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

SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 2

Posted by Securities Attorney Laura Anthony | June 7, 2016 Tags: Non-GAAP, Non-GAAP Measures, Regulation G, SEC Issues New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

This is the second part in a two-part blog series on the use of non-GAAP financial information. In the first blog I summarized the new C&DI, and in this blog I am reviewing Regulation G and Item 10(e) of Regulation S-K. The first blog in the series can be read HERE.

Background

In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.

In recent years management has used MD&A and other areas of its disclosure to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.

However, where EBITDA may not be controversial, the SEC has seen a slippery slope in the use of these non-GAAP measures. The comments letters, and objections by the SEC, relate to failure to abide by Regulation G in providing non-GAAP information, disclosures related to why non-GAAP measures are useful, and cherry-picking of adjustments within a non-GAAP measure. Corp Fin has expressed a particular concern regarding “the use of individually tailored accounting principles to calculate non-GAAP earnings; providing per share data for non-GAAP performance measures that look like liquidity measures; and non-GAAP tax expense.”

The “non-GAAP earnings” issue is really revenue recognition. Public companies are under constant pressure to increase revenues and have become creative in figuring out ways that GAAP revenue recognition standards can be adjusted to increase revenues. Where the elimination of a non-cash GAAP expense item, such as depreciation or derivative liability, seems relatively harmless, and in fact is presented in the statement of cash flows, the inclusion of unearned revenue is much more questionable. Another controversial item affecting revenue is the couching of recurring cash expenses as non-recurring to justify eliminating that item in a non-GAAP presentation. Many of the new C&DI discussed in Part I of this blog series, focus on revenue recognition.

Although I understand the SEC concern, I wonder about the continued and increasing proliferation of non-GAAP measures precipitating the controversy. If 90% of companies use non-GAAP numbers to explain their financial operations, perhaps the GAAP rules themselves needs some adjustment. If, on the other hand, the increase is due to greater economic factors, such as the fact that the US economy has been stagnant for six straight years with zero or near-zero interest rates and no real “boom” following the recession “bust” of 2008, then the SEC may be right in its recent hard-line stance. The pressure on public companies to display consistent growth and improved performance continues regardless of the state of the economy. More on that topic another day.

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

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

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

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

Definition of non-GAAP financial measure and exclusions

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

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

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

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

Regulation G and Item 10(e) requirements

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

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

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

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

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.

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« OTC Markets Amends IPO Listing Standards for OTCQX NYSE MKT Listing Requirements »

OTC Markets Amends IPO Listing Standards for OTCQX

Posted by Securities Attorney Laura Anthony | May 31, 2016 Tags: OTC Markets, OTCQX, OTCQX Application, OTCQX Listing Requirements

OTC Markets has unveiled changes to the quotations rule and standards for the OTCQX, which proposed changes are scheduled to become effective on June 13, 2016. The proposed amendments are intended to address and accommodate companies completing an IPO onto the OTCQX and which accordingly have no prior trading history. Such entities either would have a recently cleared Form 211 with FINRA or are completing the 211 application process through a market maker, at the time of their OTCQX application. The initial qualification changes apply to OTCQX Rules for U.S. Companies, U.S. Banks and International Companies.

The OTCQX previously amended its listing standards effective January 1, 2016 to increase the quantitative criteria for listing and to add additional qualitative requirements further aligning the OTCQX with a national stock exchange. To read my blog on the January 1, 2016 amendments see HERE.

The new amendments will (i) allow companies that meet the $5 bid price test to use unaudited, interim financials to meet certain OTCQX financial standards; and (ii) provide a phase-in compliance period for US companies to meet the OTCQX corporate governance requirements.

A complete summary of all OTCQX listing requirements is included below.

Morningstar Collaboration

In addition, effective May 6, 2016 OTC Markets collaborated with Morningstar, an independent research and equity ratings firm, to provide research and ratings on all OTCQX companies. The research reports are available on a company’s quote page on the OTC Markets website. As part of each Morningstar report, the company’s equity is rated as to valuation, illustrating an over or under valuation, based on the Morningstar analysis. The Morningstar reports are updated daily.

Morningstar reports are also published under the research section of each OTCQX company’s quote page on the OTC Markets website.

A well-known issue for all small- and micro-cap companies is a lack of independent research or analysts’ coverage. I’ve reviewed several of the Morningstar reports and they provide very good information.

Specific Amendments for Listing

Compliance with penny stock exemptions under Rule 3a51-1 of the Exchange Act

To be eligible to trade on the OTCQX tier of OTC Markets, all companies must meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application, and as of the most recent fiscal year-end have at least one of the following: (w) net income of $500,000; (x) net tangible assets of $1,000,000; (y) revenues of $2,000,000; or (z) total assets of $5,000,000; or (ii) have net tangible assets of $2 million if the company has been in continuous operation for at least three years, or $5,000,000 if the company has been in continuous operation for less than three years, which qualification can be satisfied as of the end of a fiscal period or as a result of an interim capital raise; or (iii) have average revenue of at least $6,000,000 for the last three years.

The OTCQX is amending its eligibility requirements to allow for the use of CEO or CFO certified pro forma financial statements to satisfy the financial qualitative criteria associated with the $5 bid price penny stock exemption, where the company has not had a prior public market for its securities and where the company has an approved Form 211 with a bid price greater than $5 per share.

A company seeking to rely on pro forma financial statements must file such statements through the EDGAR database or on OTC Markets, and such statements must be certified by the company CEO or CFO. A company may also rely on its annual, quarterly or current financial statements filed with EDGAR in accordance with the registration requirements under the Securities Act of 1933 (such as a Form S-1) or Securities Exchange Act of 1934 (such as a Form 10) or its Exchange Act reports (i.e., Form 10-Q or 10-K) as long as such financial statements reflect information as of the most recent fiscal year-end.

In addition, a company must make a written request to OTC Markets for a waiver of the requirement that it maintain a bid price over $5 per share as of the close of business on each of the 30 consecutive days prior to the date of the application. OTC Markets may grant or deny the waiver at its sole discretion.

This amendment will allow a company that is completing the IPO process and has an approved 15c2-11 at $5.00 or greater to meet the penny stock exemption for OTCQX eligibility. In addition, such company will not need to wait until its current fiscal year-end audit is completed to satisfy the qualification criteria. This will be especially helpful for a company that is completing an IPO in Q1 of its fiscal year.

The amendment related to compliance with the penny stock exemptions applies to all issuers seeking application on the OTCQX including U.S. companies, international companies and banks.

Corporate Governance Eligibility Criteria

The OTC Markets are also amending the requirements related to its corporate governance eligibility criteria for U.S. companies applying to the OTCQX in conjunction with an initial public offering. The amendment will allow a phase-in period to satisfy full compliance with the corporate governance requirements. The corporate governance amendments apply to U.S. and U.S. Premier applicants only.

Effective January 1, 2016, to list on OTCQX, U.S. companies are required to (i) have a minimum of 2 independent board members; (ii) have an audit committee comprised of a majority of independent directors; and (iii) conduct an annual shareholders meeting and submit annual financial reports to shareholders at least 15 calendar days prior to such meeting.

The new amendments, scheduled to be effective June 13, 2016, will allow a phase-in for compliance with these requirements for companies making application to the OTCQX in connection with its initial public offering and initial Form 211 application to FINRA. In particular: (i) at least one member of the board of directors and the audit committee must be independent at the time of the OTCQX application; and (ii) at least 2 members of the board of directors and a majority of the members of the audit committee must be independent at the later of 90 days after the company begins trading on the OTCQX or the company’s next shareholder meeting. Moreover, the company’s next shareholder meeting must be held within one year of the company joining OTCQX.

A Complete Summary of OTCQX Initial and Ongoing Listing Requirements

The following is a complete summary of the OTCQX listing standards as in effect on January 1, 2016 and including the proposed amendments scheduled to go effective June 13, 2016.

The OTCQX divides its listing criteria between U.S. companies and international companies, though they are very similar. The OTCQX has two tiers of quotation for U.S. companies: (i) OTCQX U.S. Premier (also eligible to quote on a national exchange); and (ii) OTCQX U.S. and two tiers for international companies: (i) OTCQX International Premier; and (ii) OTCQX International. Quotation is available for American Depository Receipts (ADR’s) or foreign ordinary securities of companies traded on a Qualifying Foreign Stock Exchange, and an expedited application process is available for such companies. The OTCQX also has specific listing criteria and rules for banks, which criteria and rules are not included in this blog.

Issuers on the OTCQX must meet specified eligibility requirements. Moreover, OTC Markets have the discretionary authority to allow quotation to substantially capitalized acquisition entities that are analogous to SPAC’s.

OTCQX – Requirements for Admission

To be eligible to be quoted on the OTCQX U.S., companies must:

Have $2 million in total assets as of the most recent annual or quarter end;

As of the most recent fiscal year-end, have at least one of the following: (i) $2 million in revenues; (ii) $1 million in net tangible assets; (iii) $500,000 in net income; or (iv) $5 million in market value of publicly traded securities;

Have a market capitalization of at least $10 million on each of the 30 consecutive calendar days immediately preceding the company’s application;

Meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application and, as of the most recent fiscal year-end, have at least one of the following: (a) net income of $500,000; (b) net tangible assets of $1,000,000; (c) revenues of $2,000,000; or (d) total assets of $5,000,000; or (ii) have net tangible assets of $2 million if the company has been in continuous operation for at least three years, or $5,000,000 if the company has been in continuous operation for less than three years, which qualification can be satisfied as of the end of a fiscal period or as a result of an interim capital raise; or (iii) have average revenue of at least $6,000,000 for the last three years;

Effective June 13, 2016, a company may satisfy the financial qualitative criteria associated with the $5 bid price penny stock exemption, where the company has not had a prior public market for its securities and where the company has an approved Form 211 with a bid price greater than $5 per share by using its most recent annual, quarterly or current event report filed through EDGAR or a pro forma financial statement, signed and certified by the CEO or CFO, posted through EDGAR or the OTC Markets Disclosure and News Service. In such case, the company may apply in writing for an exemption from the requirement to maintain a bid price over $5 per share as of the close of business on each of the 30 consecutive days prior to the company’s application day, which exemption may be granted by OTC Markets at its sole and absolute discretion.

Not be a blank check or shell company as defined by the Securities Act of 1933 (“Securities Act”);

Not be in bankruptcy or reorganization proceedings;

Be in good standing in its state of incorporation and in each state in which it conducts business;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Be quoted by at least one market maker on the OTC Link;

Have a minimum bid price of $0.25 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX. If (i) there has been no prior public market for the company’s securities in the S. and (ii) FINRA has approved a Form 211, then the company may apply to OTC Markets for an exemption from the minimum bid price requirements, which exemption is at the sole discretion of OTC Markets. In the event that the company is a Seasoned Public Issuer (i.e., has been in operation and quoted on either OTC Link, the OTCBB or an exchange for at least one year) that completed a reverse stock split within 6 months prior to applying for admission to OTCQX U.S., the company must have a minimum bid price of $0.25 per share for its common stock as of the close of business on each of the 5 consecutive trading days immediately preceding the company’s application for OTCQX, after the reverse split;

Have GAAP compliant (i) audited balance sheets as of the end of each of the two most recent fiscal years, or as of a date within 135 days if the company has been in existence for less than two fiscal years, and audited statements of income, cash flows and changes in stockholders’ equity for each of the fiscal years immediately preceding the date of each such audited balance sheet (or such shorter period as the company has been in existence), and must include all going concern disclosures including plans for mitigation; and GAAP compliant (ii) unaudited interim financial reports, including a balance sheet as of the end of the company’s most recent fiscal quarter, and income statements, statements of changes in stockholders’ equity and statements of cash flows for the interim period up to the date of such balance sheet and the comparable period of the preceding fiscal year;

Be included in a Recognized Securities Manual or be subject to the reporting requirements of the Exchange Act; and

Have an OTCQX Advisor.

To be eligible to be quoted on the OTCQX U.S. Premier, companies must:

Satisfy all of the eligibility requirements for OTCQX U.S. set forth above;

Meet one of the following: (i) Market Value Standard – have at least (a) $15 million in public float and (b) a market capitalization of at least $50 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; or (ii) Net Income Standard – have at least (a) $1 million in public float; and (b) a market capitalization of at least $10 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; and (c) $750,000 in net income as of the company’s most recent fiscal year-end;

Have at least 500,000 publicly held shares;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Have a minimum of 100 beneficial shareholders owning at least one round lot (100 shares) each;

Have a minimum bid price of $4.00 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX. If (i) there has been no prior public market for the company’s securities in the S. and (ii) FINRA has approved a Form 211 and (iii) the bid price is equal to or greater than $1.00, then the company may apply to OTC Markets for an exemption from the 30-day minimum bid price requirements, which exemption is at the sole discretion of OTC Markets. In the event that the company is a Seasoned Public Issuer (i.e., has been in operation and quoted on either OTC Link, the OTCBB or an exchange for at least one year) that completed a reverse stock split within 6 months prior to applying for admission to OTCQX U.S., the company must have a minimum bid price of $4.00 per share for its common stock as of the close of business on each of the 5 consecutive trading days immediately preceding the company’s application for OTCQX, after the reverse split;

Have at least $4 million in stockholder’s equity;

Have a 3-year operating history; and

Conduct annual shareholders’ meetings and submit annual financial reports to its shareholders at least 15 calendar days prior to such

To be eligible to be quoted as an OTCQX U.S. Acquisition Company, companies must:

Satisfy all of the eligibility requirements for OTCQX U.S. set forth above;

Have a minimum bid price of $5.00 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX; and

Be subject to the reporting requirements of the Exchange Act.

Corporate Governance Requirements for all OTCQX U.S., U.S. Premier and U.S. Acquisition Companies:

Have at least 2 independent board members on the board of directors;

Have an audit committee comprised of a majority of independent directors; and

Conduct annual shareholders’ meetings and submit annual financial reports to its shareholders at least 15 calendar days prior to such.

Effective June 13, 2016, the OTCQX will allow a phase-in for compliance with these requirements for companies making application to the OTCQX in connection with its initial public offering and initial Form 211 application to FINRA. In particular: (i) at least one member of the board of directors and the audit committee must be independent at the time of the OTCQX application; and (ii) at least 2 members of the board of directors and a majority of the members of the audit committee must be independent at the later of 90 days after the company begins trading on the OTCQX or the company’s next shareholder meeting. Moreover, the company’s next shareholder meeting must be held within one year of the company joining OTCQX.

To be eligible to be quoted on the OTCQX International, companies must:

Have U.S. $2 million in total assets as of the most recent annual or quarter end;

As of the most recent fiscal year-end, have at least one of the following: (i) U.S. $2 million in revenues; (ii) U.S. $1 million in net tangible assets; (iii)S. $500,000 in net income; or (iv) U.S. $5 million in global market capitalization;

Meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application, and as of the most recent fiscal year-end have at least one of the following: (a) net income of $500,000; (b) net tangible assets of $1,000,000; (c) revenues of $2,000,000 or (d) total assets of $5,000,000; or (ii) have net tangible assets of U.S. $2 million if the company has been in continuous operation for at least three years, orS. $5,000,000 if the company has been in continuous operation for less than three years; or (iii) have average revenue of at least U.S. $6,000,000 for the last three years;

Be quoted by at least one market maker on the OTC Link (which requires a 15c2-11 application if the company is not already quoted on a lower tier of OTC Markets);

Not be a shell company or blank check company;

Not be in bankruptcy or reorganization proceedings;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Be included in a Recognized Securities Manual or be subject to the reporting requirements of the Exchange Act;

Have its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days – provided, however, that in the event the company’s securities are listed on a non-U.S. exchange that is not a Qualified Foreign Stock Exchange, then at the company’s request and subsequent to the company providing OTC Markets Group with personal information forms for each executive officer, director, and beneficial owner of 10% or more of a class of the company’s securities and such other materials as OTC Markets Group deems necessary to make an informed determination of eligibility, OTC Markets Group may, at its sole and absolute discretion, consider the company’s eligibility for OTCQX International;

Have a global market capitalization of at least $10 million on each of the 30 consecutive calendar days immediately preceding its application day;

Meet one of the following conditions: (i) be eligible to rely on the registration exemption found in Exchange Act Rule 12g-2(b) and be current and compliant in such requirements; or (ii) have a class of securities registered under Section 12(g) of the Exchange Act and be current in its SEC reporting requirements; or (iii) if such company is not eligible to rely on the exemption from registration provided by Exchange Act Rule 12g3-2(b) because it does not (A) meet the definition of “foreign private issuer” as that term is used in Exchange Act Rule 12g3-2(b) or (B) maintain a primary trading market in a foreign jurisdiction as set forth in Exchange Act Rule 12g3-2(b)(ii), and is not otherwise required to register under Section 12(g), be otherwise current and fully compliant with the obligations of a company relying on the exemption from registration provided by Exchange Act Rule 12g3-2(b); and

Have a Principal American Liaison (PAL).

Explanation of 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: (i) 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 (ii) 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 under paragraph (b) of this section 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.

To be eligible to be quoted on the OTCQX International Premier, companies must:

Satisfy all of the eligibility requirements for OTCQX International set forth above;

Have a global market capitalization of at least $1 billion on each of the 30 consecutive calendar days immediately preceding its application day; and

Have one of the following over the prior 6 months: (i) average weekly trading volume of at least 200,000 shares; or (ii) average weekly trading volume of at least $1 million.

Application to the OTCQX

All U.S. companies that are quoted on the OTCQX must submit an application and pay an application fee. The application consists of (i) the application with information related to the company; (ii) the contractual agreement with OTCQX for quotation; (iii) personal information for each executive officer, director and beneficial owner of 5% or more of the securities, except for companies already traded on a foreign exchange or moving from a recognized U.S. exchange; (iv) designation of the OTCQX Advisor; (v) appointment form for the OTCQX Advisor; and (vi) a digital company logo.

All international companies that are quoted on the OTCQX must submit an application and pay an application fee. The application consists of (i) OTCQX application for international companies; (ii) the contractual agreement with OTCQX for international companies; (ii) the OTCQX application fee; (iv) the OTCQX Agreement for international companies; (v) an application for the international company’s desired PAL if such PAL is not already pre-qualified; (vi) an appointment form for the PAL; and (vii) a copy of the company’s logo in encapsulated postscript (EPS) format.

The application is subject to review and comment by OTC Markets. OTC Markets may require additional conditions or undertakings prior to admission. Moreover, the application may be denied if, in the opinion of OTC Markets, trading would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.

Initial Disclosure Obligations

A company must post its initial disclosure documents on the OTC Markets website as a precondition to acceptance of an application for quotation, and such posting must be confirmed with a letter by the company OTCQX ADVISOR/PAL.

Initial disclosure documents include: (i) SEC reports if the company is subject to the Exchange Act reporting requirements; (ii) current information in accordance with OTC Markets disclosure guidelines including financial statements; (iii) if the company is a Regulation A reporting company, it must be current in such reporting requirements; (iv) if the company was an SEC Reporting Company immediately prior to joining OTCQX and has a current 10-K on file with the SEC, or was a Regulation A Reporting Company immediately prior to joining OTCQX and has a current 1-K on file with the SEC, the company is not required to post an information statement through the OTC Markets, but subsequent to joining OTCQX must post all annual, quarterly, interim and current reports required pursuant to the Disclosure Guidelines; and (v) for international companies not subject to the SEC reporting requirements, all information required to be made public pursuant to Exchange Act Rule 12g3-2(b) for the preceding 24 months, which information must be posted in English.

A company must supplement and update any changes to the initial disclosure within 30 days of acceptance of its application for quotation. International companies must follow initial disclosure with a PAL Letter of Introduction.

Requirements for Ongoing Qualification for Quotation on the OTCQX

The following is a summary of the ongoing responsibilities for U.S. OTCQX quoted securities:

Compliance with Rules – OTCQX quoted companies must maintain compliance with the OTCQX rules including disclosure requirements. The company’s OTCQX ADVISOR/PAL is responsible for reporting their/its potential conflicts of interest;

Compliance with Laws – OTCQX quoted companies must maintain compliance with state and federal securities laws and must cooperate with any securities regulators, including self-regulatory organizations;

Blue Sky Manual Exemption – Companies must either properly qualify for a blue sky manual exemption or be subject to and current in their Exchange Act reporting requirements;

Retention and Advice of OTCQX ADVISOR – Companies must have an OTCQX ADVISOR at all times and are required to seek the advice of such OTCQX ADVISOR as to their OTCQX obligations;

Duty to Inform OTCQX ADVISOR – As part of its duty to seek advice from its OTCQX ADVISOR, a company has an obligation to provide disclosure and information to the OTCQX ADVISOR, including “complete access to information regarding the company, including confidential and propriety information”; access to personnel; updated personal information forms; and timely responses to requests for information or documents;

Notification of Resignation or Dismissal of OTCQX ADVISOR – A company must immediately notify OTC Markets in writing of the resignation or dismissal of the OTCQX ADVISOR for any reason;

Payment of Fees – a company must pay its annual fees to OTC Markets;

Sales of Company Securities by Affiliates – Prior to transacting in the company’s securities through a broker-dealer, each officer, director or other affiliate of the company shall make its status as an affiliate of the company known to the broker-dealer;

Distribution and Publication of Proxy Statements – The company shall solicit proxies for all meetings of shareholders. If the company is a Regulation A Reporting Company, the company shall publish, on EDGAR through SEC Form 1-U, copies of all proxies, proxy statements and all other material mailed by the company to its shareholders with respect thereto, within 15 days of the mailing of such material. If the company is not an SEC Reporting Company or a Regulation A Reporting Company, the company shall publish, through the OTC Markets, copies of all proxies, proxy statements and all other material mailed by the company to its shareholders with respect thereto, within 15 days of the mailing of such material;

Redemption Requirements – All redemptions must be either by lot or pro rata and require 15 days’ notice;

Changes in Form or Nature of Securities – All changes in form, nature or rights associated with securities quoted on the OTCQX require 20 days’ advance notice to OTC Markets;

Transfer Agent – Companies are required to use the services of a registered transfer agent and authorize such transfer agent to share information with OTC Markets;

Accounting Methods – Any change in accounting methods requires advance notice of such change and its impact, to OTC Markets;

Change in Auditors – All changes in auditor requires prompt notification and a letter from such auditor analogous to Form 8-K requirements;

Responding to OTC Markets Group Requests – OTCQX quoted companies are required to respond to OTC Markets comments and amend filings as necessary in response thereto;

Ongoing Disclosure Obligations – (i) Companies subject to the Exchange Act reporting requirements must remain current in such reports; (ii) Companies not subject to the Exchange Act reporting requirements must remain current with the annual, quarterly and current reporting requirements of OTC Markets, including posting annual audited financial statements prepared in accordance with GAAP and audited by a PCAOB auditor; (iii) Regulation A reporting companies shall maintain current compliance with their Regulation A reporting requirements and within 45 days of the end of the first and third fiscal quarters shall file quarterly disclosure including all information required in a semi-annual report (i.e., the company shall file quarterly and not just semi-annual reports); (iv) file a notification of late filing when necessary; (v) quickly release disclosure of material news and recent developments, whether positive or negative, through a press release on the OTC Markets website (in addition to SEC filings); (vi) an OTCQX company should also act promptly to dispel unfounded rumors which result in unusual market activity or price variations;

General requirements regarding integrity – OTCQX quoted companies are expected to act professionally and uphold the OTC Markets standards for “high quality,” and to release news and reports that are prepared factually and accurately with neither excessive puffery or conservatism; companies must not report or act in a way that could be misleading; must not inundate with non-material releases; and must not make misleading premature announcements;

Maintain Company Updated Profile – OTCQX quoted companies are required to maintain updated, accurate information on their profile page and to verify same every six months;

OTCQX ADVISOR Letter – Within 120 days of each fiscal year-end and after the posting of the company’s annual report, every company must submit an annual OTCQX ADVISOR letter;

To remain eligible for trading on the OTCQX U.S. tier, the company’s common stock must have a minimum bid price of $0.10 per share as of the close of business for at least one of every thirty consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $0.10 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $0.10 for ten consecutive trading days;

To remain eligible for trading on the OTCQX U.S. tier, the company must maintain a market capitalization of at least $5 million for at least one of every 30 consecutive calendar days;

To remain eligible for trading on the OTCQX U.S. tier, the company must have at least 2 market makers quote the stock;

To remain eligible for trading on the OTCQX S. Premier tier, the company’s common stock must have a minimum bid price of $1.00 per share as of the close of business for at least one of every thirty consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $1.00 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $1.00 for ten consecutive trading days. In the event that the company’s common stock does not regain compliance during the grace period, the company shall have a fast-track option to have its securities traded on the OTCQX U.S. tier.

To remain eligible for trading on the OTCQX S. Premier tier, the company must meet one of the following standards: (i) Market Value Standard – have at least (a) $15 million in public float and (b) a market capitalization of at least $35 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; or (ii) Net Income Standard – have at least (a) $1 million in public float; and (b) a market capitalization of at least $5 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; and (c) $500,000 in net income as of the company’s most recent fiscal year-end;

To remain eligible for trading on the OTCQX S. Premier tier, the company must have at least $1 million in stockholders’ equity;

To remain eligible for trading on the OTCQX S. Premier tier, the company must have at least 4 market makers quoting the stock;

All U.S. companies, whether U.S. standard or U.S. Premier, must maintain corporate governance standards including independent director and audit committee requirements. A company must notify OTC Markets immediately of a disqualification and must regain compliance by its next annual shareholder meeting or one year from the date of non-compliance.

The following is a summary of the ongoing responsibilities for OTCQX International quoted securities:

Eligibility Criteria – The international company must meet the above eligibility requirements as of the end of each most recent fiscal year;

Compliance with Rules – OTCQX quoted companies must maintain compliance with the OTCQX rules, including disclosure requirements. Officers and directors of the company are responsible for compliance and are solely responsible for the content of information;

Compliance with Laws – OTCQX quoted companies must maintain compliance with applicable securities laws of their country of domicile and applicable U.S. federal and state securities laws. The company must comply with Exchange Act Rule 10b-17 and FINRA rule 6490 regarding notification and processing of corporate actions (such as name changes, splits and dividends). The company must cooperate with any securities regulators, whether in their country of domicile or in the U.S., including self-regulatory organizations;

Blue Sky Manual Exemption – Companies must either properly qualify for a blue sky manual exemption or be subject to and current in their Exchange Act reporting requirements;

Retention and Advice of PAL – Companies must have a PAL at all times and are required to seek the advice of such PAL as to their OTCQX obligations;

Notification of Resignation or Dismissal of PAL – A company must immediately notify OTC Markets in writing of the resignation or dismissal of the PAL for any reason;

Payment of Fees – A company must pay its annual fees to OTC Markets;

Responding to OTC Markets Group Requests – OTCQX quoted companies are required to respond to OTC Markets comments and amend filings as necessary in response thereto;

To remain eligible for OTCQX International, the company must maintain a minimum bid price of $0.10 as of the close of business for at least one of every 30 consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $0.10 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $0.10 for ten consecutive trading days;

To remain eligible for OTCQX International, the company must maintain a market capitalization of at least $5 million for at least one of every 30 consecutive calendar days;

To remain eligible for OTCQX International, the company must maintain at least 2 market makers;

Ongoing Disclosure Obligations – (i) Companies subject to the Exchange Act reporting requirements must remain current in such reports; (ii) A company that is not an SEC Reporting Company must remain current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and in any event shall, on an ongoing basis, post in English through the OTC Disclosure & News Service or an Integrated Newswire, the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b); (iii) provide a letter to its PAL at least once a year, no later than 210 days after the fiscal year-end, which states that the company (a) continues to satisfy the OTCQX quotation requirements; and (b) is current and compliant in its obligations under Exchange Act Rule 12g3-2(b) and that the information required under such rule is posted, in English, on the OTC Markets website or that the company is subject to the SEC reporting requirements and is current in such reporting requirements;

PAL Letter – Within 225 days of each fiscal year-end and after the posting of the company’s annual report, every company must submit an annual PAL letter; and

To remain eligible for the OTCQX International Premier, the company must have (i) a global market capitalization of at least $500 million for at least one of every 30 consecutive calendar days; (ii) of one following over the prior 6 months (a) an average weekly trading volume of at least 100,000 shares or (b) an average weekly trading dollar volume of at least $500,000; and (iii) at least 4 market makers.

Removal from OTCQX International

A company may be removed from the OTCQX if, at any time, it fails to meet the eligibility and continued quotation requirements subject to a 30-day notice and opportunity to address them. In addition, OTC Markets Group may remove the company’s securities from trading on OTCQX immediately and at any time, without notice, if OTC Markets Group, at its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors. In addition, OTC Markets can temporarily suspend trading on the OTCQX pending investigation or further due diligence review.

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

Fees

Upon application for quotation on the OTCQX, companies must pay an initial non-refundable fee of $5,000. In addition, companies must pay an annual non-refundable fee of $20,000. The annual fee is based on the calendar year and is due by December 1st each year.

OTCQX Advisor (formerly known as Designated Advisors for Disclosure (“DAD”)) and Principal American Liaison (“PAL”) Requirements

As part of the rule changes, OTC Markets has renamed its U.S. Designated Advisor for Disclosure (DAD) to an OTCQX Advisor. All U.S. companies that are quoted on the OTCQX must have either an attorney or an Investment Bank OTCQX Advisor. A company may appoint a new OTCQX Advisor at any time, provided that the company retains an approved OTCQX Advisor at all times.

All International companies that are quoted on the OTCQX must have either an Attorney Principal American Liaison (“PAL”) or an Investment Bank PAL – provided, however, that if the company’s OTCQX traded security is an ADR, the international company may have an ADR PAL. All PAL’s must be approved by OTC Markets Group. A company may appoint a new PAL at any time provided they maintain a PAL at all times.

All OTCQX Advisors and PALs must be approved by OTCQX after submitting an application. Eligibility to act as an OTCQX Advisor or PAL is limited to experienced and qualified securities attorneys or qualified FINRA member investment banking firms. I am an approved OTCQX Advisor and PAL.

The primary roles of an OTCQX Advisor and PAL include (i) to provide advice and guidance to a company in meeting its OTCQX obligations; (ii) to provide professional guidance to the issuer on creating investor demand as they build long-term relationships with management; (iii) to assist companies in discerning the information that is material to the market and should be disclosed to investors; and (iv) to provide a professional review of the company’s disclosure. The OTCQX puts a great deal of onus on the OTCQX Advisor/PAL to be responsible for the company which it sponsors, emphasizing the negative impact on the OTCQX Advisor’s reputation for sponsoring companies that are not of acceptable quality. In addition to providing advice and counsel to a company, an OTCQX Advisor/PAL is required to conduct investigations to confirm disclosures. An OTCQX Advisor/PAL must submit a Letter of Introduction and subsequent annual letters confirming their duties and the attesting to the disclosures made by the company.

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 New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1 SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 2 »

SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1

Posted by Securities Attorney Laura Anthony | May 24, 2016 Tags: C&DI, Non-GAAP Measures, Regulation G, SEC Issues New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

The new C&DI follows a period of controversy, press and speeches on the subject. In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.

In this two-part blog I will start with the new and circle back to the old. Part I will summarize the new C&DI, and Part II will review Regulation G and Item 10(e) of Regulation S-K.

New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. Some of the C&DI are brand-new and some are revisions of existing guidance. Prior to this, the last published C&DI on non-GAAP financial measures was in July 2011.

Related to Revenue Recognition

The SEC issued four brand-new C&DI related to revenue recognition and, going directly to the issue of “misleading” information, the underpinning of fraud claims.

Question (100.01): Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.

Question (100.02): Can a non-GAAP measure be misleading if it is presented inconsistently between periods?

Answer: Yes. For example, a non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.

Question (100.03): Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?

Answer: Yes. For example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.

Question (100.04): A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.

To be sure the point is being made that adjustments may violate rules and be considered misleading and thus add risk of enforcement proceedings, the SEC has added a reference to new Question 100.01 to an existing C&DI allowing adjustments. In particular:

Question (102.03): Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?

Answer: The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. See Question 100.01.

Three of the C&DI are amendments related to the use of “funds from operations” or “FFO” as defined by the National Association of Real Estate Investment Trusts (NAREIT). The SEC accepts the NAREIT’s definition of FFO and allows the presentation of FFO as a performance measure including FFO on a per share basis. However, the amended C&DI clarify that any adjustments to the standard FFO as defined by NAREIT must comply with Regulation G and that such adjustments “may trigger the prohibition on presenting this measure.” In other words, any adjustments will be scrutinized as possibly being misleading.

Related to earnings per share and liquidity measures

Further related to per share measures of performance, the SEC reiterates the rule that non-GAAP measures may not be used to present liquidity on a per share basis. In particular:

Question (102.05): While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?

Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission, consistent with Accounting Series Release No. 142. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.

Similarly, the SEC adds a clarification to an existing C&DI (Question 102.07) to confirm that “free cash flow” is a liquidity measure that must not be presented on a per share basis.

The SEC also confirms that the generally non-controversial EBITDA may not be presented on a per share basis (Question 103.02).

Related to presentation including reconciliation and prominence

The new C&DI add completely new language, amend prior guidance and eliminate and replace other prior guidance. The new guidance provides:

Question (102.10): Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;

Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;

Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;

A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);

Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;

Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;

Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and

Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.

Question (102.11): How should income tax effects related to adjustments to arrive at a non-GAAP measure be calculated and presented?

Answer: A registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures. If a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained.

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 Concept Release On Regulation S-K; Part 2 OTC Markets Amends IPO Listing Standards for OTCQX »

SEC Issues Concept Release On Regulation S-K; Part 2

Posted by Securities Attorney Laura Anthony | May 17, 2016 Tags: Form 8-K, MD&A, Regulation S-K, Regulation S-X, S-K Concept Release, SEC

On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). This blog is the second part discussing that concept release. In Part I, which can be read HERE, I discussed the background and general concepts for which the SEC provides discussion and seeks comment. In this Part II, I will discuss the rules and recommendations made by the SEC and, in particular, those related to the 100, 200, 300, 500 and 700 series of Regulation S-K.

Background

The fundamental tenet of the federal securities laws is defined by one word: disclosure. In fact, the SEC neither reviews nor opines on the merits of any company or transaction, but only upon the appropriate disclosure, including risks, made by that company. However, excessive rote immaterial disclosure can dilute the material important information regarding that particular company and have the unintended consequence of weakening necessary disclosure to potential investors and the public trading markets.

The SEC non-financial disclosure requirements for both registration statements and reports under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are found in Regulation S-K.

At the highest level, the purpose of disclosure is to provide investors and the marketplace with information needed to make informed investment and voting decisions. As discussed in the S-K Concept Release, proper disclosure “may lead to more accurate share prices, discourage fraud, heighten monitoring of the managers of companies, and increase liquidity.” Further, effective disclosure should “increase the integrity of securities markets, build investor confidence, and support the provision of capital to the market.”

The SEC seeks comment on hundreds of questions from broad conceptual points to specific rule changes. In many cases the SEC indicates that additional disclosure might be necessary on a particular topic. Although disclosure improvement is the goal, that does not necessarily mean less information and, in many cases, may actually mean more information.

Description of Business and Properties

The SEC believes that the information elicited under Item 101 regarding a description of the company’s business and Item 102 related to the company’s materially important physical properties, provides the necessary foundation needed by investors to make investing and voting decisions. This basic information assists in putting other disclosure items into context. The SEC seeks comment on whether Items 101 and 102 should be eliminated or modified and whether new or different disclosure requirements should be added to these Items.

The Concept Release contains detailed discussion of each of the requirements under Items 101 and 102, including prior comments received from the public and SEC views. Currently Item 101 requires a description of the general development of the company’s business over the past 3 years for smaller reporting companies and 5 years for other classes of company, or such shorter period as the company has been in business. Item 102 requires disclosure of the location and general character of plants, mines and other materially important physical properties.

Examples of information required include disclosure of the basic background of the business such as: (i) the year of formation; (ii) type of entity; (iii) nature and results of any bankruptcy, receivership or similar; (iv) nature and result of any material reclassification, merger or consolidation; (v) the acquisition or disposition of any material assets outside the ordinary course of business; and (vi) material changes to the business operations. In addition, Item 101 requires a narrative description of a company’s business, including 13 specific areas as follows: (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of business; (vi) working capital practices; (vii) dependence on certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) company sponsored research and development activities; (xii) compliance with environmental laws; and (xiii) number of employees.

Smaller reporting companies benefit from several other scaled disclosures from the standard requirements, including: (i) elimination of the requirement to discuss seasonality, working capital practices, backlog or government contracts; (ii) names of principal suppliers; (iii) royalty agreements or labor contracts; (iv) need for government approval for products or services; and (v) effects of existing or probable government regulations.

Emerging growth companies must meet all of the standard requirements. Moreover, keeping in line with the concept of materiality, where a smaller reporting company is in a business that makes any of the standard disclosures material to its business, it must include those discussions, even if not technically required. Accordingly, for example, a smaller reporting company in a cannabis-related industry would need to include a discussion on the need for government approval for products and services, and the effects of existing or probable government regulations on its business, even though the scaled disclosure requirements would not otherwise require such discussion.

As with other areas of discussion, the SEC requests comments on the scaled disclosure requirements and whether the current disparities between requirements related to smaller reporting companies and emerging growth companies should be eliminated.

The SEC discusses eliminating redundancies in the 101 and 102 disclosure requirements. In particular there are several categories in Form 8-K that request the same information elicited in Items 101 and 102 and included in all 10-Q’s and 10-K’s. Information on business background is included in the MD&A discussion and in footnotes to financial statements. Redundancies could be eliminated by allowing cross-referencing, including internal hyperlinks. Moreover, the SEC could, and should, distinguish between new registrants disclosing their business background for the first time, and those that are established reporting companies repeating information again and again.

Many of the detailed requirements may not be relevant in today’s business environment, which differs greatly from even twenty years ago. For instance, many businesses no longer have physical locations or corporate headquarters but rather run through virtual offices. For those businesses, providing a detailed discussion of each location (home office…) would not be relevant and rather could diminish the value of the business discussion. Likewise, businesses in today’s world often outsource or hire independent contractors. Consideration should be given to expanding the requirements to include such independent contractors, or eliminate this requirement altogether where it does not add value to the particular business. For example, it may be important to know that certain companies are scaling back on their workforce, while for others, the information is not relevant.

Likewise, Regulation S-K does not currently address the current reliance on web-based and intellectual property-based assets and as such, additional disclosure items may need to be included. Another area that may need increased disclosure relates to international business operations and reliance on non-U.S.-based assets.

Management Discussion and Analysis

Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis (“MD&A”) not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.

MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity for MD&A to use a principles/materiality approach and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.

In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. There has been a rise in recent controversy over the use of these non-GAAP numbers, an in-depth discussion of which will be the topic of a future blog.

However, the short version is that 90% of companies use non-GAAP numbers to explain their financial operations and the SEC is pushing back, making a review of the rules related to non-GAAP use a priority. There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves needs some adjustment.

Risk Factors

Risk-related disclosures need a thorough review and potential overhaul. Although the SEC has long stated that risk factors should not be boilerplate repetition of items applicable to the market as a whole and not necessarily applicable to a particular company, most companies use boilerplate language. I note that Item 503 contains examples of risks that a company can make related to its offerings, and so, of course, those risks, in boilerplate format, are always included in registration statements and reports.

Currently, risk-related disclosures are currently included in multiple items under Regulation S-K, including Item 503 related to investment risk and Item 305 related to market risk. The focus of the SEC discussion is on aggregating risk information in a more central readable format and improving the content to enhance investors’ ability to evaluate the particular risk factors.

Securities of the Company

Several Items in Regulation S-K address the securities of a company. For example, Item 202 requires a description of the terms and conditions of securities being registered; Item 201 requires disclosure of the number of holders of common securities; Item 701 requires disclosure of sales of unregistered securities and use of proceeds from offerings, and Item 703 requires disclosure of securities re-purchased by a company and its affiliates.

As with other areas, the SEC focuses on whether these disclosures should be modified, increased or eliminated and on the presentation of the information.

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 ofLawCast.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 Issues Final Rules Implementing The JOBS ACT And Rules On The FAST ACT SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1 »

SEC Issues Final Rules Implementing The JOBS ACT And Rules On The FAST ACT

Posted by Securities Attorney Laura Anthony | May 10, 2016 Tags: Fast Act, JOBS ACT, The Fast Act, the jobs act

On May 3, 2016, the SEC issued final amendments to revise the rules related to the thresholds for registrations, termination of registration, and suspension of reporting under Section 12(g) of the Securities Exchange Act of 1934. The amendments mark the final rule making and implementation of all provisions under the JOBS Act, and implement further provisions under the FAST Act.

The amendments revise the Section 12(g) and 15(d) rules to reflect the new, higher shareholder thresholds for triggering registration requirements and for allowing the voluntary termination of registration or suspension of reporting obligations. The new rules also make similar changes related to banks, bank holding companies, and savings and loan companies.

Specifically, the SEC has amended Exchange Act Rules 12g-1 through 12g-4 and 12h-3 related to the procedures for termination of registration under Section 12(g) through the filing of a Form 15 and for suspension of reporting obligations under Section 15(d), to reflect the higher thresholds set by the JOBS Act. The SEC also made clarifying amendments to: (i) cross-reference the definition of “accredited investor” found in rule 501 of Regulation D, with the Section 12(g) registration requirements; (ii) add the date for making the registration determination (last day of fiscal year-end); and (iii) amend the definition of “held of record” to exclude persons who received shares under certain employee compensation plans.

The new rules were initially proposed on December 18, 2015. A few days before the proposed rules were issued, on December 4, 2015, the FAST Act was enacted into law, including provisions implementing the revised thresholds for savings and loan holding companies, effective immediately without further action by the SEC. Despite this overlap, the SEC has now cleaned up all the provisions, thus aligning the rules with the statutory requirements.

Following the final implementation of the relevant JOBS Act and FAST Act provisions, a company that is not a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. The same thresholds apply to termination of registration and suspension of reporting obligations. As discussed below, determining which shareholders are accredited as of the last day of a fiscal year-end can be difficult.

A company that is a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if it has more than $10 million in assets and securities that are held of record by more than 2,000 persons and is allowed to terminate or suspend registration if its securities are held of record by fewer than 1,200 persons.

Registration, Termination of Registration and Suspension of Reporting Obligations

The JOBS Act amended Sections 12(g) and 15(d) of the Exchange Act to adjust the thresholds for registration, termination of registration and suspension of reporting. Prior to enactment of the JOBS Act on April 5, 2012, the Exchange Act required companies with greater than $10 million in total assets and greater than 500 record holders of any class of equity security to register and file periodic reports with the SEC. This requirement was burdensome for companies aspiring to raise capital and grow but that were not yet ready to become publicly reporting.

Section 12(g) of the Exchange Act and the rules promulgated thereunder allowed a company to deregister and relieve itself of the reporting requirements of the Exchange Act if it has fewer than 300 shareholders, or fewer than 500 shareholders and less than $10 million of assets.

Non-bank, Bank Holding Company and Saving and Loan Holding Company Issuers

Title V and Title VI of The JOBS Act amended Section 12(g) and Section 15(d) of the Exchange Act. Section 501 of Title V amended Section 12(g) of the Exchange Act to increase the “holders of record” threshold for triggering Section 12(g) registration for issuers with total assets of more than $10 million (other than banks and bank holding companies) from 500 or more persons to either (i) 2,000 or more persons or (ii) 500 or more persons who are not accredited investors. Issuers are required to register within 120 days after its fiscal year-end, if on the day of such fiscal year-end, it meets these thresholds.

Although Section 501 went effective upon passage of the JOBS Act, the automatic amendments did not include a change to the deregistration provisions under Section 12(g). Accordingly, since April 2012, a company would not be required to register until it had 2,000 shareholders of record or 500 or more persons who are not accredited investors, but could not deregister unless it had fewer than 300 shareholders, or 500 shareholders for those companies with less than $10 million in assets.

The new rules have now aligned the right to terminate registration or suspend reporting obligations with the higher threshold amounts.

With the passage of the new rules, together with all the JOBS Act rules enacted previously, a company is not required to register a class of securities under Section 12(g) if, on the last day of its most recent fiscal year: (i) the company has total assets not exceeding $10 million; or (ii) the class of securities is held of record by fewer than 2,000 persons or 500 persons that are not accredited as defined in Securities Act rule 501.

Bank, Bank Holding Company and Saving and Loan Holding Company Issuers

Section 601 of the JOBS Act amended Section 12(g) to increase the total assets to $10 million and the holders of record threshold for triggering registration for banks and bank holding companies, as such term is defined in the Bank Holding Company Act of 1956, as of any fiscal year-end after April 5, 2012, from 300 or more persons to 2,000 or more persons. Similarly, Section 601 of the JOBS Act amended Sections 12 and 15 of the Exchange Act to increase the holders of record threshold for deregistration and suspension of reporting obligations for banks and bank holding companies from 300 to 1,200 persons.

Following enactment of the JOBS Act, regulators realized that the Section 601 provisions had inadvertently left out saving and loan holding companies from the new registration and deregistration threshold changes. Accordingly, both the SEC through rule making, and the legislature through the FAST Act, have implemented changes to correct the oversight and include saving and loan holding companies in these changes. Following implementation of the FAST Act, the SEC also issued guidance through Compliance and Disclosure Interpretations (C&DI) to help clarify the provisions. My blog on that guidance can be read HERE.

The new rules clean up the procedures and timing of termination of registration for banks, bank holding companies and savings and loan holding companies as well such that these entities may immediately terminate registration upon the filing of a Form 15 rather than the existing procedures, which required the entities to wait 90 days after filing the Form 15 to be relieved of their obligations. Similarly, the existing procedures only allowed for the suspension of reporting obligations at the beginning of a fiscal year. The new rules allow banks, bank holding companies and savings and loan holding companies to suspend reporting obligations, effective immediately, at any time during the year by filing a Form 15, as long as they meet the thresholds for such suspension.

Application of the Increased Threshold for Accredited Investors

Knowing whether an investor or shareholder is accredited has always been a basic premise in determining the availability of an exemption from the registration requirements and the disclosure delivery requirements applicable to such an exemption. The new registration and deregistration thresholds now extend the importance and timing of knowing the accredited status of shareholders beyond what was ever previously required.

Identifying accredited investors for purposes of the registration, and especially deregistration, requirements could be problematic. Suggestions in this regard included: (i) allowing issuers to rely on annual affirmations from record shareholders; (ii) reliance on information obtained at the time of an initial investment or most recent sale of securities to such investor; or (iii) third-party verification.

The new rules rely on the current definition of “accredited investor” enumerated in Securities Act Rule 501(a) and require that the “accredited investor” determination be made as of the last day of the fiscal year rather than at the time of the sale of securities. This provides a dramatic change for issuers who currently have no obligations to assess accredited status after a sale of securities is completed.

In rejecting the ability to unilaterally rely on representations made at the time of a sale of securities to a particular investor, the SEC expressed concern regarding the use of outdated, unreliable information. Instead, an issuer will need to determine, based on facts and circumstances, whether it can rely upon prior information to form a reasonable basis for believing that the security holder continues to be an accredited investor as of the last day of the fiscal year.

The new rule requires the company to have a reasonable belief as to whether a shareholder is accredited. The SEC is leaving it to the discretion of the company to determine, based on facts and circumstances, whether it has a reasonable belief that a shareholder is accredited or not. A company is not precluded from relying on prior information if it has a reasonable belief that such information is still accurate, such as based on the close proximity to the time of sale. The SEC notes that sale information can be years or even decades old, in which case the issuer could not, of course, rely on such prior information.

However, this begs the practicality question of how exactly that issue will gain the information. The SEC declined to offer guidance, establish a safe harbor, or otherwise provide any assistance to companies in this regard.

It seems to me that issuers will now need to obtain contractual agreements from investors to provide updated representations; however, determining fair and reasonable consequences for a breach of such an agreement is problematic. Direct damages will be hard to determine. I doubt an issuer could claim that the shareholders’ refusal to provide updated information results in the issuer having to register, or continue reporting, and seek damages in the amount of reporting costs. Likewise, investors will balk at consequences directed toward their share ownership, such as a restriction on voting or dividend rights, though remedies along these lines seem the most workable.

As the proliferation of rules centered on a distinction between accredited and non-accredited investors continues, the definition of accreditation has become the subject of much debate and the SEC is considering, and ultimately will implement, changes to the definition. For further reading on the definition of accredited investor, see my blog HERE.

Employee Compensation Plans; Determining Holders of Record

The new rules establish a non-exclusive safe harbor that companies may follow to exclude persons who received securities pursuant to employee compensation plans when calculating the shareholders of record for purposes of triggering the registration requirements under Section 12(g). Exchange Act Section 12(g)(5) as amended of the JOBS Act provides that the definition of “held of record” shall not include securities held by persons who received them pursuant to an “employee compensation plan” in exempt transactions. By its express terms, this new statutory exclusion applies solely for purposes of determining whether an issuer is required to register a class of equity securities under the Exchange Act and does not apply to a determination of whether such registration may be terminated or suspended.

The new rule implements the JOBS Act by establishing a statutory exclusion for security holders who received their stock in unregistered employee stock compensation plans, and provides a safe harbor for determining whether holders of their securities received them pursuant to an employee compensation plan in exempt transactions.

The SEC declines to add a new definition of “employee compensation plan”; rather, the SEC incorporates Rule 701(c) and the guidance under that rule for issuers to rely on in their Section 12(g) analysis. The proposed safe harbor allows an issuer to conclude that shares were issued pursuant to an employee compensation plan in an unregistered transaction as long as all the conditions of Rule 701(c) are met, even if other requirements of Rule 701, such as 701 (b) (volume limitations) or 701(d) (disclosure delivery requirements) are not met.

The new Rule amends the definition of “held of record” such that for purposes of Section 12(g), an issuer may exclude securities that are either:

held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or

held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

The SEC also excludes securities issued under the “no-sale” exemption to registration theory from the “held of record” definition, including shares issued as a dividend to employees. That is, the SEC is excluding securities that did not involve a sale within the meaning of Section 2(a)(3), as well as exempt securities issued under Section 3 of the Securities Act. Examples of securities issued under Section 3 include exchange securities under sections 3(a)(9) and 3(a)(10).

The new rules are meant to encompass securities issued in exchange for or related to business combination transactions, as long as the employee or former employee was eligible to receive the securities under Rule 701(c) at the time of original issuance.

The new rules related to determining securities “held of record,” including both determinations of accredited investors and shareholders that have received shares under employee compensation plans, are complicated and will require meticulous record keeping, chains of title, and follow-up. I imagine that either transfer agents or separate third-party service providers will need to offer tracing services to assist companies in maintaining these records and meeting their registration requirements.

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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« NASDAQ Listing Requirements SEC Issues Concept Release On Regulation S-K; Part 2 »

NASDAQ Listing Requirements

Posted by Securities Attorney Laura Anthony | April 26, 2016 Tags: listing requirements for NASDAQ, NASADAQ Listing Application, NASDAQ, NASDAQ Capital Market, NASDAQ Listing Requirements, NASDAQ Requirements, NASDAQ Small Cap Listing Requirements, OTC to NASDAQ, The NASDAQ Global Market, The NASDAQ Global Select Market, The NASDAQ Stock Market

This blog is the first in a two-part series explaining the listing requirements for the two small-cap national exchanges, NASDAQ and the NYSE MKT, beginning with NASDAQ. In addition to often being asked about the listing requirements on NASDAQ and the NYSE MKT, I am asked about the benefits of trading on such an exchange. Accordingly, at the end of this blog I have included a discussion on such benefits.

The NASDAQ Stock Market

The NASDAQ Stock Market currently has three tiers of listed companies: (1) The NASDAQ Global Select Market, (2) The NASDAQ Global Market and (3) The NASDAQ Capital Market. Each tier has increasingly higher listing standards, with the NASDAQ Global Select Market having the highest initial listing standards and the NASDAQ Capital Markets being the entry-level tier for most micro- and small-cap issuers. Keeping in line with the focus of my blogs and practice, this blog is focused on the NASDAQ Capital Market tier.

A company seeking to list securities on NASDAQ must meet minimum listing requirements, including specified financial, liquidity and corporate governance criteria. NASDAQ has broad discretion over the listing process and may deny an application, even if the technical requirements are met, if it believes such denial is necessary to protect investors and the public interest.

Once listed, a company must meet continued listing standards. In order to apply for listing on NASDAQ, a company must complete and submit to NASDAQ a listing application including specified documents and information.

The application process generally takes four to six weeks. Upon submittal of the application, a NASDAQ analyst will be assigned to the file as a lead interface with the company. The company will receive an initial comment letter within two to three weeks, and the comment and review process will continue until the application is either approved or denied. Like a filing with the SEC, a well prepared NASDAQ application will result in fewer comments and a smoother, quicker process. Generally, a company’s securities counsel takes the lead and is the point person in preparing the application and communicating with NASDAQ.

Also similar to an SEC review process, NASDAQ will review publicly available information about a company, including but not limited to SEC filings, a company’s website, management communications and speeches, and press releases. For the most part, the back-and-forth process does not require a formal protocol, and communications will include e-mail correspondence and phone calls.

Listing Criteria for NASDAQ

To list its securities on NASDAQ, a company is required to meet: (a) certain initial quantitative and qualitative requirements and (b) certain continuing quantitative and qualitative requirements. The quantitative listing thresholds for initial listing are generally higher than for continued listing, thus helping to ensure that companies have reached a sufficient level of maturity prior to listing. NASDAQ also requires listed companies to meet stringent corporate governance standards.

Prior to submitting a full listing application, a company can seek a preliminary listing eligibility review. The Listing Qualifications staff will review the company’s public filings to determine if it satisfies the numerical listing requirements. The staff will also consider compliance with the corporate governance requirements of Marketplace Rules (“Rules”).

Once the preliminary review is completed, the Listing Qualifications staff will determine whether the company satisfies the numerical listing criteria and whether any corporate governance or regulatory issues raised by the company would preclude listing approval. Any final approval, however, will require the company to submit a formal listing application, which application will undergo an extensive review by NASDAQ Listing Qualifications staff. Moreover, any final approval will require satisfactory compliance with certain other qualitative reviews, including a review of the regulatory history of the company’s officers, directors and significant shareholders.

The following information sets forth the requirements to list on the NASDAQ Capital Market, the lowest of the three NASDAQ market tiers, as well as the Corporate Governance Requirements required for such tiers…

Click Here To Download Whitepaper- NASDAQ Listing Requirements

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 includingNASDAQ 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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Download our mobile app at iTunes.

« The U.S. Capital Markets Clearance And Settlement Process SEC Issues Final Rules Implementing The JOBS ACT And Rules On The FAST ACT »

The U.S. Capital Markets Clearance And Settlement Process

Posted by Securities Attorney Laura Anthony | April 19, 2016 Tags: Clearance And Settlement Process, DTC Eligibility, The U.S. Capital Markets Clearance And Settlement Process

Within the world of securities there are many sectors and facets to explore and understand. To be successful, a public company must have an active, liquid trading market. Accordingly, the trading markets themselves, including the settlement and clearing process in the US markets, is an important fundamental area of knowledge that every public company, potential public company, and advisor needs to comprehend. A basic understanding of the trading markets will help drive relationships with transfer agents, market makers, broker-dealers and financial public relations firms as well as provide the knowledge to improve relationships with shareholders. In addition, small pooled funds such as venture and hedge funds and family offices that invest in public markets will benefit from an understanding of the process.

This blog provides a historical foundation and summary of the clearance and settlement processes for US equities markets. In a future blog, I will drill down into specific trading, including short selling.

History and Background

The Paperwork Crisis

Prior to the advent of modern technology, securities were literally cleared and transferred by providing paper certificates to a company’s transfer agent, who would record the transfer on their books and records and issue new securities to the new holders. A transfer agent would receive a bundle of documents from a broker-dealer and physically process all of the paperwork and then send it to a separate registrar to record each of the transfers. In order to reduce time, most brokers, transfer agents and registrars were located in New York City in the Wall Street district. The broker would courier the documents to the transfer agent each day, who would process the paperwork and courier them to the registrar to process the transfers each after following a series of document checks, balances and audits, and then deliver the new certificates to the designated parties using a messenger or courier.

As the volume of transactions increased, numerous clearing brokers and clearing agencies emerged to help with the processing. However, the system was disjointed and as the physical certificate process remained the same, each of these clearing brokers and agencies maintained offices physically near each other to messenger paper back and forth. By the 1960s and early 1970s the sheer volume of paperwork crushed the system and caused what came to be known as the Paperwork Crisis.

At the time the Paperwork Crisis was the biggest crisis to face the securities industry since the Great Depression and to this day remains one of the most difficult and largest challenges the markets have faced. As a result of the Paperwork Crisis, the entire industry, including Congress, state and federal regulators, brokers, banks and security exchanges, all participated in a complete overhaul of the markets’ operational systems, which ultimately resulted in the current national clearing and settlement system. Years of expensive studies all came to the same basic conclusion regarding the Paperwork Crisis, which is that the securities industry needed a uniform, coordinated nationwide system for the clearance and settlement of securities transactions.

The birth of DTC

The current system did not pop up overnight, but rather took years and a series of changes and adjustments and then more changes and adjustments. In 1968 the NYSE created the Central Certificate Service as a division of the Stock Clearing Corporation to act as a clearing agency and depository service. In 1973, the Central Certificate Service (“CCS”) changed its name to the Depository Trust Company (DTC).

A clearing agency or depository typically compares member transactions, clears, nets and settles trades, and provides risk management services, such as trade guarantees. Depositories centralize securities by holding them on deposit for their participants and effect transfers of interests in those securities through book-entry credits and debits of participants’ accounts. Currently DTC, through its subsidiaries, is both the only central depository in the United States and the only one registered with the SEC as a clearing agency, but it wasn’t always. In the beginning CCS was only used by the NYSE and soon after by the American Stock Exchange.

In its early years, broker-dealers and banks would deposit their certificated securities with CCS, which would transfer them into the name of the CCS nominee and physically hold them in custody. That nominee account came to be referred to as “street name” and the nominee as CEDE. CCS maintained book accounts for all its members. When a member transferred securities, the transfer was recorded by book entry with a debit and credit between accounts rather than a physical transfer of securities. The securities themselves remained registered to CCS’s nominee account (today CEDE). Today DTC continues to hold physical custody of certificated securities held in street name. As an aside, the flooding from Hurricane Sandy destroyed massive amounts of paper certificates and records held by DTC in its New York storage, taking years to sort out and causing huge delays in the processing of transactions.

Around the same time that the NYSE created the CCS, the NASD formed the National Clearing Corporation (NCC) in an effort to develop and implement a nationwide system of interconnected regional clearinghouses for the clearance of all OTC and NASDAQ securities. In 1977 the NCC merged with CCS and formed the National Securities Clearing Corporation (“NSCC”). The NSCC in turn later merged with DTC. The NSCC net settles securities amongst all the participating broker participants, who in turn maintain records for each client account.

SEC gains regulatory power

It was quickly apparent to the thought leaders of the time that it was imperative to give the SEC the power to regulate the clearance and settlement process, including requiring clearing agencies to register with the SEC and to give the SEC the power to implement rules and regulations related to both the system and its participants. In 1975 Congress enacted the Securities Act Amendments of 1975, making sweeping changes to the federal laws and creating what is today the national market system and national clearance and settlement system.

The 1975 Amendments directed the SEC to “(i) facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities; (ii) end the physical movement of securities certificates in connection with the settlement among brokers and dealers of transactions in securities; and (iii) establish a system for reporting missing, lost, counterfeit, and stolen securities.” In addition, related to the national market system, the SEC was directed to establish a national market system to link together the multiple individual markets that trade securities to achieve the business objective of efficient, competitive, fair and orderly markets.

In the early ’70s the CCS and NCC were not the only clearing agencies; several others had popped up as well. However, using the power of the 1975 Amendments, the SEC required registration of and imposed regulations and compliance on these clearing agencies. In 1982 and 1983 the NASD (now FINRA) and the five major stock exchanges all amended their rules to require members to use an SEC registered clearing firm and depository. By the late ’90s DTC was the largest depository and NSCC was the largest clearing firm. In 1999 the two merged and DTC remained the only SEC registered clearing agency and depository.

DTC introduces FAST

By the mid to late ’70s, technological advancements were assisting in overall system advancements. In 1975 DTC created the Fast Automated Securities Transfer Program (“FAST”), which was approved by the SEC in 1976. Also, in 1977 Article 8 of the Uniform Commercial Code (UCC) was amended to allow for uncertificated book entry records of security ownership.

Prior to FAST, and today for those securities not eligible for the FAST program, when a security is being deposited into DTC, a broker-dealer physically sends the certificate to DTC, who in turn sends it to the transfer agent to register in CEDE. Again, CEDE is DTC’s nominee name for holding legal title to securities in the DTC system. Likewise for the withdrawal of these securities from the DTC system, DTC physically sends the certificate back to the transfer agent, who re-registers it and sends it back to DTC, who then sends it to the participating broker. If the participating broker is a clearing broker, that clearing broker then sends the certificate to the introducing broker, who then sends it to the account holder!

The FAST system allows transfer agents to act as custodians for all shares in the CEDE account. Each individual brokerage firm DTC participant maintains corresponding books representing their customers shareholder accounts for securities held in street name. When securities are deposited into or withdrawn from DTC, the FAST transfer agent makes an electronic adjustment which is electronically confirmed and balanced between DTC and the participating brokers on a daily basis.

Improving matters further, in 1996 the Direct Registration System (“DRS”) was implemented, which allowed investors to hold uncertificated securities in registered form directly on the books of the transfer agent. FAST eligibility is a prerequisite to using DRS. Using DRS and FAST together, a shareholder can electronically transfer shares to and from a brokerage account to facilitate their sale or transfer.

To become FAST, and therefore DRS eligible, a FAST approved transfer agent must apply to DTC on behalf of an issuer. The approval is not automatic. All FAST applications undergo a DTC review process. At a minimum, in order to be FAST eligible, an issuer must be eligible for DTC’s book-entry-only services, which requires a Blanket Letter of Representation (BLOR) in a form subscribed by DTC. DTC can ask for opinion letters to accompany an application. Beyond the BLOR and standard published DTC eligibility criteria, I was unable to find published criteria by DTC as to exactly what review requirements are included in a FAST application review process. I also spoke to several transfer agents that submit FAST issuer applications on a regular basis, and they likewise were unsure as to the review criteria used by DTC. However, it seems generally agreed that DTC conducts an issuer quality review looking at similar issues that would result in chills and locks, compliance with SEC reporting requirements, trading market price, volume and liquidity, and possibly bad actor reviews.

For further reading on DTC eligibility and chills and locks, see HERE; HERE; HERE; and HERE (Please note that DTC never implemented the rules discussed in that particular blog; however, the proposed process became a sort of industry practice. Also, note that the advent of chills and locks has dramatically decreased in recent years.)

Many OTC traded securities remain ineligible for the FAST program and DRS services today. The entire process of depositing securities into and removing securities from DTC is time-consuming for these non-FAST securities. The DTC, brokerage firms and transfer agents all charge for their part in the process—thus the current approximate $1,000 fee to deposit paper securities into DTC. This process, together with heightened regulatory scrutiny related to the deposit of all OTC traded securities and especially penny stocks, adds to the overall difficulty for OTC traded companies and the flow of their securities. See my blogHERE for a discussion on issues related to depositing penny stocks in today’s regulatory environment.

The Current Clearance and Settlement System

Today, DTC provides the depository and book entry settlement services for substantially all equity trading in the US. Over $600 billion in transactions are completed at DTC each day. Although all similar, the exact clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name (i.e., legally titled in the name of DTC’s nominee, CEDE) which have been deposited with a brokerage firm and are in the DTC system. As discussed, these securities show up on the shareholder list in the CEDE account. Each brokerage firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Where securities are held at DTC, the member brokerage firm will be identified on the books and records of DTC as having the entitlement to their pro rata share of all of the securities of that issuer held by DTC. The individual investor will then be identified on the books and records of the DTC member—i.e., the brokerage firm where the investors maintains an account and has deposited the securities. The specific rights of the individual investor are determined by rules and regulations, as well as by contract between the investor/shareholder and the particular brokerage firm.

Also, there may be two brokerage firms between DTC and the customer account holder. Brokerage firms that are direct members with DTC are referred to as “clearing brokers.” Many brokerage firms make arrangements with these DTC members (clearing brokers) to clear the securities on their behalf. Those firms are referred to as “introducing brokers.” A clearing broker will directly route an order through the national exchange or OTC Market, whereas an introducing broker will route the order to a clearing broker, who then routes the order through the exchange or OTC Market.

Only a limited number of clearing brokers will clear penny stocks and accordingly, only introducing brokers with clearing arrangements through those specific clearing brokers will, in turn, accept and clear penny stocks. COR Clearing, Alpine Securities and Wilson-Davis & Co. are the most widely known DTC member clearing brokers that will process penny stocks. Management of companies that issue penny stocks should communicate to their shareholders as to firms that will or will not clear their securities.

All securities trades involve a legally binding contract. In general the “clearing” of those trades involves implementing the terms of the contract, including ensuring processing to the correct buyer and seller in the correct security and correct amount and at the correct price and date. This process is effectuated electronically.

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In the US equities markets, settlement usually occurs three business days after the trade date, commonly referred to as “T+3.” As discussed, delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts.

DTC’s clearing arm generally nets all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. This process is continuous. Moreover, brokerage firms can either settle each day or carry their open account forward until the next business day. Because all transactions are netted out, 99% of all trade obligations do not require the exchange of money.

The SEC concept release on transfer agent rules contained a good summary of this process. In particular, “…final settlement of the securities leg of the transaction will involve the following sequential steps: (i) the DTC securities account of the seller’s clearing broker will be debited with the securities being purchased; (ii) NSCC’s securities account at DTC will be credited with the securities purchased; (iii) the DTC securities account of the buyer’s clearing broker will also be credited; and (iv) each broker will credit or debit their respective customers’ securities accounts held with the broker. On the cash side, final settlement will involve the following sequential steps: (i) the Federal Reserve bank account of the buyer’s clearing broker will be debited for the sale price of the securities; (ii) DTC’s Federal Reserve bank account will credited for the sale price of the securities; (iii) DTC will transfer this cash to the Federal Reserve bank account of the seller’s Clearing Broker; and (iv) each broker will credit or debit its respective customers’ cash accounts held with the broker.”

This process is the same for all buy and sell transactions, whether the transaction involves a long or short sale. However, where the transaction involves a short sale, there are added “locate” and “close-out” requirements, generally governed by Regulation SHO. In a future blog, I will drill down on the short selling process and Regulation SHO.

Although the order flow is all electronic, certain fundamentals cannot be bypassed. For instance, for every sell order there must be a matching buyer, and for every buy order a matching seller. The ability to match a buyer and seller is often referred to as the liquidity of a company’s trading market.

Conclusion

It is important for high-level securities attorneys to go beyond the technical ability to draft a contract, 10-K or registration statement, but to also understand how trading markets work and thus be able to provide guidance and advice as to relationships with transfer agents, market makers and financial public relations firms.

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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« Regulation SCI NASDAQ Listing Requirements »

Regulation SCI

Posted by Securities Attorney Laura Anthony | April 18, 2016 Tags: Regulation SCI

The SEC adopted Regulation Systems Compliance and Integrity (Regulation SCI) on November 3, 2015 to improve regulatory standards and processes related to technology in the securities business including by financial services firms. Regulation SCI was originally proposed in March 2013. Security and standards related to technological processes, data storage and systems has been a top priority of the SEC over the last few years and continues to be so this year.

Background

Technology has transformed the securities industry over the last years both in the area of regulatory oversight such as through algorithms to spot trading anomalies that could indicate manipulation and/or insider trading issues, and for market participants through enhanced speed, capacity, efficiency and sophistication of trading abilities. Enhanced technology carries the corresponding risk of failures, disruptions and of course hacking/intrusions. Moreover, as U.S. securities market systems are interconnected; an issue with one entity or system can have widespread consequences for all market participants.

Regulation SCI was proposed and adopted to require key market participants to have comprehensive written policies and procedures to ensure the security and resilience of their technological systems, to ensure systems operate in compliance with federal securities laws, to provide for review and testing of such systems and to provide for notices and reports to the SEC. Key market participants generally include national securities exchanges and associations, significant alternative trading systems (such as OTC Markets, which has confirmed is in compliance with the Regulation), clearing agencies, and plan processors.

Prior to enactment of Regulation SCI, there was no formal regulatory oversight of U.S. securities markets technological systems. Rather, oversight was historically through a voluntary Automation Review Policy (“ARP”). Under the ARP, the SEC created an ARP Inspection Program as well as policy statements and ongoing guidance. Compliance with ARP policies has been included in rules over the years, including Regulation ATS for high-volume automated trading systems. Although most major market participants, including SRO’s and national exchanges, participate in the ARP program, it remained voluntary and the SEChad no power to ensure compliance or enforce standards.

In recent years technology has outpaced the ARP program’s reach. Today the U.S. securities markets are almost entirely electronic and, as noted in the SEC rule release, “highly dependent on sophisticated trading and other technology, including complex and interconnected routing, market data, regulatory, surveillance and other systems.” The need for a codified regulatory system has been amplified by real-world issues such as, for example, the effects of hurricane Sandy on DTC and the markets in general; the multiple occasions of halting and delay of trading on exchanges due to systems issues; the highly publicized NYSE breakdown resulting in orders being booked at incorrect prices as well as multiple well known breaches in security. In fact, the SEC rule release contains multiple pages of examples of breakdowns and issues with technology in the markets.

Overview of Regulation SCI

Regulation SCI consists of 7 rules (Rules 1000 through 1007) as follows: (i) Rule 1000 contains definitions, including defining an SCI entity; (ii) Rule 1001 contains the policies and procedures requirements for SCI entities for operational capability, the maintenance of fair and orderly markets and systems compliance; (iii) Rule 1002 contains the obligations of SCI entities when there is an SCI defined event, including corrective measures, SEC notification and public notification; (iv) Rule 1003 contains requirements related to material changes and SCI reviews; (v) Rule 1004 contains requirements related to business continuity and disaster testing; (vi) Rule 1005 contains recordkeeping requirements; (vii) Rule 1006 contains requirements related to electronic filings and submissions; and (viii) Rule 1007 contains requirements for service bureaus.

SCI Entities

Regulation SCI broadly defines an SCI Entity as “an SCI self-regulatory organization, SCI alternative trading system, plan processor, or exempt clearing agency subject to ARP” and then contains drilled-down definitions within the broad categories. Regulation SCI is meant to encompass and include any entity that is significant in the operation and maintenance of fair and orderly markets.

SCI self-regulatory organizations include registered national securities associations (FINRA being the only one), all national securities exchanges, registered clearing agencies (DTC) and the Municipal Securities Rulemaking Board (MSRB). As a side note, there are currently 18 registered national securities exchanges including: (1) BATS Exchange, Inc. (“BATS”); (2) BATS Y-Exchange, Inc. (“BATS-Y”); (3) Boston Options Exchange LLC (“BOX”); (4) CBOE; (5) C2; (6) Chicago Stock Exchange, Inc. (“CHX”); (7) EDGA Exchange, Inc. (“EDGA”); (8) EDGX Exchange, Inc. (“EDGX”); (9) International Securities Exchange, LLC (“ISE”); (10) Miami International Securities Exchange, LLC (“MIAX”); (11) NASDAQ OMX BX, Inc. (“Nasdaq OMX BX”); (12) NASDAQ OMX PHLX LLC (“Nasdaq OMX Phlx”); (13) Nasdaq; (14) National Stock Exchange, Inc. (“NSX”); (15) NYSE; (16) NYSE MKT; (17) NYSE Arca; and (18) ISE Gemini, LLC (“ISE Gemini”).

An SCI Alternative Trading System is defined by volume broken down by NMS (National Market Systems) and non-NMS stocks and generally includes an Alternative Trading System with 1% or more of the NMS stocks volume or 5% or more of non-NMS stocks volume. Alternative Trading Systems which trade only municipal securities or corporate debt securities are excluded from the requirements. The OTC Markets is an SCI Entity and has confirmed that it is in compliance with Regulation SCI.

Interestingly, broker-dealers are not included as SCI Entities. The SEC reasoned that all broker-dealers are subject to Rule 15c3-5 and other FINRA rules which impose requirements related to the capacity, integrity and security of the broker-dealers’ systems and technology. However, the SEC did note that some broker-dealers are large enough that they could pose a real market risk if their systems were to break down or be infiltrated. The SEC may amend the rules in the future to include these firms.

An SCI “plan processor” includes “any self-regulatory organization or securities information processor acting as an exclusive processor in connection with the development, implementation and/or operation of any facility contemplated by an effective national market system plan.” There are currently four plan processors including the CTA Plan, CQS Plan, NASDAQ UTP Plan and OPRA Plan.

An “exempt clearing agency subject to ARP” includes “an entity that has received from the Commission an exemption from registration as a clearing agency under Section 17A of the Act, and whose exemption contains conditions that relate to the Commission’s Automation Review Policies, or any Commission regulation that supersedes or replaces such policies.” There is currently only one entity that meets this definition, Omgeo Matching Services – US, LLC.

In addition, Regulation SCI breaks systems down into three categories, including “SCI systems,” “critical SCI systems” and “indirect SCI systems,” meant to encompass systems and processes that are subject to heightened requirements, processes and procedures. “SCI Systems” include trading, clearance and settlement, order routing, market data, market regulation, and market surveillance. In particular, an “SCI System” is defined as “all computer, network, electronic, technical, automated, or similar systems of, or operated by or on behalf of, an SCI entity that, with respect to securities, directly support trading, clearance and settlement, order routing, market data, market regulation, or market surveillance.”

A “critical SCI system” is an SCI system that directly supports (i) clearance and settlement systems of clearing agencies; (ii) openings, reopenings, and closings on primary trading markets; (iii) trading halts; (iv) initial public offerings; (v) the provision of consolidated market data (i.e., SIPs); or (vi) exclusively listed securities. In addition, a “critical SCI system” is an SCI system that provides critical functionality to the market. An “indirect SCI system” is “any systems of, or operated by or on behalf of, an SCI entity that, if breached, would be reasonably likely to pose a security threat to SCI systems” and such systems only have to comply with the Regulation SCI provisions related to security and intrusions.

SCI Events

An SCI Event is defined as “an event at an SCI entity that constitutes: (1) a systems disruption; (2) a systems compliance issue; or (3) a systems intrusion.” A “systems disruption” is “an event in an SCI entity’s SCI systems that disrupts, or significantly degrades, the normal operation of an SCI system.” A “systems compliance issue” is defined as an “an event that has caused an SCI system to operate in a manner that does not comply with the [Securities Exchange] Act” and the rules and regulations thereunder and the entity’s rules and governing documents, as applicable. A “systems intrusion” is defined as “any unauthorized entry into the SCI systems or indirect SCI systems of an SCI entity.”

An SCI Event triggers certain obligations including taking corrective action, notifying the SEC and disseminating information. While the response to an SCI Event does not include a materiality analysis, it does include a risk-based analysis. Although the SEC provided for exceptions to the reporting and information requirements for events the de minimus or no impact on the SCI Entity’s operations or market participants, all disruptions require certain recordkeeping, assessment, and corrective measures regardless of how seemingly small they might be.

The SEC rightfully points out that outwardly inconsequential technological issues may later prove to have been a significant cause of larger issues. In addition, an SCI entity’s records of small events may prove useful to the SEC in identifying patterns, weaknesses or circumstances that result in significant issues. Along the same lines, the SEC requires recordkeeping and reporting related to both intentional and unintentional SCI Events.

Obligations of SCI Entities

Regulation SCI requires covered entities to establish written policies and procedures, with specific controls and systems that support trading, clearance and settlement, order routing, market data, market regulation and market surveillance. The written procedures must address levels of capacity, integrity, resiliency, availability and security. Such written policies must be designed to ensure that technological systems can maintain operations with minimal disruptions to the trading markets.

Regulation SCI also requires covered entities to comply with quarterly regulatory notification and reporting requirements and mandatory testing. Testing must include designated third parties and test business continuity and disaster recovery plans, including backup systems. SCI-covered entities must report any disruptions in their systems, compliance issues or system intrusions. The systems and technology of an SCI-covered entity must be reviewed annually by third-party qualified sources.

The specific systems obligations of SCI entities are laid out in Rules 1001-1004 of Regulation SCI. Rule 1001 contains the policy and procedure requirements with respect to operational capacity and maintenance of fair and orderly markets. Rule 1002 contains the obligations with respect to SCI events, including corrective action, SEC notification and information dissemination. Rule 1003 contains requirements related to material system changes, and SCI reviews. Finally, Rule 1004 contains requirements related to business continuity and disaster recovery plan testing.

Rule 1001 generally requires SCI entities to maintain reasonably designed policies and procedures to ensure the adequate capacity, integrity, resiliency, availability, and security of SCI systems (and security for indirect SCI systems) to maintain the SCI entity’s operational capability and promote the maintenance of fair and orderly markets. Guidance and discussion on the Rule indicate that the SEC has a risk-based approach requiring more robust policies and procedures for higher-risk systems. An SCI entity’s policies and procedures should ensure its own operational capability, including the ability to maintain effective operations, minimize or eliminate the effect of performance degradations, and have sufficient backup and recovery capabilities.

SCI policies and procedures must provide, at a minimum, (i) the establishment of reasonable current and future technology infrastructure capacity planning estimates; (ii) periodic capacity stress tests of systems to determine their ability to process transactions in an accurate, timely, and efficient manner; (iii) a program to review and keep current systems development and testing methodology; (iv) regular reviews and testing, as applicable including backup systems, to identify vulnerabilities pertaining to internal and external threats, physical hazards, and natural or man-made disasters.; (v) business continuity and disaster recovery plans that include maintaining backup and recovery capabilities sufficiently resilient and geographically diverse and are reasonably designed to achieve next-business-day resumption of trading and two-hour resumption of clearance and settlement services following a wide-scale disruption; (vi) standards that result in systems being designed, developed, tested, maintained, operated, and surveilled in a manner that facilitates the successful collection, processing, and dissemination of market data (in this regard, a sample of reasonable standards are provided in Table A); and (vii) standards for monitoring SCI systems and making prompt changes as necessary.

Rule 1001 requires that SCI entities establish written policies and procedures designed to ensure that the entity complies with the Securities Exchange Act and the rules and regulations thereunder as well as the entity’s own governing documents. The Rule provides a non-exhaustive list of minimum elements that must be included in such compliance policies and procedures. These elements include: “(i) testing of all SCI systems and any changes to SCI systems prior to implementation; (ii) a system of internal controls over changes to SCI systems; (iii) a plan for assessments of the functionality of SCI systems designed to detect systems compliance issues, including by responsible SCI personnel and by personnel familiar with applicable provisions of the Act and the rules and regulations thereunder and the SCI entity’s rules and governing documents; and (iv) a plan of coordination and communication between regulatory and other personnel of the SCI entity, including by responsible SCI personnel, regarding SCI systems design, changes, testing, and controls designed to detect and prevent systems compliance issues.”

Rule 1002 contains the obligations with respect to SCI events, including corrective action, SEC notification and information dissemination. Under the Rule an SCI-delineated person must take the required action upon reasonably confirming that an SCI event has occurred. As such, the SEC requires an SCI entity to have written policies and procedures that “include the criteria for identifying responsible SCI personnel, the designation and documentation of responsible SCI personnel, and escalation procedures to quickly inform responsible SCI personnel of potential SCI events.” Such “responsible SCI personnel” means “for a particular SCI system or indirect SCI system impacted by an SCI event, such senior manager(s) of the SCI entity having responsibility for such system, and their designee(s).”

The Rule contains in-depth and detailed discussion of corrective actions, notification requirements and information dissemination requirements. In essence, the SEC must be immediately notified of all SCI events other than de minimis events, although even de minimis events contain recordkeeping requirements and must be included In SCI reports. Until the SCI event is resolved, the SCI entity must keep the SEC regularly updated as to the progress of the investigation and resolution of the event, and must file a report with the SEC once the event is resolved. Subject to certain exceptions, the SCI entity must disseminate information to its members and participants regarding all SCI events.

Rule 1003 contains requirements related to material system changes, and SCI reviews. In particular, Rule 1003 requires quarterly reports to the SEC describing completed, ongoing, and planned material systems changes to its SCI systems and security of indirect SCI systems. Rule 1003 also requires a minimum of an annual review of an SCI entity’s compliance with Regulation SCI.

Rule 1004 contains requirements related to business continuity and disaster recovery plan testing. As with notification requirements, an SCI entity must designate certain personnel to complete business continuity and disaster recovery plan testing. In particular, the SCI entity must designate those members or participants “that the SCI entity reasonably determines are, taken as a whole, the minimum necessary for the maintenance of fair and orderly markets in the event of the activation of such plans.” Such testing must be completed at least once every 12 months.

The recordkeeping and electronic filing requirements of Regulation SCI are laid out in Rules 1005 through 1007.

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.

« Mergers And Acquisitions: Types Of Transactions The U.S. Capital Markets Clearance And Settlement Process »

Mergers And Acquisitions: Types Of Transactions

Posted by Securities Attorney Laura Anthony | April 5, 2016 Tags: Merger Types, OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities

As merger and acquisition (M&A) transactions completed its most active year since the financial crisis, it is helpful to go back to basics. Activity has been prevalent in all market sectors, including large, mid and small cap and across all industries, including biotech, financial services, technology, consumer goods and services, food and beverage and healthcare, among others.

Although I’ve written about M&A transactions multiple times, this will be the first time I’ve given a broad overview of the forms that an M&A transaction can take.

Types of Mergers and Acquisitions

A merger or acquisition transaction is the combination of two companies into one resulting in either one corporate entity or a parent-holding and subsidiary company structure. Mergers can categorized by the competitive relationship between the parties and by the legal structure of the transaction. Related to competitive relationship, there are three types of mergers: horizontal, vertical and conglomerate. In a horizontal merger, one company acquires another that is in the identical or substantially similar industry eliminating a competitor. In a vertical merger, one company acquires a customer or supplier. A conglomerate merger covers all other transactions where there is no direct competitive or vertical relationship between the merging parties. The result is generally the creation of a conglomerate – thus the name.

From a legal structure perspective, an M&A transaction can be an asset purchase, a stock purchase, a forward merger or a forward or reverse triangular merger. In an asset purchase, stock acquisition, forward merger or forward triangular merger, the acquiring company remains in control. In a reverse merger or a reverse triangular merger, the target company shareholders and management gain control of the acquiring company.

In an asset purchase transaction, the acquirer can pick and choose the assets that it is purchasing, and likewise the liabilities it is assuming. An asset purchase can be complex and requires careful drafting to ensure that the desired assets are included, including all tangible and intangible rights thereto, and that only the specified liabilities are legally assumed. Third-party consents are often required to achieve the result.

In a stock acquisition, the acquiring company purchases the stock from the target company shareholders. A stock acquisition can result in a forward or reverse acquisition depending on the control of the target company shareholders at the closing of the transaction. In a stock acquisition transaction, the operations, assets and liabilities of the target remain unchanged; it just has different ownership. Complexities arise if some of the target company shareholders refuse to participate in the transaction, leaving unfriendly minority shareholders. Oftentimes a stock acquisition is structured such that a closing is contingent upon a certain percentage participation, such as 90% or even 100%.

In a forward merger or a forward or reverse triangular merger, two companies combine into one, resulting in either one corporate entity or a parent-holding and subsidiary company structure. The shareholders of the target company receive either stock of the acquirer, cash or a combination of both. All assets and liabilities are included in the M&A transaction. A triangular merger is one in which a new acquisition subsidiary is formed to complete the transaction and results in a parent-subsidiary structure.

As mentioned above, a reverse merger results in a change of control of the acquirer. In particular, in a reverse or reverse triangular merger the shareholders of the target company exchange their shares for either new or existing shares of the acquiring company so that at the end of the transaction, the shareholders of the target company own a majority of the acquiring company and the target company has become a wholly owned subsidiary of the acquiring company or has merged into a newly formed acquisition subsidiary. A reverse merger is often used as a private to public transaction for a target company where the acquiring company is a public entity.

The specific form of the transaction should be determined considering the relevant tax, accounting and business objectives of the overall transaction.

Refresher on Other Aspects of the Transaction

An Outline of the Transaction Documents

Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent followed by the merger agreement itself. In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information, including allowable disclosure both internally and to third parties. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality, such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

A letter of intent (“LOI”) is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with the “who do” identification.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. A “window shop” provision allows for some level of third-party negotiation. For example, a window shop provision may allow for the consideration of unsolicited proposals.

Much different from a no shop or window shop provision is a “go shop” provision. To address a board of directors’ fiduciary duty and, in some instances, to maximize dollar value for its shareholders, a potential acquirer may request that the target “go shop” for a better deal up front to avoid wasted time and expense. A go shop provision is more controlled than an auction and allows both target and acquiring entities to test the market prior to expending resources. A go shop provision is common where it is evident that the board of directors’ “Revlon Duties” have been triggered.

A standstill provision prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning off subsidiaries, hiring or firing management teams and the like. Many companies also protect their interests in the LOI stage by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The Merger Agreement

In a nutshell, the merger agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being purchased and provides for rights and remedies in the event that this description proves to be materially inaccurate. The merger agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.

The main components of the merger agreement and a brief description of each are as follows:

Representations and warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. Both parties represent as to the accuracy of public filings, financial statements, material contract, tax matters and organization and structure of the entity.
Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing. All covenants require good faith in completion.
Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
Deal protections – Like the LOI, the merger agreement itself will contain deal protection terms. These deal protection terms can include no shop or window shop provisions, requirements as to business operations by the parties prior to the closing, breakup fees, voting agreements and the like.
Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the merger agreement may contain due diligence provisions. Due diligence refers to the legal, business and financial investigation of a business prior to entering into a transaction. Although the due diligence process can vary depending on the nature of a transaction (a relatively small acquisition vs. a going public reverse merger), it is arguably the most important component of a transaction (or at least equal with documentation).

Board of Directors’ Fiduciary Duties in the Merger Process

State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Generally a court will not second-guess directors’ decisions as long as the board has conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases, including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).

However, in certain instances, such as in a merger and acquisition transaction, where a board may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) and Unocal vs. Mesa Petroleum, 493 A.2d 946 (Del. 1985).

A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving directors and/or shareholders such as where directors are on both sides of the transaction. Under the entire fairness standard, the directors must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms.

In all matters, directors’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director to provide complete and materially accurate information to a corporation.

As with many aspects of the law, a director’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors is reduced and only the basic business judgment rule will apply. For example, in instances where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers.

Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective of maximizing the return to shareholders though social interests and considerations (such as the loss of jobs) may also be considered in the process.

The law focuses on the process, steps and considerations made by the board of directors, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors in the face of scrutiny. Courts will consider facts such as attendance at meetings, the number and frequency of meetings, knowledge of the subject matter, time spent deliberating, advice and counsel sought by third-party experts, requests for information from management, and requests for and review of documents and contracts.

In the performance of their obligations and fiduciary responsibilities, a board of directors may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction.

Dissenter and Appraisal Rights

Unless they are a party to the transaction itself, such as in the case of a share-for-share exchange agreement, shareholders of a company in a merger transaction generally have what is referred to as “dissenters” or “appraisal rights.” An appraisal right is the statutory right by shareholders that dissent from a particular transaction, to receive the fair value of their stock ownership. Generally such fair value may be determined in a judicial or court proceeding or by an independent valuation. Appraisal rights and valuations are the subject of extensive litigation in merger and acquisition transactions.

Although the details and appraisal rights process vary from state to state (often meaningfully), as with other state corporate law matters, Delaware is the leading statutory example and the Delaware Chancery Court is the leader in judicial precedence in this area of law. More than half of U.S. public companies and more than two-thirds of Fortune 500 companies are domiciled in Delaware.

As is consistent with all states, the Delaware General Corporation Law (“DGCL”) Section 262 providing for appraisal rights requires both petitioning stockholders and the company to comply with strict procedural requirements. Section 262 of the DGCL gives any stockholder of a Delaware corporation who (i) is the record holder of shares of stock on the date of making an appraisal rights demand, (ii) continuously holds such shares through the effective date of the merger, (iii) complies with the procedures set forth in Section 262, and (iv) has neither voted in favor of nor consented in writing to the merger, to seek an appraisal by the Court of Chancery of the fair value of their shares of stock.

Generally there are four recurring valuation techniques used in an appraisal rights proceeding: (i) the discounted cash flow (DCF) analysis; (ii) a comparable company’s analysis and review; (iii) a comparable transactions analysis and review; and (iv) the merger price itself. Merger price is usually reached through the reality of a transaction process, as opposed to the academic and subjective valuation processes used in litigation challenging such price.

In a recent line of cases, the Delaware court has upheld the merger price as the most reliable indicator of fair value where the merger price was reached after a fair and adequate process in an arm’s-length transaction. Where there is a question as to the process resulting in the final merger price, Delaware courts generally look to the DCF analysis as the next best indicator of fair value.

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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« Responding To SEC Comments Regulation SCI »

Responding To SEC Comments

Posted by Securities Attorney Laura Anthony | March 29, 2016 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities, responding to sec comments, SEC, sec comment process

Background

The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and to enhance such disclosures as to each particular issuer. CorpFin will also be cognizant of the anti-fraud provisions of the federal securities laws and may refer a matter to the Division of Enforcement where material concerns arise over the adequacy and accuracy of reported information or other securities law violations, including violations of the Section 5 registration requirements. CorpFin has an Office of Enforcement Liason in that regard.

CorpFin’s review and responsibilities can be described with one word: disclosure!

CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed. Forms 8-K reporting a change of auditor, a material acquisition, or a change in financial statements are almost always reviewed. Moreover, the Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

CorpFin does not publicly disclose the criteria it uses to identify companies and filings for review. Essentially, a publicly reporting company’s filings may be reviewed at any time and periodic comment letters are a standard part of being a public company.

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

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

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

Comment Letters and Responses

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

A company generally responds to the particular comment letter with a responsive letter that addresses each comment and where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure. CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses. The company should carefully consider its responses to comments that could open the door to additional review and comments. Comments related to accounting treatment and the flow-through to MD&A can be especially tricky and open the door to further review and changes.

Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, explain how the company is burdened and how the alternative provided by the company will provide adequate disclosure for investors. The argument that technical compliance is overly burdensome rarely succeeds with CorpFin, but at times a middle ground can be reached if the company is convincing enough in its analysis.

The comment and response process continues until the staff has resolved all comments. CorpFin may request that the reasoning behind a disclosure be added to the SEC report itself, and so the company should consider whether it wants particular language included in public filings when drafting a response letter to a comment.

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

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

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

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

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

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

Comment letters and responses are posted on the EDGAR database by CorpFin no earlier than 20 days after it has finished the review process.

The SEC generally requires an affirmative statement from the company acknowledging that the company cannot use the SEC’s comment process as a defense in any securities-related litigation. This language is referred to as a “Tandy” letter. The Tandy portion of a response must be agreed to by the company itself, so if the response letter is on attorney letterhead, a signature line must be provided for the company or the company can submit a separate letter. The Tandy language for an Exchange Act filing is generally as follows:

The company acknowledges that:

the company is responsible for the adequacy and accuracy of the disclosure in the filing;

staff comments or changes to disclosure in response to staff comments do not foreclose the Commission from taking any action with respect to the filing; and

the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

Tandy language for a Securities Act registration statement is generally as follows:

The company acknowledges the following:

should the Commission or the staff, acting pursuant to delegated authority, declare the filing effective, it does not preclude the Commission from taking any action with respect to the filing;

the action of the Commission or the staff, acting pursuant to delegated authority, in declaring the filing effective does not relieve the company from its full responsibility for the adequacy and accuracy of the disclosure in the filing; and

the company may not assert staff comments and the declaration of effectiveness as a defense in any proceeding initated by the Commission or any person under the federal securities laws of the United States.

A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting. The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included. As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports. As CorpFin is only reviewing information provided by, or publicly available related to, a company, the completion of a review is not a guarantee as to the accuracy or adequacy of the information in the filing and cannot be used as a defense to claims of fraud or misrepresentations.

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

Conclusion

The very best way to handle comments and responses is to have a competent team in place that submits high-quality SEC reports in the first place and that is able to communicate with the SEC and understand the legal disclosure and accounting requirements, including interpretative changes over time. The topic of disclosures and disclosure requirements is in the forefront these days, and changes are being reviewed and considered by the SEC (see, HERE for example). Understanding the disclosure requirements for your particular company and industry will save substantial time and effort for a public company.

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

The Author

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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