Offer vs Merger, What does it mean to tender shares, What is a Tender Offer?

ABA Journal’s 10th Annual Blawg 100

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The SEC has been issuing a slew of new Compliance and Disclosure Interpretations (“C&DI”) on numerous topics in the past few months. On November 18, 2016, the SEC issued seven new C&DI providing guidance on tender offers in general as well as on abbreviated debt tender and debt exchange offers, known as the Five-Day Tender Offer. The guidance related to the Five-Day Tender Offer clarifies a previously issued January 2015 no-action letter on the subject. As I have not written on the subject of tender offers previously, I include a very high-level summary of tender offers in general and together with specific discussion on the new C&DI.

What Is a Tender Offer?

A tender offer is not statutorily defined, but from a high level is a broad solicitation made by a company or a third party to purchase a substantial portion of the outstanding debt or equity of a company. A tender offer is set for a specific period of time and at a specific price. The purchase offer can be for cash or for equity in either the same or another company (an exchange offer). Where a tender offer is an exchange offer, the offeror must either register the securities being offered for exchange or there must be an available exemption from registration such as under Section 4(a)(2) or Rule 506 of Regulation D.

A tender offer must be made at a fixed price and can include conditions to a closing, such as receiving a certain minimum percentage of accepted tenders. If the person making the tender may own more than 5% of the company’s securities after the tender offer is completed, they must file a Schedule TO with the SEC, including certain delineated disclosures.

Where a tender offer is being made by a company or its management, it is often in association with a going private transaction. Where it is being made by a third party, it is generally for the purpose of acquiring control over the target company and can be either a friendly or hostile takeover attempt.

As mentioned, a tender offer is not statutorily defined but rather can be applied to a broad array of transactions that include the change of ownership of securities. Over the years, a judicially established eight-factor test is used to determine whether the tender offer rules have been implicated and need to be complied with. In particular, in Wellman v. Dickinson, 475 F. Supp. 783 (S.D,N.Y. 1979) the court listed the following eight factors in determining whether a transaction is a tender offer:

An active and widespread solicitation of public shareholders for the shares of a company is made;
A solicitation is made for a substantial percentage of the company’s securities;
The offer to purchase is made at a premium to prevailing market price;
The terms of the offer are firm rather than negotiable;
The offer is contingent on the tender of a fixed number of minimum shares and may be subject to a fixed maximum;
The offer is open for a limited period of time;
The offeree is subjected to pressure to sell their securities; and
Public announcements are made regarding the offer.

Not all factors need be present for a transaction to be considered a tender offer, but rather all facts and circumstances must be considered. The SEC has historically focused on whether an investor is being asked to make an investment decision and whether there is pressure to sell. Once it is determined that a transaction involves a tender offer, the tender offer rules and regulations must be complied with.

Tender offers are governed by the Williams Act, which added Sections 13(d), 13(e), 14(d) and 14(e) to the Securities Exchange Act of 1934. The principle behind the regulatory framework is to ensure proper disclosures to, and equal treatment of, all offerees and to prevent unfair selling pressure. Section 14(d) and Regulation 14D govern tender offers by third parties. Section 14(d) and Regulation 14D set forth the SEC filing requirements and information that must be delivered to those being solicited in association with a tender offer, including the requirement to file a Schedule TO with the SEC.

As with any disclosure document relating to the solicitation or sale of securities, a Schedule TO is comprehensive and includes:

(i) A summary term sheet;

(ii) Information about the issuer;

(iii) The identity and background of the filing persons;

(iv) The terms of the transactions;

(v) Any past contacts, transactions and negotiations involving the filing person and the target company and offerees;

(vi) The purposes of the transactions and plans or proposals;

(vii) The source and amount of funds or other consideration for the tender offer;

(viii) Interests in the subject securities, including direct and indirect ownership;

(ix) Persons/assets retained, employed, compensated or used in the tender process. In its November 18, 2016 C&DI the SEC clarifies that the terms of employment and compensation to financial advisors engaged by an issuer’s board or independent committee to provide financial advice, would need to be disclosed in this section even if such financial advisor is not soliciting or making recommendations to shareholders. In addition, another of the new C&DI clarifies the specificity needed related to compensatory disclosure for financial advisors that are active in soliciting or making recommendations to shareholders. Such disclosure may not always need to include the exact dollar figure of the fees paid or payable to the financial advisor but must include a detailed discussion of the types of fees (such as independence fees, sale or success fees, advisory fees, discretionary fees, bonuses, etc.), when and how such fees will be paid, including any contingencies and any other information that would reasonably be material for a shareholder to judge the merits and objectivity of the financial advisor’s recommendations.

(x) Financial Statements;

(xi) Additional information as appropriate; and

(xii) Exhibits.

Section 14(e) and Regulation 14E contain the antifraud provisions associated with tender offers and apply to all tender offers, whether by insiders or third parties, for cash or an exchange, and whether full or mini offers. Section 14(e) prohibits an offeror from making any untrue statement of a material fact, or omitting to state any material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Section 14(e) also prohibits any fraudulent, deceptive or manipulative acts in connection with a tender offer.

Regulation 14E contains certain requirements designed to prevent fraudulent conduct and must be complied with in all tender offers. Regulation 14E requires:

(i) A tender offer must be open for at least 20 days;

(ii) The percentage of the class of securities being sought and the consideration offered cannot change unless the offer remains open for at least an additional 10 business days following notice of such change;

(iii) The offeror must promptly make full payment, or return the tendered securities, upon the termination, withdrawal or closing of the offering. Prompt payment is generally considered to be within 3 days;

(iv) Public notice must be made of any extension of an offer, and such notice must disclose the amount of any securities already tendered. Public notice is usually made via a press release in a widely disseminated publication such as the Wall Street Journal;

(v) The company subject to a tender offer must disclose its position on the tender offer (for, against, or expresses no opinion) to its shareholders. The disclosure must be made within 10 days of notice of the tender offer being provided to the target shareholders;

(vi) All parties must be mindful of insider trading rules and avoid trading when in possession of information related to the launch of a tender offer. Where the company is tendering for its own shares, it must be extra careful and cannot conduct a tender while in possession of insider information;

(vii) Tendering persons must have a net long position in the subject security at the time of tendering and at the end of the proration period in connection with partial tender offers (and not engage in short-tendering and hedged tendering in connection with their tenders); and

(viii) Subject to certain exceptions, no covered person can purchase or arrange to purchase any of the subject securities from the time of announcement of the tender until its completion through closing, termination or expiration. A covered person is broadly defined to include the offeror and its affiliates, including its dealer-manager and advisors.

Section 13(e) governs the information delivery requirements for the repurchase of equity securities by an issuer company and its affiliates. Rule 13e-4 sets forth disclosure, filing and procedural requirements for a company tendering for its own equity securities, including the filing of a Schedule TO with the SEC. An equity security is broadly defined and includes securities convertible into equity securities such as options, warrants and convertible debt but does not include non-convertible debt. Companies often use the SEC no-action letter process for relief as to whether a particular security is an equity security invoking Rule 13e-4 or similar enough to debt as to not require compliance with the rule.

In addition to an initial Schedule TO, which must be filed with the SEC on the commencement date of the offer, under Rule 13e-4, a company must file any of its written communications related to the tender offer, an amendment to the Schedule TO reporting any material changes, and a final amendment to the Schedule TO reporting the results of the tender offer. Moreover, a company must further disseminate information through either mail or widely distributed newspaper publications or both.

Where a company or affiliate is the offeror, Rule 13e-4 requires that such offeror allow a tendering shareholder the right to withdraw their tender at any time while the tender offer remains open. The tender offer must be made to all holders of the subject class of securities and where an offer is oversubscribed, the company must accept tenders up to its disclosed limit on a pro rata basis.

There are several exemptions from the Section 13(e) and Rule 13e-4 requirements. Also, careful consideration should be given when a company embarks on a stock repurchase program under Rule 10b-18 to ensure that such program does not actually result in a tender offer necessitating compliance with the tender offer rules. For a summary of Rule 10b-18, see my blog HERE.

Where the target company remains public, upon acquiring 5% or more of the outstanding securities, Section 13(d) requires that a Schedule 13D must be filed by the acquirer. For more information on Schedule 13D disclosure requirements, see my blog HERE.

Mini-tenders

Many provisions of the Williams Act, including Sections 13(d), 13(e), 14(d) and Regulation 14D do not have to be complied with for a tender offer that will result in less than 5% ownership (“mini-tender”); however, the antifraud provisions still apply. Mini-tenders are really just a bid for the purchase of stock, usually through a purchase order with a broker, which bid must remain open for a minimum of 20 days. A mini-tender bidder must make payment in full promptly upon a closing. Bidders in a mini-tender do not have to file documents with the SEC or provide the delineated disclosures required by a full tender offer.

Key differences between a mini-tender and full tender offer include: (i) a mini-tender is not required to file a Schedule TO with the SEC, and thus a target company is not given the opportunity to file a responsive Schedule 14d-9; (ii) a mini-tender bidder is not required to treat all offerees equally; (iii) a mini-tender bidder is not required to carve back offerees on a pro rata basis if oversubscribed; (iv) a mini-tender is not required to allow investors to change their minds and withdraw shares prior to a full closing; (v) a mini-tender deadline can be extended indefinitely.

Mini-tenders tend to be at or below market price, whereas full tenders tend to be at a premium to market price, reflecting the increased value in obtaining a control position over the target company. As a result of the lack of investor protections, and that mini-tenders are generally below market price, they are considered predatory and have a high level of negative stigma. The primary criticism against a mini-tender is that target shareholders are likely confused about the distinctions between the mini and full tender and do not realize that the offer is below market, irrevocable, and does not require equal and fair treatment for all shareholders, although all of this information would be required to be disclosed under the still applicable tender offer antifraud provisions.

There does not appear to be a rational reason as to why an investor in a liquid market would choose to sell to a bidder below market price unless there is confusion as to the terms of the offer being presented. The SEC even has a warning page on mini-tenders urging investors to carefully review all terms and conditions. Where a market is not liquid, a mini-tender could be a viable exit strategy, though in practice, mini-tenders are largely launched for the purchase of larger, highly liquid securities.

Abbreviated Debt Tender Offers (Five Business Day Tender Offer)

As discussed above, Section 14(e) of the Exchange Act and Regulation 14E set forth certain requirements for all tender offers designed to prevent fraud and manipulative acts and practices. One of those requirements is that a tender offer be open for a minimum of 20 business days and remain open for at least an additional 10 business days after notice of any change in the consideration offered.

Beginning in 1986, the SEC began issuing a series of no-action letters providing relief from the 20-day rule for certain non-convertible, investment-grade debt tender offers. The SEC recognized that tender offers in a straight debt transaction are often effectuated to refinance debt at a lower interest rate or to extend looming maturity dates. The tender is often at a small premium to the prevailing market or pay-off price and does not include any equity upside or kicker considerations. All parties to a debt tender offer are motivated to move quickly and without the equity considerations; the SEC recognized that the same investor protections are not necessary as in an equity tender offer.

The SEC relief generally required that the debt tender remain open for 7-10 days. In January 2015, in response to a request from numerous top industry law firms, the SEC granted further no-action relief establishing a Five Business Day Tender Offer for non-convertible debt securities, which meets certain delineated terms and conditions.

The conditions to a Five Business Day Tender Offer include:

(i) Immediate Widespread Dissemination – the debt tender must begin with immediate (prior to 12:00 noon on the first day of the offer) widespread dissemination of the offer including by press release and Form 8-K containing certain disclosures and including a hyperlink to an Internet address where the offeree can effectuate the tender. The November 18, 2016 C&DI clarifies that a foreign private issuer may satisfy this requirement by filing a Form 6-K instead of Form 8-K.

(ii) Be made for non-convertible debt securities only;

(iii) Only be initiated by the issuer of the debt securities or a direct or indirect wholly owned subsidiary or parent company;

(iv) Be made solely for cash consideration or an exchange for Qualified Debt Securities. Qualified Debt Securities means non-convertible debt securities that are identical in all material respects (including issuer, guarantor, collateral, priority, and terms and covenants) to the debt securities that are the subject of the tender offer except for the maturity date, interest payment and record dates, redemption provisions and interest rate, and provided further that to be Qualified Debt Securities, all interest payments must be solely in cash (no equity) and the weighted average life to maturity must be longer than the debt that is subject to the offer.

(v) Be open to all record and beneficial holders of the debt securities, provided that in an exchange offer, the exchange offer can be limited to Qualified Institutional Buyers as defined in Rule 144A and/or non-U.S. persons as defined in Regulation S under the Securities Act, and as long as all other record and beneficial holders are offered cash with a value reasonably equal to the value of the exchange securities being offered to those qualified to receive such exchange. The November 18, 2016 C&DI clarifies that although the offer has to be made equally to all holders, like other tender offers, it can have conditions to closing such as that a minimum number of debt holders accept the tender.

(vi) The November 18, 2016 C&DI clarifies that where the offer includes an exchange of Qualified Debt Securities to Qualified Institutional Buyers as defined in Rule 144A of the Securities Act, the cash consideration to the other record holders can be calculated by reference to a benchmark as long as it is the same benchmark used to calculate the value of the Qualified Debt Securities.

(vii) Not be made in connection with the solicitation of consents to amend the outstanding debt securities;

(viii) Not be made if a default exists with respect to the subject tender, or any other, material credit agreement to which the company is a party;

(ix) Not be made if at the time of the offer the company is in bankruptcy or insolvency proceedings;

(x) Not be financed with the proceeds of a Senior Indebtedness;

(xi) Permits tender procedures through a certificate as long as the actual debt security is delivered within 2 business days of closing;

(xii) Provide for certain withdrawal rights until the expiration of the offer or any extension;

(xiii) Provide that consideration will be promptly paid for the tendered debt securities; and

(xiv) Not be made in connection with a change of control, merger or other extraordinary transaction involving the company and not be commenced within ten business days of an announcement of the purchase, sale or transfer of a material subsidiary or amount of assets. The November 18, 2016 C&DI clarifies that a company could announce a plan to conduct a Five Business Day Tender Offer but could not commence the offer until the ten-business-day period had passed.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

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« The SEC Has Issued New C&DI Guidance On Regulation A+ House Passes Creating Financial Prosperity For Business And Investors Act »

The SEC Has Issued New C&DI Guidance On Regulation A+

Posted by Securities Attorney Laura Anthony | January 24, 2017 Tags: Form 1-K, Form 1-SA, Form 1-U, Form 1-Z, Section 12(g)

On November 17, 2016, the SEC Division of Corporation Finance issued three new Compliance and Disclosure Interpretations (C&DI) to provide guidance related to Regulation A/A+. Since the new Regulation A+ came into effect on June 19, 2015, its use has continued to steadily increase. In my practice alone I am noticing a large uptick in broker-dealer-placed Regulation A+ offerings, and recently, institutional investor interest.

Following a discussion on the CD&I guidance, I have included some interesting statistics, practice tips, and thoughts on Regulation A+, and a refresher summary of the Regulation A+ rules.

New CD&I Guidance

In the first of the new 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 confirms 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.

New question 182.13 clarifies 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. In particular, 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 an increase, cannot result in an offering above the respective thresholds for Tier 1 ($20 million) or Tier 2 ($50 million).

In the third CD&I, the SEC confirms that companies using Form 1-A benefit from Section 71003 of the FAST Act. In particular, 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. Interestingly, 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.

Regulation A+ Statistics; Practice Tip; Further Thoughts

Regulation A+ Statistics

According to The Vintage Group, through November 30, 2016, there were a total of 165 Regulation A+ filings, 16 of which were subsequently withdrawn. Of these, 130 have been qualified by the SEC, with the average time to receive qualification being 101 days. Some companies have filed multiple Regulation A+ offerings. The 130 qualified offerings represent 94 different companies. Thirty eight (38) of the 94 companies completed Tier 1 offerings and 56 completed Tier 2. The average offering size of Tier 1 offerings is $9.5 million and $28.9 million for Tier 2 offerings. As reported by The Vintage Group, the average cost of a Tier 1 offering has been $120,000 and of a Tier 2 offering has been $920,000. I am assuming this includes marketing costs.

Regulation A/A+ – Private or Public Offering?

Although a complete discussion is beyond this blog, the legal nuance that Regulation A/A+ is an “exempt” offering under Section 5 has caused confusion and the need for careful thought by practitioners and the SEC staff alike. So far, it appears that Regulation A/A+ is treated as a public offering in 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/A+.

When considering integration, in addition to the discussion in the summary below, the SEC has now confirmed that a Regulation A/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. 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 regardless of the filing of a registration statement.

However, Regulation A/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 will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. 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. With the filing of a Form 8-A, the issuer can apply to trade on a national exchange.

This marks a huge change and opportunity for companies that wish to go public directly 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.

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

In light of the fact that Regulation A/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/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/A+ if the intent is to be sure that the shareholder is covered. Likewise, if the intent is to exclude Regulation A/A+ offerings from the registration rights, that exclusion should be added to the language to avoid any dispute.

Further Thoughts

Tier 2 offerings in particular present a much-needed opportunity for smaller companies to go public without the added time and expense of state blue sky compliance but with added investor qualifications. Tier 2 offerings preempt state blue sky laws. To compromise with opponents to the state blue sky preemption, the SEC included investor qualifications for Tier 2 offerings. In particular, Tier 2 offerings have a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth.

However, as companies continue to learn about Regulation A+, many still do not understand 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/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.

Refresher: The Final Rules – Summary of Regulation A+

History of Regulation A+; Goals and Purpose

The original Regulation A was adopted in the 1960s as a sort of short-form registration process with the SEC. However, since Regulation A still required a lengthy and expensive state review and qualification process, known as “blue sky registration,” over the years it was used less and less until it was barely used at all. Literally years would go by with only a small handful, if any, Regulation A filings; however, the law remained on the books and the authors and advocates behind the JOBS Act saw potential to use Regulation A to democratize the IPO process by implementing some changes.

Without going down a rabbit hole on “blue sky laws” from a high level, in addition to the federal government, every state has its own set of securities laws and securities regulators. Unless the federal law specifically “pre-empts” 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 state’s interpretations or focus under the statutes differs 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.

Title IV of the JOBS Act that 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, which it did. The new rules quickly became known as Regulation A+ and came into effect on June 19, 2015. Regulation A+ has a path to pre-empt state law, and allows for unlimited marketing – as long as certain disclaimers are used, and of course, subject to antifraud laws – you have to be truthful.

As with all of the provisions in the JOBS Act, Regulation A+ was created to provide a less expensive and easier method for smaller companies to access capital. One of the biggest impediments to reaching potential investors has always been strict prohibitions against marketing offerings – whether the offerings were registered with the SEC or under a private placement. Historically, companies wishing to sell securities could only contact people they know and have a business relationship with – which was a small group for anyone. Even the marketing of non-Regulation A registered offerings and IPO’s have been strictly limited. The use of a broker-dealer would be helpful because a company could then access that broker’s client base and contacts, but broker-dealers are not always interested in helping smaller companies raise money.

The JOBS Act made the most dramatic changes to the landscape for the marketing and selling of both private and public offerings since the enactment of the Securities Act of 1933, one of which is the overhaul of Regulation A.

In essence, Regulation A+ has given companies a mechanism and tools to empower them to reach out to the masses in completing an IPO and has concurrently put protections in place to prevent an abuse of the process.

Specifics of Regulation A+ – How Does it Work?

The new Regulation A+ actually divided Regulation A 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 more marketing. The old Regulation A was limited to offerings of $5 million or less in any 12-month period. The new Tier 1 has been increased to up to $20 million. Since Tier 1 does not pre-empt 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 will likely not be used for a going public transaction.

On June 23, 2015, the SEC updated its Division of Corporation Finance C&DI to provide guidance related to Regulation A/A+ by publishing 11 new questions and answers and deleting 2 from its forms C&DI which are no longer applicable under the new rules. This summary includes that guidance.

Both Tier I and Tier 2 offerings have minimum basic requirements, including issuer eligibility provisions and disclosure requirements. In addition to the affiliate resale restrictions, resales of securities by selling security holders are limited to no more than 30% 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 a registration statement with the SEC to raise up $50 million in a 12-month period. Tier 2 pre-empts state blue sky law. The registration statement is a little less lengthy than a traditional IPO registration, the SEC review process is a little shorter, and a company can market in a way that it cannot with a traditional IPO. The trade-off is that Regulation A+ is limited in dollar amount to $50 million, there are specific company eligibility requirements, and there are 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 registered 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+ will be available to companies organized and operating in the United States and Canada. The following issuers will not be 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 Exchange Act 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 “bad actor” rules and, in particular, Rule 262 of Regulation A+.

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/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.

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+. A company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to rely on Regulation A/A+. A wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A/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. 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.

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

Eligible Securities

The final rule limits securities that may be issued under Regulation A+ 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 will be required to review and comply with applicable state law related to such solicitation and advertising, including any prohibitions related to same.

Regulation A+ allows for pre-qualification 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 truth. 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 pre-qualification 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 a registration statement 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.

As such, 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/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.

A company can use Twitter and other social media that limit the number of characters in a communication, to test the waters as long as the company provides a hyperlink to the required disclaimers. In particular, 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 could 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, will be allowed and will not be considered solicitation materials.

Continuous or Delayed Offerings

Continuous or delayed offerings (a form of a shelf offering) will be allowed if (i) they commence within two days of the offering statement qualification date, (ii) are made on a continuous basis, (iii) will continue for a period of in excess of thirty days following the offering statement qualification date, and (iv) at the time of qualification are reasonably expected to be completed within two years of the qualification date.

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.

Continuous or delayed offerings are available for all securities qualified in the offering, including securities underlying convertible securities, securities offered by an affiliate or other selling security holder, and securities pledged as collateral.

Additional Tier 2 Requirements; Ability to List on an Exchange

In addition to the basic requirements that will apply to all Regulation A+ offerings, Tier 2 offerings will also require: (i) audited financial statements (though I note that state blue sky laws almost unilaterally require audited financial statements, so this federal distinction may 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 (new Forms 1-K, 1-SA and 1-U, respectively); and (iii) a limitation on the number of securities non-accredited investors can purchase to no more than 10% of the greater of the investor’s annual income or net worth.

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.

This third provision provides additional purchaser suitability standards and the Regulation A+ definition of “qualified purchaser” for purposes of allowing state law pre-emption. During the proposed rule comment process many groups, including certain U.S. senators, were very vocal about the lack of suitability standards of a “qualified purchaser.” Many pushed to align the definition of “qualified purchaser” to the current definition of “accredited investor.” The SEC’s final rules offer a compromise by adding suitability requirements to non-accredited investors to establish quantitative standards for non-accredited investors.

The new rules allow Tier 2 issuers to file a Form 8-A to be filed concurrently with a Form 1-A, to register under the Exchange Act, and the immediate application to a national securities exchange. Where the securities will be listed on a national exchange, the accredited investor limitations will not apply.

Although the ongoing reporting requirements will be substantially similar in form to a current annual report on Form 10-K, the issuer will not be considered to be subject to the Exchange Act reporting requirements. Accordingly, such issuer would not qualify for a listing on the OTCQB or national exchange, but would also not be disqualified from engaging in future Regulation A+ offerings.

Tier 2 issuers that have used the S-1 format for their Form 1-A filing will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. A Form 8-A is a simple (generally 2-page) registration form used instead of a Form 10 for issuers 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 concurrently with the Form 1-A. That is, an issuer could not qualify a Form 1-A, wait a year or two, then file a Form 8-A. In that case, they would need to use the longer Form 10.

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.

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, which is not yet legal).

In the absence of a clear exemption from integration, issuers 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. In particular, 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 statement with, and have it qualified by, the SEC. The offering statement will be filed with the SEC using the EDGAR database filing system. Prospective investors must be provided with the filed pre-qualified 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 will be reviewed much like an S-1 registration statement and 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 indicated that reviewers will be assigned filings based on industry group.

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. To qualify additional securities, a post-qualification amendment must be used.

Offering Statement – Non-Public (Confidential) Submission

As is allowed for emerging growth companies, the rules permit an issuer 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. However, the confidential filing, SEC comments, and all amendments must be publicly filed as exhibits to the offering statement at least 21 calendar days before qualification. When an S-1 is filed confidentially, the offering materials need be filed 21 calendar days before effectiveness, but the SEC comment letters and responses are not required to be filed. This, together with the requirement to file “test the waters” communications, are significant increased pre-offering disclosure requirements for Regulation A+ offerings.

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 registration 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” (21 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. In particular, 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

The rules require use of new modified 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 issuer 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 will include issuer information; issuer eligibility; application of the bad actor disqualification and disclosure; jurisdictions in which securities are to be offered; and unregistered securities issued or sold within one year.

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 issuer 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.

Moreover, issuers that had previously completed a Regulation A offering and had thereafter been subject to and filed reports with the SEC under Tier 2 could 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.

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.

Part III requires an exhibits index and a description of exhibits required to be filed as part of the offering statement.

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

Tier 2 companies are also required to file certain offering termination information and would have the choice of using Form 1-Z or including the information in their first annual report on new 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).

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). The SEC anticipates that companies would use their Regulation A+ offering circular as the groundwork for the ongoing reports, and they may incorporate by reference text from previous filings.

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 Pink tier of the OTC Markets. Such issuer, however, would not be deemed to be “subject to the Exchange Act reporting requirements” to support a listing on the OTCQB or OTCQX levels of the OTC Markets.

Freely Tradable Securities

Securities issued to non-affiliates in a Regulation A+ offering will be freely tradable. Securities issued to affiliates in a Regulation A+ offering will be 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.

However, since neither Tier 1 nor Tier 2 Regulation A+ issuers are subject to the SEC reporting requirements, the shareholders of issuers would not be able to rely on Rule 144 for prior shell companies. Moreover, the Tier 2 reports do not constitute reasonably current public information for the support of the use of Rule 144 for affiliates in the future.

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.

The new 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 having 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 Pre-emption

Tier I offerings do not pre-empt state law and remain subject to state blue sky qualification. The SEC, in its press release, encouraged 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 the company is completing the blue sky process independently.

Tier 2 offerings are not subject to state law review or qualification – i.e., state law is pre-empted. State securities registration and exemption requirements are only pre-empted 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 pre-empted.

The text of Title IV of the JOBS Act provides, among other items, a provision that certain Regulation A securities should be treated as covered securities for purposes of the National Securities Markets Improvement Act (NSMIA). 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.

The definition of “qualified purchaser” became the subject of debate and contention during the comment process associated with the initially issued Regulation A+ proposed rules. In a compromise, the SEC has imposed a limit on Tier 2 offerings such that the amount of securities non-accredited investors can purchase is to be no more than 10% of the greater of the investor’s annual income or net worth. In light of this investor suitability limitation, the SEC has then defined a “qualified purchaser” as any purchaser in a Tier 2 offering.

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 agent will be required to comply with FINRA Rule 5110 regarding filing of underwriting compensation, for a Regulation A+ offering.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

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« SEC Issues New C&DI Clarifying The Use Of Form S-3 By Smaller Reporting Companies; The Baby Shelf Rule SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers »

SEC Issues New C&DI Clarifying The Use Of Form S-3 By Smaller Reporting Companies; The Baby Shelf Rule

Posted by Securities Attorney Laura Anthony | January 17, 2017

The SEC has been issuing a slew of new Compliance and Disclosure Interpretations (“C&DI”) on numerous topics in the past few months. I will cover each of these new C&DI in a series of blogs starting with one C&DI that clarifies the availability of Form S-3 for the registration of securities by companies with a public float of less than $75 million, known as the “baby shelf rule.”

The Baby Shelf Rule

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 and trade on a national exchange. An S-3 also contains certain limitations on the value of securities that can be offered. Companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, may offer the full amount of securities under an S-3 registration. For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, Instruction 1.B.6(a) limits the amount that the company can offer to up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.”

To calculate the non-affiliate float for purposes of S-3 eligibility, a company may look back 60 days and select the highest of the last sales prices or the average of the bid and ask prices on the principal exchange. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold under the same S-3 in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases.

New C&DI

On November 2, 2016, the SEC issued a new C&DI clarifying the calculation of the one-third limitation under the baby shelf rule. In particular, some companies were effecting an S-3 shelf takedown with an investor while simultaneously completing a private placement with the same investor and registering the private placement securities via a new resale S-3 filing. Although the shelf takedown was a primary direct issuance from the company and the resale registration filed on behalf of the selling shareholder, the combined effect was the use of S-3 for an amount of securities in excess of the $75 million limitation.

This workaround had become somewhat commonplace until the SEC issued the new C&DI on November 2, 2016 clarifying that this will no longer be allowed. The new C&DI provides in total:

Question: An issuer with less than $75 million in public float is eligible to use Form S-3 for a primary offering in reliance on Instruction I.B.6, which permits it to sell no more than one-third of its public float within a 12-month period. May it sell securities to the same investor(s), with a portion coming from a takedown from its shelf registration statement for which it is relying on Instruction I.B.6 and a portion coming from a separate private placement that it concurrently registers for resale on a separate Form S-3 in reliance on Instruction I.B.3, if the aggregate number of shares sold exceeds the Instruction I.B.6 limitation that would be available to the issuer at that time?

Answer: No. Because we believe that this offering structure evades the offering size limitations of Instruction I.B.6, the securities registered for resale on Form S-3 should be counted against the issuer’s available capacity under Instruction I.B.6. Accordingly, an issuer may not rely on Instruction I.B.3 to register the resale of the balance of the securities on Form S-3 unless it has sufficient capacity under Instruction I.B.6 to issue that amount of securities at the time of filing the resale registration statement. If it does not, it would need to either register the resale on Form S-1 or wait until it has sufficient capacity under that instruction to register the resale on Form S-3.

Although the SEC has made it clear that the private placement and shelf takedown shares will both count towards the $75 million baby shelf limit, a company can still conduct concurrent shelf takedowns and private placements with the same investor. In such case the investor can either hold the private placement shares for the applicable Rule 144 holding period, or the shares can be registered for resale on Form S-1.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

« SEC Issues Guidance On Integration With A 506(c) Offering The SEC Has Issued New C&DI Guidance On Regulation A+ »

SEC Issues Guidance On Integration With A 506(c) Offering

Posted by Securities Attorney Laura Anthony | January 10, 2017 Tags: 506 C offering, 506(c) Offering, Integration With A 506(c) Offering, SEC

ABA Journal’s 10th Annual Blawg 100

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On November 17, 2016, the SEC Division of Corporation Finance issued a new Compliance and Disclosure Interpretations (C&DI) related to the integration of a completed 506(b) offering with a new 506(c) offering. The new C&DI confirms that 506(c) offering will not integrate with a previously completed 506(b) offering.

Effective September, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. The enactment of new 506(c) resulting in the elimination of the prohibition against general solicitation and advertising in private offerings to accredited investors has been a slow but sure success. Trailblazers such as startenging.com, realtymogul.com, circleup.com, wefunder.com and seedinvest.com proved that the model can work, and the rest of the capital marketplace has taken notice. Recently, more established broker-dealers have begun their foray into the 506(c) marketplace with accredited investor-only crowdfunding websites accompanied by the use of marketing and solicitation to draw investors.

The historical Rule 506 was renumbered to Rule 506(b) and issuers have the option of completing offerings under either Rule 506(b) or 506(c). Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors, provided however that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.

The new Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly the issue of integration, or when the 506(c) offering could be deemed to taint the previously completed 506(b) offering, is extremely important for companies utilizing these types of corporate finance transactions.

Integration and the New C&DI

In general the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. The new C&DI effectively treats a 506(c) offering as a public offering and provides in total:

Question: An issuer has been conducting a private offering in which it has made offers and sales in reliance on Rule 506(b). Less than six months after the most recent sale in that offering, the issuer decides to generally solicit investors in reliance on Rule 506(c). Are the factors listed in the Note to Rule 502(a) the sole means by which the issuer determines whether all of the offers and sales constitute a single offering?

Answer: No. Under Securities Act Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently decides to make a public offering. Therefore, we believe under these circumstances that offers and sales of securities made in reliance on Rule 506(b) prior to the general solicitation would not be integrated with subsequent offers and sales of securities pursuant to Rule 506(c). So long as all of the applicable requirements of Rule 506(b) were met for offers and sales that occurred prior to the general solicitation, they would be exempt from registration and the issuer would be able to make offers and sales pursuant to Rule 506(c). Of course, the issuer would have to then satisfy all of the applicable requirements of Rule 506(c) for the subsequent offers and sales, including that it take reasonable steps to verify the accredited investor status of all subsequent purchasers.

Rule 502(a) of Regulation D provides a five-factor test to determine whether separate offerings should be integrated (and thus whether an exemption is available for the private offering and there have been no violations of Section 5 for the registered offering). The five factors are: (1) whether the offerings are part of a single plan of financing; (2) whether the offerings involve issuance of the same class of security; (3) whether the offerings are made at or about the same time; (4) whether the same type of consideration is to be received; and (5) whether the offerings are for the same general purpose. The five-factor test is subjective, and the SEC staff has not provided definitive guidance as to what weight to give to the various factors or, indeed, how many of them have to be met.

Rule 502(a) also provides for a six-month safe harbor wherein multiple private offerings that are conducted at least six (6) months apart will not be integrated. A private offering that is conducted at least six (6) months before or after a registered or exempt public offering will not be integrated with the public offering.

Rule 152 is a safe harbor for issuers undertaking a registered public offering after conducting a private offering. As interpreted by the SEC, a completed private offering will not be integrated with a subsequently commenced registered public offering. Clearly as a result of the ability to publicly solicit, the SEC is treating a Rule 506(c) offering as a public offering in making an integration analysis.

Brief Summary of 506(c)

Effective September 23, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. For a complete discussion of the final rules, please see my blog HERE. For a discussion on the use of general solicitation and advertising, including when a solicitation may not be considered “general solicitation” for purposes of the 506 Rules, see my blog HERE.

Title II of the JOBS Act required the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors. The JOBS Act required that the rules necessitate that the issuer take reasonable steps to verify that purchasers of the securities are accredited investors using such methods as determined by the SEC. Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transactions by an issuer not involving a public offering. In a Rule 506 offering, an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors. The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer.

Rule 506(c) permits the use of general solicitation and advertising to offer and sell securities under Rule 506, provided that the following conditions are met:

the issuer takes reasonable steps to verify that the purchasers are accredited;
all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.

Rule 506(c) includes a non-exclusive list of methods that issuers may use to verify that investors are accredited. An issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors. An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

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