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

SEC Issues Report On Accredited Investor Definition

Posted by Securities Attorney Laura Anthony | January 12, 2016 Tags: Accedited Investor, accredited investor definition, SEC

On December 18, 2015, the SEC issued a 118-page report on the definition of “Accredited Investor” (the “Report”). The report follows the March 2015 SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) recommendations related to the definition. The SEC is reviewing the definition of “accredited investor” as directed by the Dodd-Frank Act, which requires that the SEC review the definition as relates to “natural persons” every four years to determine if it should be modified or adjusted.

The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation.

Although the Report contains detailed discussions on the various aspects of the definition of an accredited investor, the history of the different aspects of the definition, a discussion of different approaches taken in other U.S. regulations and in foreign jurisdictions and an in-depth discussion on the reasoning behind its recommendations, the actual recommendations are only conceptual and broad-based and do not contain specifics. Accordingly, we will need to wait for a future proposed rule release to see what, if any, of the recommendations will be implemented and to what degree. This blog provides a broad summary of the Report.

Background

All offers and sales of securities must either be registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or be subject to an available exemption to registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration – thus the registration exemptions in Sections 3 and 4 of the Securities Act and the rules promulgated thereunder. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.

Regulation D provides the most commonly used transactional exemptions to registration. The SEC notes in its Report that $1.3 trillion was raised under Regulation D in 2014 alone. The definition of “accredited investor” provides the backbone to the Regulation D exemptions and is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”

In addition to investor protection, the SEC also has a mandate to assist businesses with capital formation and the definition of “accredited investor” must walk the line between these goals. An overly restrictive definition will damage the ability of businesses to access private capital, and an overly broad definition would be contrary to the SEC’s investor protection goals.

Qualifying as an accredited investor makes the difference between being able to participate in an exempt offering or not, and the ability for an issuer to rely on an exemption or not, and accordingly is a very important component of the securities regulations. For example, some exemptions like Rule 506(c) are limited to accredited investors only. Rules 505 and 506(b) limit offers and sales to no more than 35 unaccredited investors. Many state law exemptions limit offers and sales of securities based on the status of an investor as accredited or not.

An issuer’s required disclosure is also tied into whether investors and potential investors are accredited. For example, under Rules 505 and 506(b) issuers must provide certain delineated financial and non-financial disclosures if an offering will be made to any non-accredited investors.

The Current Definition of “Accredited Investor”

An “Accredited investor” is defined as any person who comes within any of the following categories:

Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;

Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;

Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and

Any entity in which all of the equity owners are accredited investors.

The SEC Report contains an interesting table comparing the regulatory approach to determining the status of investors that are not in need of certain investor protections. I’m reproducing the entire table as appears in the Report:

Standard	Financial Threshold for Natural Persons	Regulatory Purpose
Accredited Investor(Securities Act Rule 501(a))	$200,000 in income$300,000 in joint income $1 million in net worth, excluding the value of a primary residence	Exemption from Securities Act registration for offers and sales to accredited investors
Qualified Client(Advisers Act Rule 205-3)	$1 million in assets under management with an investment adviser$2 million in net worth, excluding the value of a primary residence Subject to inflation adjustment every 5 years	Exemption from Advisers Act’s prohibition on charging performance fees to clients
Qualified Purchaser(Investment Company Act Section 2(a)(51)(A))	$5 million in investments	Exemption from Investment Company Act registration for sales to qualified purchasers
Qualified Investor(Exchange Act Section 3(a)(54))	$10 million in asset-backed securities and loan participations$25 million in other investments	Exemption from broker-dealer registration for banks that sell certain securities to qualified investors
Eligible Contract Participant(Commodity Exchange Act Section 1a(18))	$10 million in investments$5 million in investments if hedging	Eligible contract participants are able to engage in certain derivatives and swaps transactions

The SEC Report discusses the different approaches and their respective histories. The Report also considers the approach taken by different countries including Australia, Canada, the EU, Israel, Singapore and the United Kingdom. The SEC considered these different approaches in making its recommendations. Although a synopsis of these discussions is beyond the scope of this blog, it does provide for interesting reading and insight into the regulatory regime.

SEC Recommendations Related to the Accredited Investor Definition

The Report considered numerous different approaches and potential changes and contains discussion supporting each element in determining an accredited investor and the recommended changes. The Report discusses the numerous different proposals considered, the input of commenters, the challenges that will be associated with each of its recommendations and the reasoning behind such recommendations. However, notably absent from the Report are specific recommendations associated with the broad concepts.

The SEC staff recommends a complete revision to the definition of accredited investor and in particular makes the following recommendations:

Leave the current income and net worth thresholds in place, subject to investment limitations;

Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations;

Index all financial thresholds for inflation on a going-forward basis;

Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors;

Add a new qualification for individuals based on measures of sophistication including parameters considering the person’s (i) amount of investments; (ii) professional credentials; (iii) experience investing in exempt offerings; and (iv) status as a knowledgeable employee of a private fund for investments in the employer’s fund. In addition, the SEC recommends permitting individuals who pass an accredited investor examination to qualify as an accredited investor.

Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than the specifically enumerated types of entities; and

Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

I agree with each of the proposed conceptual changes and in particular the addition of the sophistication qualifications; however, until actual proposals are made that include specifics, such as the specific investment limitations, specific criteria to establish sophistication and specific proposed adjustments, I remain as unspecific in my opinion as the SEC is in its recommendations!

Leaving a strict bright line financial test, without the additional sophistication test, is too restrictive to meet the goal of assisting businesses in accessing capital. According to the SEC Report, in 2013, only 10.1% of U.S. households qualified as accredited investors and adjusting the financial tests for inflation will drop that percent to 3.6%.

The SEC staff points out that there is currently no definition of the term “income” and very limited guidance on the matter. The recommendations do not offer further guidance or suggest any changes. From a practitioner’s perspective, we generally go by the individual’s tax return.

The SEC Report also discussed the net worth calculation. The only asset excluded from the calculation is the person’s primary residence. Many commenters have suggested changes such as the exclusion of retirement assets. The SEC rightfully points out the numerous problems with this approach including, but certainly not limited to, the obvious impact of discouraging retirement investments or encouraging the withdrawal of retirement funds to participate in private investments. Moreover, the Advisory Committee previously pointed out, and the SEC Report acknowledges, that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition.

I also like the reasoning behind adding investment limitations at certain thresholds and removing them at higher thresholds. Currently the income and net worth tests are absolute. An investor with a $999,999 net worth cannot invest and an investor with a $1,000,000 can invest an unlimited amount. Permitting all individuals that with a level of financial sophistication to be deemed accredited and invest in private offering subject to caps based on net worth or income, will greatly expand the pool of potential investors and be consistent with the need to protect investors.

The SEC Reports suggests a few methods of implementing investment limitations but does not make a specific, precise proposal. The SEC Report suggests examples of limitations such as: (i) an even percentage application across all investors (this approach is rejected); (ii) a gradual increase in investment limitation which limitation is eventually eliminated based on net worth and/or income; and (iii) either separately or in conjunction with other limitations, adding a per issuer limitation.

The SEC Staff recommendations in the Report are consistent with the Advisory Committee’s recommendations made to the SEC in March 2015. In particular, the Advisory Committee made four recommendations related to the definition of “accredited investor”:

(1) That if any change is made to the definition of “accredited investor,” such change should “have the effect of expanding, not contracting, the pool of accredited investors.” For example, they recommended that the definition include investors that satisfy a sophistication test that is not tied to income or net worth. In addition, the Advisory Committee recommended that that tax treatment of assets be excluded from any net worth calculation.

(2) That the SEC take into account the effect of inflation and adjust the accredited investor thresholds in accordance with the consumer price index.

(3) “Rather than attempting to protect investors by raising the accredited investor thresholds or excluding certain asset classes from the calculation to determine accredited investor… the Commission should focus on enhanced enforcement efforts and increased investor education” and

(4) The SEC should continue to gather data on the subject.

Additional History and Further Background

The vast majority of the SEC’s 118-page report provides a history of the Securities Act registration and exemption provisions and the role of the accredited investor definition. The SEC provides the background of the Section 4(a)(2) exemption and a summary of SEC vs. Ralston Purina Co., the leading Supreme Court case interpreting the provision. I’ve previously covered some of this history in my blogs HERE and HERE (written prior to renumbering 4(2) to 4(a)(2)). The following blog HERE on obstacles in depositing penny stocks also provides insight into the exemptions and investor qualifications and as such is beneficial ancillary reading with this blog.

The Advisory Committee Letter to the SEC in March 2015 contained a list of practical facts and realities related to small business and emerging company capital formation in support of its recommendations that I found informative and so am re-publishing. In particular:

Smaller and emerging companies are “critical to the economic well-being of the United States,” generating the majority of net new jobs in the last five years and continuing to add more jobs;

Rule 506 of Regulation D is the most widely used private offering exemption, resulting in $1 trillion of raised capital in 2013;

Most early-stage, venture capital and angel investments are made in reliance on Rule 506;

Other than Rule 506(b), which allows up to 35 unaccredited investors (when certain disclosures and financial information are provided), all investors in Rule 506 offerings must be accredited;

The Dodd-Frank Act requires the SEC to review the accredited investor definition to determine whether it “should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy”;

There are groups and commentators that advocate increasing the thresholds in the accredited investor definition to prevent fraud against investors. However, the SEC is not of “any substantial evidence suggesting that the current definition of accredited investor has contributed to the ability of fraudsters to commit fraud or has resulted in greater exposure for potential victims.” In addition, “the connection between fraud and the current accredited investor thresholds seems tenuous at best”;

Some groups and commentators advocate excluding “retirement assets” from the calculation of net worth. The Advisory Committee rightfully and logically points out that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition; and

There is little or no evidence to suggest that the existing definition of accredited investor has led to widespread fraud or other harm to investors; rather, there is substantial evidence that the current definition works.

The Advisory Committee concluded that if the income and net worth thresholds are increased, it “will materially decrease the pool of capital available for smaller businesses.” It continued by stating that such a change “would have a disparate impact on those areas having a lower cost of living, which areas often coincide with regions of lower venture capital activity.”

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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« SEC Guidance On Proxy Presentation Of Certain Matters In The Merger And Acquisition Context The SEC Issues Guidance On The FAST Act As It Relates To Savings And Loan Companies »

SEC Guidance On Proxy Presentation Of Certain Matters In The Merger And Acquisition Context

Posted by Securities Attorney Laura Anthony | January 7, 2016 Tags: 14A Proxy Solicitation

In late October the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years – Staff Legal Bulletin No. 14H (“SLB 14H”). Please see my blog on SLB 14H HERE. On the same day the SEC published two new Compliance and Disclosure Interpretations (“C&DI”) related to the unbundling of matters presented for a vote to shareholders in merger and acquisition transactions. The new C&DI has in essence granted voting rights to target company shareholders, on acquiring company organizational documents, where none existed before and has in essence pre-empted state law on the issue.

Unbundling under Rule 14a-4(a)(3) in the M&A Context

Exchange Act Rule 14a-4 relates to the requirements for a proxy card general. Rule 14a-4(a) provides:

(A) The form of proxy:

(1) Shall indicate in bold-face type whether or not the proxy is solicited on behalf of the registrant’s board of directors or, if provided other than by a majority of the board of directors, shall indicate in bold-face type on whose behalf the solicitation is made;

(2) Shall provide a specifically designated blank space for dating the proxy card; and

(3) Shall identify clearly and impartially each separate matter intended to be acted upon, whether or not related to or conditioned on the approval of other matters, and whether proposed by the registrant or by security holders.

Part (b) continues with a requirement that the proxy shall provide a means “whereby the person solicited is afforded an opportunity to specify by boxes a choice between approval or disapproval of, or abstention with respect to each separate matter” other than director elections and votes on the frequency of votes on executive compensation (i.e., frequency of say-on-pay votes).

Exchange Act Rule 14a-4(a)(3) relates to the unbundling of separate matters that are submitted to a shareholder vote through proxy materials. The SEC previously issued C&DI guidance in January 2014. The new C&DI specifically addresses Rule 14a-4(a)(3) in the context of mergers, acquisitions and similar transactions. The SEC has historically been against bundling of proposals in a proxy and that trend continues with the new C&DI.

Following the January 2014 C&DI, the rules substantially provided that multiple matters that are inextricably intertwined need not be unbundled. However, separate matters do not rise to the level of “inextricably intertwined” just because they were negotiated as part of a single transaction with a third party. Moreover, matters that are immaterial may be bundled with other matters. Materiality is determined by considering whether a matter substantially affects shareholder rights or whether a shareholder would reasonably be expected to express or want to express a view on a matter.

The SEC has issued 2 new C&DI as follows:

Question: Rule 14a-4(a)(3) requires that the form of proxy “identify clearly and impartially each separate matter intended to be acted upon.” Rule 14a-4(b)(1) further requires that the form of proxy provide a means for shareholders “to specify by boxes a choice… with respect to each separate matter referred to therein as intended to be acted upon.” In a merger, acquisition, or similar transaction in which shareholders of the target are receiving equity securities of the acquirer, amendments to the organizational documents of the acquirer can often be required by the transaction agreement. Under these proxy rules, under what circumstances must a target seeking shareholder approval of such a transaction present separately on its form of proxy a proposal or proposals relating to the amendments to the organizational documents of the acquirer? In other words, when are these amendments which are embedded within the transaction agreement a “separate matter” for target shareholders?

Answer: As a preliminary matter, if a material amendment to the acquirer’s organizational documents would require the approval of its shareholders under state law, the rules of a national securities exchange, or its organizational documents if presented on a standalone basis, the acquirer’s form of proxy must present any such amendment separately from any other material proposal, including, if applicable, approval of the issuance of securities in a triangular merger or approval of the transaction agreement in a direct merger. See Question 101.02 relating to “Unbundling under Rule 14a-4(a)(3) Generally.” As a general principle, however, only material matters must be unbundled, and acquirers should consider whether the provisions in question substantively affect shareholder rights. Examples of provisions meeting this standard that may be adopted in connection with a transaction include governance and control-related provisions, such as classified or staggered boards, limitations on the removal of directors, supermajority voting provisions, delaying the annual meeting for more than a year, eliminating the ability to act by written consent, or changes in minimum quorum requirements. In contrast, provisions such as name changes, restatements of charters, or technical changes, such as those resulting from anti-dilution provisions, would likely be immaterial.

If, consistent with the guidance in Question 101.02, the acquirer is required under Rule 14a-4(a)(3) to present an amendment or multiple amendments separately on its form of proxy, or would be so required if it were conducting a solicitation subject to Regulation 14A, then a target subject to Regulation 14A also must present any such amendment separately on its form of proxy. This is because the amendment, which is a term of the transaction agreement that target shareholders are being asked to approve, would effect a material change to the equity security that target shareholders are receiving in the transaction. Target shareholders should have an opportunity to express their views separately on these material provisions that will establish their substantive rights as shareholders, even if as a matter of state law these provisions might not require a separate vote. Similarly, if the acquirer presents a material amendment on its form of proxy as the only matter to be approved by acquirer’s shareholders, then the target must present the amendment separately on its form of proxy. The target need not present as a separate matter on its form of proxy an amendment to increase the number of authorized shares of the acquirer’s equity securities, provided that the increase is limited to the number of shares reasonably expected to be issued in the transaction.

In all cases, the parties are free to condition completion of a transaction on shareholder approval of any separate proposals. Any such conditions should be clearly disclosed and indicated on the form of proxy.

Question 201.02

Question: Does the answer to Question 201.01 change if the parties form a new entity to act as an acquisition vehicle that will issue equity securities in the transaction?

Answer: No. In that case, the party whose shareholders are expected to own the largest percentage of equity securities of the new entity following consummation of the transaction would be considered the acquirer for purposes of this analysis. As in Question 201.01, the acquirer must present separately on its form of proxy any material provision or provisions of the new entity’s organizational documents that are a term of the transaction agreement, if the provision or provisions represent a material change from the acquirer’s organizational documents, and the change would require the approval of the acquirer’s shareholders under state law, the rules of a national securities exchange, or its organizational documents if proposed to be made directly to its own organizational documents. Provisions that are required by law in the jurisdiction of incorporation of the new entity need not be presented separately on the form of proxy. As in Question 201.01, if the acquirer is or would be required under Rule 14a-4(a)(3) to present separately on its form of proxy any provision of the new entity’s organizational documents that is a term of the transaction agreement, then a target subject to Regulation 14A must also present the same provision separately on its form of proxy.

Question 101.02 referred to in Question 201.01 provides:

Question: Management of a registrant intends to present an amended and restated charter to shareholders for approval at an annual meeting. The proposed amendments would change the par value of the common stock, eliminate provisions relating to a series of preferred stock that is no longer outstanding and is not subject to further issuance, and declassify the board of directors. Under Rule 14a‑4(a)(3), must the individual amendments that are part of the restatement be unbundled into separate proposals?

Answer: No. The staff would not ordinarily object to the bundling of any number of immaterial matters with a single material matter. While there is no bright-line test for determining materiality in the context of Rule 14a‑4(a)(3), registrants should consider whether a given matter substantively affects shareholder rights. While the declassification amendment would be material under this analysis, the amendments relating to par value and preferred stock do not substantively affect shareholder rights, and therefore both of these amendments ordinarily could be included in a single restatement proposal together with the declassification amendment. However, if management knows or has reason to believe that a particular amendment that does not substantively affect shareholder rights nevertheless is one on which shareholders could reasonably be expected to wish to express a view separate from their views on the other amendments that are part of the restatement, the amendment should be unbundled.

The staff notes that the analysis under Rule 14a-4(a)(3) is not governed by the fact that, for state law purposes, these amendments could be presented to shareholders as a single restatement proposal. If, for example, the restatement proposal also included an amendment to the charter to add a provision allowing shareholders representing 40% of the outstanding shares to call a special meeting, the staff would view the special meeting amendment as material and therefore required to be presented to shareholders separately from the similarly material declassification amendment.

In an M&A context the new guidance is a significant change. The SEC is in essence requiring that target company shareholders be afforded an opportunity to vote on changes to the acquiring company’s organizational documents, separate and apart from voting on the merger itself. The SEC reasons that since the target company shareholders will become acquiring company shareholders, they have an interest in the organizational documents. Although I understand that argument, I would think that the target company shareholders could consider the acquiring company’s organizational documents, or changes thereto, in deciding whether to vote on the merger or not. I fail to see the benefit of a separate vote, nor the practical result if, for instance, the target company shareholders approve a merger but not the organizational document changes (other than giving plaintiff’s attorneys another matter to litigate!)

From a company’s point of view, it can make more sense to present an integrated proposal for a full merger plan. By unbundling the various items to the plan, including corporate governance and structure changes, the company could have a shareholder approval of the corporate changes but not the merger itself or vice versa. Moreover and worse yet, the reconfigured pieces of the transaction, following a shareholder vote on the parts as opposed to the whole, may have an unintended result. The SEC suggests that one can be conditioned on the other, but if that is the case, why require the unbundling in the first place?

The new C&DI continues the trend that I have written of several times, of the federal government imposing on state corporate law regulations. I am a vocal advocate of federal pre-emption of state securities laws, but am also an advocate of leaving corporate law matters to the states. In this case the SEC clearly spreads its reach into state law with the statement “[T]arget shareholders should have an opportunity to express their views separately on these material provisions that will establish their substantive rights as shareholders, even if as a matter of state law these provisions might not require a separate vote.” In this instance, the target shareholders do not have the right to vote on the acquirer’s organizational documents under state law, but apparently do have such right if the acquirer is subject to the SEC proxy rules.

The new C&DI goes beyond the historical SEC requirements to provide information in a proxy related to corporate organizational changes, in advance of a merger (see my blog HERE for more on that topic) and grants voting rights where none existed previously.

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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« OTC Markets Amends Listing Standards For The OTCQX SEC Issues Report On Accredited Investor Definition »

OTC Markets Amends Listing Standards For The OTCQX

Posted by Securities Attorney Laura Anthony | December 30, 2015 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities

OTC Markets has unveiled changes to the quotations rule and standards for the OTCQX, which changes become effective January 1, 2016. The amended listing standards increase the quantitative criteria for listing and add additional qualitative requirements continuing to align the OTCQX with standards associated with a national stock exchange. Companies already listed on the OTCQX as of December 31, 2015 will have until January 2017 to meet the new ongoing eligibility 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, 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 in 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.

Summary of Changes

The OTCQX has increased its quantitative initial and ongoing listing standards for U.S. companies including: (i) increase of initial bid price requirement from $0.10 to $0.25 for initial qualification and to $0.10 for ongoing eligibility; (ii) addition of initial minimum market capitalization requirement of $10 million; (iii) addition of continued listing minimum market capitalization requirement of $5 million; (iv) minimum of two market makers with priced quoted on OTC Markets within 90 days of joining; and (v) expands the requirement that the company remain qualified for a penny stock exemption under Rule 3a51-1 or be removed.

The OTCQX has also increased its quantitative initial and ongoing listing standards for international companies including: (i) increase of initial bid price requirement from $0.10 to $0.25 for initial qualification and to $0.10 for ongoing eligibility; (ii) addition of initial minimum market capitalization requirement of $10 million; (iii) addition of continued listing minimum market capitalization requirement of $5 million; and (iv) minimum of two market makers with priced quoted on OTC Markets within 90 days of joining.

The OTCQX has added new qualitative corporate governance requirements for U.S. issuers as well. In particular to list on OTCQX, U.S. companies will be 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 standards for the OTCQX U.S. and International Premier tiers have also increased. The U.S. Premier increases are meant to align such companies with the financial standards recognized by most states for issuer state blue sky exemptions. In particular U.S. Premier companies will require (i) a minimum bid price of $4 for initial qualification and $1 on an ongoing basis; (ii) a minimum market capitalization of $10 million for initial qualification and $5 million on an ongoing basis for companies with a public float of at least $15 million or a minimum market capitalization of $50 million for initial qualification and $35 million on an ongoing basis for companies with a public float of at least $1 million and $750,000 in net income as of the most recent fiscal year end; (iii) stockholders’ equity of $4 million for initial qualification and $1 million for ongoing eligibility; (iv) minimum of 4 market makers with prices quoted on OTC Markets within 90 days of joining; and (v) a minimum of 3 years’ operating history.

The International Premier standards have increased to align with the margin eligibility standards set by the Federal Reserve and SEC. In particular International Premier Companies must have: (i) a global market capitalization of $1 billion for initial qualification and $500 million for ongoing eligibility; (ii) a minimum 5 years’ operating history; (iii) average weekly share volume of 200,000 shares or $1 million for initial qualification and 100,000 shares or $500,000 for ongoing eligibility; and (iv) minimum of 4 market makers with prices quoted on OTC Markets within 90 days of joining.

The annual fee for all companies on the OTCQX has been raised to $20,000.

As part of the changes, the term “OTCQX Advisor” has replaced the current Designated Advisor for Disclosure (DAD) for U.S. companies. I am a qualified approved OTCQX Advisor.

OTCQX

The following is a complete summary of the OTCQX listing standards as they will be in effect on January 1, 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.

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: (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;

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 U.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 U.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 meetings.

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 meetings.

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) U.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 (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 U.S. $2 million if the company has been in continuous operation for at least three years, or U.S. $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, upon 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 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; (iii) 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 (iv) 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 U.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 U.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 U.S. Premier tier, the company must have at least $1 million in stockholders’ equity;

To remain eligible for trading on the OTCQX U.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 (y) continues to satisfy the OTCQX quotation requirements; and (z) 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, upon its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors. In addition, OTC Markets can temporarily suspend trading on the 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

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, 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.

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

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« The Fast Act (Fixing American’s Surface Transportation Act) SEC Guidance On Proxy Presentation Of Certain Matters In The Merger And Acquisition Context »

The Fast Act (Fixing American’s Surface Transportation Act)

Posted by Securities Attorney Laura Anthony | December 15, 2015 Tags: LawCast Network

On December 4, 2015, President Obama signed the Fixing American’s Surface Transportation Act (the “FAST Act”) into law, which included many capital markets/securities-related bills. The FAST Act is being dubbed the JOBS Act 2.0 by many industry insiders. The FAST Act has an aggressive rulemaking timetable and some of its provisions became effective immediately upon signing the bill into law on December 4, 2015.

In July 2015, the Improving Access to Capital for Emerging Growth Companies Act (the “Improving EGC Act”) was approved by the House and referred to the Senate for further action. Since that time, this Act was bundled with several other securities-related bills into a transportation bill (really!) – i.e., the FAST Act.

In addition to the Improving EGC Act, the FAST Act incorporated the following securities-related acts: (i) the Disclosure Modernization and Simplifications Act (see my blog HERE ); (ii) the SBIC Advisers Relief Act; (iii) the Reforming Access for Investments in Startup Enterprises Act; (iv) the Small Business Freedom and Growth Act; and (v) the Holding Company Registration Threshold Equalization Act.

A number of the provisions in the FAST Act that were not self-executing and effective immediately require SEC rulemaking within 30-45 days. This timeline is not realistic for many reasons, including that it would be impossible to comply with the provisions of the Administrative Procedures Act and its requirements related to proposing rules and receiving comments, in that short period of time, not to mention the realities of the holiday season schedule. However, I do expect a quick turnaround from the SEC on drafting, publishing and enacting final rules.

On December 10, 2015, the SEC Division of Corporate Finance addressed the FAST Act by making an announcement with guidance and issuing two new Compliance & Disclosure Interpretations (C&DI). As the FAST Act is a transportation bill that rolled in securities law matters relatively quickly and then was signed into law even quicker, this is the first SEC acknowledgement and guidance on the subject. I suspect more in the near future.

Summary of Securities Law Related Matters Included in the FAST Act

The Improving Access to Capital for Emerging Growth Companies Act

The Improving the EGC Act became Sections 71001-71003 and Section 85001 of the FAST Act. The Improving the EGC Act is a very short bill with specific provisions designed to help smooth the IPO and follow-on offering process for companies qualifying as an EGC, which is most companies completing an IPO in today’s market. The short provisions carry a big impact.

Effective immediately, the Improving EGC Act allows a company to exclude certain historical financial statements from its initial confidential S-1 filing as long as all required financial statements are included in the S-1 filing that will be distributed or available to potential investors. In particular, the Improving EGC Act specifically provides that a confidential registration statement may “omit financial information for historical periods otherwise required by regulation S-X as of the time of filing (or confidential submission of such registration statement, provided that: (A) prior to the issuer distributing a preliminary prospectus to investors, such registration statement is amended to include all relevant periods required at the date of such amendment; and (B) the issuer reasonably believes such financial disclosure will no longer be required to be included in the Form S–1 at the time of the contemplated offering.”

This provision will greatly assist issuers that are timing and planning IPO’s late in their fiscal year. For example, under today’s rules an issuer with a FYE of December 31 that begins to plan an IPO after September 30, 2015, must decide whether to audit the two prior fiscal years (i.e., December 31, 2013 and 2014) and review September 30, 2015, for the filing or wait until the first quarter of 2016 and only audit December 31, 2014 and 2015. In addition to the excess cost of auditing 2013 in this scenario, the issuer must consider that the September 30 financials go stale after 135 days (mid-February), and that taking into account the 3-4 month S-1 review process, it will likely need to update for the 2015 audit prior to going effective in any event. Adding to the considerations is that most issuers do not close out their books until approximately 30 days post FYE (in this case, the end of January to close out books) and an audit takes at least 4 weeks.

Under the new FAST Act in this fact scenario the issuer could file its registration statement with just the 2013 audit and September 30, 2015 reviewed stub period. The stub period would still need to be included even though at the time of effectiveness it is contemplated that this stub period would be replaced with the full 2015 audit.

This timing creates a difficult dilemma on the timing of filing an S-1 for a first or early second quarter IPO. In my office, I feel like we are “doing the timing math” every week for new or contemplated IPO’s. The amendment proposed in the Improving EGC Act will provide real-world assistance to EGC’s and their deal team in preparing for and launching an IPO. Again, this provision became effective immediately on December 4, 2015.

Both of the two issued C&DI’s is on this subject. In particular, the SEC clarifies that you cannot omit stub period financial statements even if that stub period will ultimately be included in a longer stub period or year-end audit before the registration statement goes effective. The SEC clarified that the FAST Act only allows the exclusion of historical information that will no longer be included in the final effective offering. The C&DI clarifies that “Interim financial information “relates” to both the interim period and to any longer period (either interim or annual) into which it has been or will be included.”

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

The Improving EGC Act also reduces the number of days prior to the road show or effectiveness of an S-1 that confidentially submitted S-1 filings must be made public from 21 days to 15 days. The change shortens the time that a company has to wait launch the road show. In particular, An EGC that has used a confidential submission process must publicly file its registration statement and all previously submitted drafts no later than 15 days (rather than 21 days) before conducting a road show. In offerings that do not involve a road show, the public filing must occur at least 15 days before the registration statement goes effective. This provision became effective immediately upon signing of the FAST Act on December 4, 2015. EGCs with initial public offerings pending before the FAST Act became law or at any time thereafter may take advantage of the provision.

Also effective immediately, the Improving EGC Act also allows an issuer that has filed a confidential S-1 as an EGC, but thereafter ceases to be an EGC, to continue to be treated as an EGC until the earlier of: (i) the completion of its initial public offering for which the confidential S-1 was filed; or (ii) one year from the date it ceased being an EGC.

The Improving EGC Act has an equally short and potentially helpful provision effecting follow-on offerings for an EGC. In particular, the Improving EGC Act provides
“FOLLOW-ON OFFERINGS.—An emerging growth company may, within 1 year of the company’s initial public offering, confidentially submit to the Commission a draft registration statement for any securities to be issued subsequent to its initial public offering, for confidential nonpublic review by the staff of the Commission prior to publicly filing a registration statement, provided that the initial confidential submission and all amendments thereto shall be publicly filed with the Commission not later than 2 days before the date on which the emerging growth company issues such securities.”

Although I can think of benefits for all market levels, in the small cap market space in particular, follow-on offerings often include an uplisting to a national exchange or higher tier of such exchange. Allowing confidential submission and review will ease the pressure on the follow-on offering deal team as it works through exchange applications such as NASDAQ or NYSE MKT. On the other hand, a one-year time frame for a follow-on is very short and only high-growth companies will be in a position to take advantage of this new benefit if passed.

As a reminder, the Jumpstart our Business Startups Act (JOBS Act) enacted in April 2012 created a new category of company: an “Emerging Growth Company” (EGC). An EGC is defined as a company with annual gross revenues of less than $1 billion that first sells equity in a registered offering after December 8, 2011. In addition, an EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1 billion in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1 billion in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).

EGC status is not available to asset-backed securities issuers (“ABS”) reporting under Regulation AB or investment companies registered under the Investment Company Act of 1940, as amended. However, business development companies (BDCs) do qualify.

The Disclosure Modernization and Simplifications Act

In early December 2014, the House passed the Disclosure Modernization and Simplification Act of 2014, following which it was bundled into the FAST Act and now passed into law. I previously wrote on this Act HERE ). The Disclosure Modernization and Simplification Act of 2014 became Sections 72001-72003 of the FAST Act.

The Disclosure Modernization and Simplification Act of 2014 requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K (Section 72001); and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for EGCs, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K (Section 72002). In addition, the SEC is required to conduct yet another study on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information (Section 72003).

In particular, Section 72001 of the FAST Act requires the SEC to issue regulations within 180 days permitting issuers to submit a summary page on Form 10-K if each item identified in the summary includes a cross-reference to the relevant information. Section 72002 related to amendments to Regulation S-K has the same 180-day deadline.

Section 72003 requires that the SEC conduct a study of Regulation S-K and provide a detailed report within 360 days.

The bill requests that the SEC emphasize a “company by company approach that allows relevant and material information to be disseminated to investors without boilerplate language or static requirements while preserving completeness and comparability of information across registrants” and “evaluate methods of information delivery and presentation and explore methods for discouraging repetition and the disclosure of immaterial information.”

The Reforming Access for Investments in Startup Enterprises Act

The FAST Act incorporates the new Reforming Access for Investments in Startup Enterprises Act (the “RAISE Act”). The Raise Act is included in Section 76001 of the FAST Act. The RAISE Act is meant to codify the so-called Section 4(a)(1 ½) exemption. See my blog on the Section 4(a)(1 ½) exemption and the SEC Advisory Committee on Small and Emerging Companies recommendation for codification HERE.

The RAISE Act, through the FAST Act, creates a new Section 4(a)(7) of the Securities Act. The new Section 4(a)(7) exemption allows for the resale of securities by shareholders for transactions that meet the following requirements:

Each purchaser is an accredited investor as defined in the Securities Act;

Neither the seller nor any persons acting on the seller’s behalf engages in any form of general solicitation or advertising;

In the case of a non-reporting issuer or an issuer exempt from the reporting requirements pursuant to Rule 12g3-2(b), at the request of the seller, the issuer must provide reasonably current information to the seller and a prospective purchaser;

Current information includes: (i) The issuer’s exact name (as well as the name of any predecessor); (ii) The address of the issuer’s principal place of business; (iii) The exact title and class of the offered security, its par or stated value, and the current capitalization of the issuer; (iv) Details for the transfer agent or other person responsible for stock transfers; (v) A statement of the nature of the issuer’s business that is dated as of 12 months before the transaction date; (vi) The issuer’s officers and directors; (vii) Information about any broker, dealer or other person being paid a commission or fee in connection with the

sale of the securities; (viii) The issuer’s most recent balance sheet and profit and loss statement and similar financial statement for the two preceding fiscal years during which the issuer has been in business, prepared in accordance with GAAP or, in the case of a foreign issuer, IFRS. The balance sheet will be reasonably current if it is as of a date not less than 16 months before the transaction date, and the profit and loss statement shall be reasonably current if it is as of a date not less than 12 months preceding the date of the issuer’s balance sheet. If the balance sheet is not as of a date less than six months before the transaction date, it must be accompanied by additional statements of profit and loss for the period from the dates of such balance sheet to a date less than six months before the transaction date; and (ix) If the seller is an affiliate, a statement regarding the nature of the affiliation accompanied by a certification from the seller that it has no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.

The new Section 4(a)(7) exemption is not available in the following circumstances:

In a transaction where the seller is a direct or indirect subsidiary of the issuer;

If the seller or any person that will be compensated as part of the transaction, including a broker-dealer, is subject to the bad actor disqualifications in Rule 506 of Regulation D or under Section 3(a)(39) of the Exchange Act;

If the issuer is a blank check, blind pool, shell company, SPAC or in bankruptcy or receivership;

Where the transaction relates to a broker-dealer or underwriter’s unsold allotment; or

Where the security being sold is part of a class of securities that has not been authorized and outstanding for at least 90 days prior to the transaction date.

The securities sold in a Section 4(a)(7) resale transaction will be considered “restricted securities” for purposes of Rule 144. Securities sold will be “covered securities” under the NSMIA and therefore will pre-empt state law. A transaction pursuant to this exemption will not be deemed to be a “distribution” under the Securities Act.

Incorporation by Reference in Form S-1 by Smaller Companies

A significant change included in the FAST Act is in Section 84001 that requires the SEC to revise Form S-1 to allow smaller reporting companies to incorporate by reference to both prior and future Exchange Act filings. This is significant as currently smaller reporting companies are specifically prohibited from incorporating by reference and must prepare and file a post-effective amendment to keep a resale “shelf” registration current, which can be expensive. A shelf registration is one that allows continuous sales over a period of time.

Section 12(g) Correction

Section 85001 of the FAST Act amends Section 12(g) of the Securities Exchange Act to add savings and loans to the class of entities subject to the higher threshold registration requirements. Now, both savings and loan companies and banks are not required to register under the Exchange Act unless they have, at the end of the most recent fiscal year, at least $10 million in assets and a class of equity securities held of record by at least 2,000 shareholders. The prior omission of saving and loans was thought to be an inadvertent error in the JOBS Act.

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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« SEC Guidance on Shareholder Proposals and Procedural Requirements OTC Markets Amends Listing Standards For The OTCQX »

SEC Guidance on Shareholder Proposals and Procedural Requirements

Posted by Securities Attorney Laura Anthony | December 8, 2015 Tags: LawCast Network

In late October the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years – Staff Legal Bulletin No. 14H (“SLB 14H”). The legal bulletin comes on the heels of the SEC’s announcement on January 16, 2015, that it would no longer respond to no-action letters seeking exclusion of shareholder proposals on the grounds that the proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders and the same meeting, as further discussed herein. SLB 14H will only allow exclusion of a shareholder proposal if “a reasonable shareholder could not logically vote in favor of both proposals.” As a result of the restrictive language in SLB 14H, it is likely that the direct conflict standard will rarely be used as a basis for excluding shareholder proposals going forward. With the publication of SLB 14H, the SEC will once again entertain and review no-action requests under the “direct conflict” grounds for exclusion.

SLB 14H also provides guidance on the allowable exclusion related to proposals that request actions or changes in ordinary business operations, including the termination, hiring or promotion of employees.

Background

The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.

All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.

The underlying premise of an annual or special meeting is that the company is soliciting the shareholders to vote in favor of particular matters, such as particular directors or particular corporate actions. Accordingly, the proxy is prepared by the company, presenting matters the company’s board of directors have already approved or recommended for approval and has an underlying goal of getting the shareholder to return a proxy card with a “yes” vote. However, Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors, and is accordingly a source of much contention.

Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that meet substantive and procedural requirements to be included in the company’s proxy materials for annual and special meetings, and provide a method for companies to either accept or attempt to exclude such proposals. State laws in general allow a shareholder to attend a meeting in person and, at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process.

As shareholder activism in general has increased, Rule 14a-8 has been the subject of much debate and controversy. This debate and controversy has expanded exponentially since the SEC adopted amendments to the rule to require a company to include in its proxy materials any proposals from qualifying shareholders that would amend, or request an amendment to, a company’s director nomination procedures in its charter documents, as long as such amendment would not conflict with or violate applicable law.

Over the years the SEC has issued guidance on the rule, including Staff Legal Bulletin No. 14 published on July 13, 2001. An entire treatise could be written on Rule 14a-8, including SEC guidance and court interpretation, and this blog is limited to a high-level review. In late October the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years – Staff Legal Bulletin No. 14H. The legal bulletin comes following and was likely motivated by the SEC’s announcement on January 16, 2015, that it would no longer respond to no-action letters seeking exclusion of shareholder proposals on the grounds that the proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders and the same meeting. SLB 14H will only allow exclusion of a shareholder proposal if “a reasonable shareholder could not logically vote in favor of both proposals.”

Shareholder Proposals – Rule 14a-8

Rule 14a-8 of Regulation 14A permits qualifying shareholders to submit matters for inclusion in the company’s proxy statement for consideration by the shareholders at the company’s annual meeting. The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so.

Shareholder Qualification and Procedure

Procedurally to qualify to submit a proposal, a shareholder must:

Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;

If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;

If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;

Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;

Clearly state the proposal and course of action that the shareholder desires the company to follow;

Submit no more than one proposal for a particular annual meeting;

Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;

Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;

If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;

The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.

A proposal that does not meet the procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.

Company Response to Shareholder Proposal

Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC.

If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.

The company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure as discussed above. The company may also seek to exclude the proposal based on substantive grounds, in which case it will may file a no-action letter with the SEC seeking confirmation of its decision and provide a copy of the letter to the shareholder as further discussed below. The company may also seek to exclude the proposal on the grounds of conflict if it follows the procedures set out in the new SLB 14H also as discussed below.

Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal. According to the 2014 Annual Corporate Governance Review released by Georgeson, Inc., approximately 43% of the proposals submitted by shareholders in 2014 were later withdrawn or omitted from the proxy statement and not considered at the annual meeting as a result of these negotiations.

Substantive Requirements and Grounds for Exclusion

If a company seeks to exclude a proposal based on most of the substantive grounds (other than direct conflict under Rule 14a-8(i)(9)), it must seek concurrence from the SEC by utilizing the SEC no-action letter process. That is, the company must submit a no-action letter to the SEC explaining the reasons for excluding the proposal and seeking confirmation that the SEC will not consider the exclusion a violation of Rule 14a-8. The letter must be submitted no later than 80 days prior to filing a definitive proxy statement with the SEC. The shareholder must be provided a copy of the no-action letter submittal and such shareholder has the opportunity to reply to the company and the SEC. The SEC may require agreement with the company’s request to exclude the proposal, require unconditional inclusion of the proposal, or provide for shareholder revision of the proposal as a condition to requiring its inclusion.

The company faces the burden of proving that a particular shareholder proposal may be excluded from the proxy materials. In the no-action process, the SEC will only consider the facts, arguments and information submitted by the company, so it is very important that a company work with company counsel to ensure a comprehensive submittal. Like the registration process, the SEC bases its determination on the disclosure and ultimate information that will be provided to shareholders in proxy statements, as opposed to the underlying merits of the requested shareholder proposal. Moreover, the decision by the SEC in the no-action process is as to whether they would pursue enforcement against the company for a violation of Rule 14a-8 for an exclusion of the proposal, but is not otherwise binding on the company or shareholder.

On January 16, 2015, the SEC announced that it would no longer respond to no-action letters seeking exclusion of shareholder proposals on the grounds that the proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders and the same meeting. With the publication of SLB 14H, the SEC will once again entertain and review no action requests under the “direct conflict” grounds for exclusion.

Rule 14a-8 provides many substantive grounds in which a company may exclude a proposal from the proxy, including if:

The proposal is not a proper subject for shareholder vote in accordance with state corporate law;

The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;

The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;

The proposal would cause the company to publish materially false or misleading statements in its proxy materials;

The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;

The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;

The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees, provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);

The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;

The proposal seeks to disqualify a director nominee or specifically include a director for nomination;

The proposal seeks to remove an existing director whose term is not completed;

The proposal questions the competence, business judgment or character of one or more director nominees;

The company has already substantially implemented the requested action;

The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;

The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;

The proposal seeks to require the payment of a dividend; or

The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.

Staff Legal Bulletin No. 14H

SLB 14H addresses the controversial “direct conflicts” standard for excluding shareholder proposals and provides guidance on the “ordinary business operations” exclusion.

SLB 14H – Direct Conflicts Standard for Exclusion

Beginning in 2009 there has been a substantial increase in proposals and company counterproposals that conflict. In particular, for example, a shareholder could request that the company amend its bylaws to permit shareholders holding 10% of the outstanding stock to hold a special meeting and a company could counter with its own proposal setting a 25% or some other threshold. The company could then seek to exclude the shareholder proposal as conflicting with its own on the same subject.

Last year Whole Foods sought to exclude a shareholder proposal that would allow shareholders owning at least 3% of the outstanding stock for at least 3 years to nominate up to 20% of the directors but no fewer than 2. Whole Foods responded with its own proposal allowing any shareholder that owned at least 9% of the outstanding stock for at least 5 years to nominate 10% of the directors but no fewer than 1. The SEC supported Whole Foods and the shareholder sought reconsideration. The SEC then decided not to address any exclusion requests related on conflicting proposals, including that of Whole Foods. In other words, the SEC bowed out of the fight altogether and spent some time considering its policy. SLB 14H articulates that consideration.

The SEC will only allow exclusion “if a reasonable shareholder could not logically vote in favor of both proposals.” With the publication of SLB 14H, the SEC will once again entertain and review no-action requests under the “direct conflict” grounds for exclusion, with no-action relief only being granted if a reasonable shareholder could not logically vote in favor of both proposals.

The SEC’s view is that the “direct conflict” right to exclude a shareholder proposal is intended to prevent shareholder proposals that, if voted on along with a management proposal, “could present alternative and conflicting decisions for the shareholders and create the potential for inconsistent and ambiguous results.” SLB 14H continues to state that “…we believe that a direct conflict would exist if a reasonable shareholder could not logically vote in favor of both proposals, i.e., a vote for one proposal is tantamount to a vote against the other proposal.” The SEC admits that the burden to exclude proposals articulated in SLB 14H is likely higher than they had historically been requiring in the no-action process. As a result of this higher burden, it is generally believed by practitioners that the direct conflict basis for exclusion will rarely be used.

However, the bulletin does give four examples of application of the new standard for review of such direct conflicts. In particular, a direct conflict would exist where: (i) a company seeks shareholder approval of a merger, and a shareholder proposal asks shareholders to vote against the merger; and (ii) a shareholder proposal that asks for the separation of the company’s chairman and CEO would directly conflict with a management proposal seeking approval of a bylaw provision requiring the CEO to be the chair at all times. Conversely, examples of where no direct conflict would exist include: (i) “a company does not allow shareholder nominees to be included in the company’s proxy statement, a shareholder proposal that would permit a shareholder or group of shareholders holding at least 3% of the company’s outstanding stock for at least 3 years to nominate up to 20% of the directors would not be excludable if a management proposal would allow shareholders holding at least 5% of the company’s stock for at least 5 years to nominate for inclusion in the company’s proxy statement 10% of the directors” and (ii) “a shareholder proposal asking the compensation committee to implement a policy that equity awards would have no less than four-year annual vesting would not directly conflict with a management proposal to approve an incentive plan that gives the compensation committee discretion to set the vesting provisions for equity awards.”

The SEC provides guidance on how a company can manage potentially confusing and conflicting proposals that do not rise to the high standard of a direct conflict to support exclusion. In particular, footnote 22 to SLB 14H states: “[W]here a shareholder proposal is not excluded and companies are concerned that including proposals on the same topic could potentially be confusing, we note that companies can, consistent with Rule 14a-9, explain in the proxy materials the differences between the two proposals and how they would expect to consider the voting results. As always, we expect companies and proponents to respect the Rule 14a-8 process and encourage them to find ways to constructively resolve their differences.”

SLB 14H – “Ordinary Business Operations” Standard for Exclusion

SLB 14H provides guidance on the “ordinary business operations” exclusion. Rule 14a-8(i)(7) allows the exclusion of a shareholder proposal where the proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees, provided, however, that proposals may relate to succession planning for a CEO. The “ordinary business operations” basis for exclusion has also been the subject of debate and adversarial proceedings.

In the recent Trinity Wall Street v. Wal-Mart Stores, Inc. ruling by the U.S. District Court in Delaware, the shareholder proposal requested that the board assign a committee the responsibility of “overseeing the formulation, implementation, and public reporting of policies that determine whether the company should sell a product that especially endangers public safety and well-being, has the potential to impair the company’s reputation, or would be considered offensive to the values integral to the company’s brand.” The SEC supported the company’s exclusion of the proposal as being the subject of ordinary course of business matters; however, the court sided with the shareholder and concluded that the proposal was improperly excluded.

The court found that “because the proposal merely sought board oversight of the development and implementation of a company policy, leaving day to day aspects of implementation of this policy to the company’s officers and employees, the proposal itself did not have the consequence of dictating what products Wal-Mart could sell.” The SEC, in contrast, had considered whether the underlying issue involved ordinary business matters and determined in this case that it did. The company appealed the court decision and the court of appeal overruled the Delaware court, supporting both the SEC’s no-action decision and Wal-Mart’s right to exclude the proposal.

The appellate court agreed with the SEC and Wal-Mart that the proposal’s subject matter related to Wal-Mart’s ordinary business operations – specifically, “a potential change in the way Wal-Mart decides which products to sell.” SLB 14H reiterates that the SEC analysis related to the request to exclude proposals under the ordinary business exclusion focuses on the underlying subject matter of a proposal. The SEC recognizes that it is not always easy to determine if a proposal transcends ordinary business operations and actually relates to significant policy issues, and thus cannot be excluded under the ordinary course of business exclusion rule. That is, even though a shareholder may present a proposal as being one that addresses a significant policy issue, including social policies, the SEC will look beyond that presentation to determine if the proposal is in fact related to ordinary business operations. Summarizing its position, the SEC quotes the court “whether a proposal focuses on an issue of social policy that is sufficiently significant is not separate and distinct from whether the proposal transcends a company’s ordinary business. Rather, a proposal is sufficiently significant ‘because’ it transcends day-to-day business matters.”

I note that although SLB 14H may be attempting to provide further guidance on the subject, the distinction and interrelationship between significant policy decisions and daily business operations remains complex and will continue to be subject to difficult interpretation.

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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« SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part II- Rules 504 And 505 The Fast Act (Fixing American’s Surface Transportation Act) »

SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part II- Rules 504 And 505

Posted by Securities Attorney Laura Anthony | December 1, 2015 Tags: LawCast Network

On October 30, 2015, the SEC published proposed rule amendments to facilitate intrastate and regional securities offerings. The SEC has proposed amendments to Rule 147 to modernize the rule and accommodate adopted state intrastate crowdfunding provisions. In addition, the SEC has proposed amendments to Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad actor disqualifications from reliance on the rule. The SEC has also made technical amendments to Rule 505 of Regulation D.

In Part I of the blog, I discussed the Rule 147 amendment, and in this Part II will discuss the changes to Rules 504 and 505. I have never really written about either Rules 504 or 505 in the past, the simple reason being that they are rarely used exemptions. Perhaps with the current proposed changes, Rule 504 will have a new life. I do not think Rule 505 will gain favor, and in fact, as part of the rule release the SEC is seeking comment as to whether Rule 505 should simply be eliminated.

Overview

Currently Rule 504 of Regulation D provides an exemption from registration for offers and sales up to $1 million in securities in any twelve-month period. Current Rule 504, like Regulation A/A+, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or blank check companies. Moreover, current rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

Rules 504, 505 and 506 together comprise Regulation D. Rule 506 is promulgated under Section 4(a)(2) of the Securities Act and preempts state law. Rules 505 and 506 are promulgated under Section 3(b) of the Securities Act and do not preempt state law. Currently Rules 505 and 506 have bad actor disqualification provisions but Rule 504 does not.

The vast majority of states require the registration of Rule 504 offerings. Rule 504 is similar to the Intrastate Offering found in Section 3(a)(11) in that on the federal level it defers to state legislation and oversight. In fact, of the 29 states that have recently passed state-based crowdfunding exemptions, Maine specifically allows an issuer to rely on Rule 504 in utilizing its crowdfunding provisions.

As Rule 504 is in essence a deferral to the states for small offerings, the SEC is of the position that it does not warrant imposing extensive regulation on the federal level. I agree. As stated by the SEC, the purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions and general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Proposed Amendments

The SEC has proposed to increase the amount of securities that may be offered and sold in reliance on Rule 504 to $5 million in any 12-month period, and to add bad actor disqualification provisions to the rule. The SEC believes the change will help facilitate capital formation and give states greater flexibility in developing state-coordinated review programs for multi-state registrations. The proposed rule also corrects the technical reference to Section 3(b) of the Securities Act in the current Rules 504 and 505 to Section 3(b)(1), which change was made by the JOBS Act in 2012.

The proposed bad actor disqualification provisions are substantially the same as those in place for Rule 506 offerings. For a review of the Rule 506 bad actor disqualification provisions, 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.

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« SEC Advisory Committee Recommendations Related To Finders SEC Guidance on Shareholder Proposals and Procedural Requirements »

SEC Advisory Committee Recommendations Related To Finders

Posted by Securities Attorney Laura Anthony | November 24, 2015 Tags: LawCast Network

On September 23, 2015, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding the regulation of finders and other intermediaries in small business capital formation transactions. This is a topic I have written about often, including a recent comprehensive blog which can be read HERE.

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

The Advisory Committee discussed the topic at its meetings on June 3, 2015 and again on July 15, 2015 before finalizing its recommendations, which were published on September 23, 2015. In formulating its recommendations, the Advisory Committee gave specific consideration to the following facts:

The Advisory Committee made four recommendations related to the regulation of finders and other intermediaries in small business capital formation transactions, which I support but have doubts as to the realistic implementation. In particular:

The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act.

The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level.

The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and

The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

Advisory Committee Considerations in Support of Its Recommendations

The Advisory Committee Letter lists practical facts and realities related to small business and emerging company capital formation in support of its recommendations. In particular:

Small businesses account for the creation of two-thirds of all new jobs, and are the incubators of innovation, generating the majority of net new jobs in the last five years and continuing to add more jobs;

Early-stage capital for these small businesses is raised principally through private offerings that are exempt from registration under the Securities Act of 1933 and state blue sky laws;

More than 95% of private offerings rely on Rule 506 of Regulation D; however, less than 15% of those use a financial intermediary such as a broker-dealer. This is due in part to a lack of interest from registered broker-dealers given the legal costs and risk involved in undertaking a small transaction, ambiguities in the definition of “broker” and the danger of using unregistered finders. (For more on the topic of incentives for broker-dealers to work with smaller offerings, see my blog HERE.

As documented in the findings of an American Bar Association Business Law Section Task Force in 2005 and endorsed by the SEC Government Business Forum on Small Business Capital Formation: (i) failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies; (ii) the current broker-dealer registration system and FINRA membership process is a deterrent to meaningful oversight; (iii) appropriate regulation would enhance economic growth and job creation; and (iv) solutions are achievable through SEC leadership and coordination with FINRA and the states. For more on the ABA Task Force study, see my blog HERE.

The Advisory Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protections and safeguards on private placement intermediaries with limited activities that do not hold customer funds or securities and deal only with accredited investors, would enhance capital formation and promote job creation.

My Thoughts

I’m practically jumping up and down with excitement that the Advisory Committee gets the issues and is discussing the matter from an overarching theoretical top-down standpoint. To create a workable system, there first has to be a general mapping and understanding of the directional goals. However, my excitement turns realistic, and unfortunately pessimistic, at the thought of the states, FINRA and the NASAA working together to find and actually implement a comprehensive regulatory solution.

Despite the SEC support for the NASAA coordinated review program to simplify the state blue sky process for securities offerings, such as under Tier 1 of Regulation A+, only 43 states participate. I say “only” in this context because the holdouts – including, for example, Florida, New York, Arizona and Georgia – are extremely active states for small business development and private capital formation. Moreover, even using the coordinated review program, the states have vastly different rules and interpretations of the same rules. See my blog HERE for further discussion.

I simply am an advocate for federal over state regulation on securities law matters. Rather than requiring state registration, I would simply create a federal exemption to the broker-dealer registration requirements for finders provided that:

The offering was being made in reliance on an exemption from the Securities Act registration requirements which exemption also exempts state law under the NSMIA (such as Rule 506 of Regulation D or Tier 2 of Regulation A+);

All offers and sales are limited to accredited investors;

The finders do not hold customer funds or securities;

The issuers and finders have disclosure requirements related to the role of the finder and compensation being paid (similar to Section 17(b) disclosure requirements under the Securities Act); and

The finders have liability for violations of the anti-fraud provisions by the issuers to the same extent as underwriter liability.

Of course, issuers would remain subject to all of the current anti-fraud provisions of the private offering exemption laws and thus would be responsible for the representations and actions of their finders, as they are now. Allowing an “above the line” profession of finders to develop will naturally create an environment where those finders that engage in unscrupulous methods will be easily identified and avoided.

For a review of the NSMIA and state blue sky laws, see my two-part blog HERE and HERE.

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 OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. 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 producer and host of LawCast, 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 Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1 SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part II- Rules 504 And 505 »

SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1

Posted by Securities Attorney Laura Anthony | November 17, 2015 Tags: LawCast Network

On October 30, 2015, the SEC published proposed rule amendments to facilitate intrastate and regional securities offerings. This rule proposal comes following the September 23, 2015, Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) recommendation to the SEC regarding the modernization of the Rule 147 Intrastate offering exemption. The SEC has proposed amendments to Rule 147 to modernize the rule and accommodate adopted state intrastate crowdfunding provisions. The proposed amendment eliminates the restriction on offers and eases the issuer eligibility requirements, provided however the issuer must comply with the specific state securities laws. In addition, the SEC has proposed amendments to Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad actor disqualifications from reliance on the rule. Finally, the SEC has made technical amendments to Rule 505 of Regulation D.

In this Part I of the blog, I will discuss the Rule 147 amendment and in Part II, I will discuss the changes to Rules 504 and 505.

Background on Rule 147 and Rationale for Amendments

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption.

Rule 147 as it exists is a safe harbor promulgated under Section 3(a)(11) and provides further details on the application of the Intrastate Exemption. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.

Rule 147 was adopted in 1974 and has not been updated since that time. Rule 147 has limitations that simply do not comport with today’s world. For example, the rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.

Also, the current Rule 147 requires that an issuer be incorporated in the state in which the offering occurs. In today’s world, many companies incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, the current Rule 147 requires that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be unduly burdensome.

The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the current statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 make it difficult for issuers to take advantage of these new state crowdfunding provisions.

Recently the SEC Advisory Committee on Small and Emerging Companies made recommendations to the SEC related to amendments to the Rule 147 Intrastate offering exemption. The Advisory Committee made the following specific recommendations to modernize Rule 147:

Allow for offers made in reliance on Rule 147 to be viewed by out-of-state residents but require that all sales be made only to residents of the state in which the issuer has its main offices;

Remove the need to use percentage thresholds for any type of issue eligibility requirements and evaluate whether alternative criteria should be used for determining the necessary nexus between the issuer and the state where all sales occur; and

Eliminate the requirement that the issuer be incorporated or organized in the same state where all sales occur.

Considering the Advisory Committee’s recommendations, as well as those of other market participants, the SEC has published proposed Rule 147 amendments related to intrastate offerings, and Rule 504 related to intrastate and regional offerings.

The proposed rule changes generally: (i) eliminate the offer restrictions while continuing to require that sales be made only to residents of the issuer’s state; (ii) redefine “intrastate offering” to ease some issuer eligibility requirements; (iii) limit the availability of the Rule 147 exemption to offerings that are either registered or exempt at the state level and which offerings are limited to no more than $5 million; (iv) amend Rule 504 to increase the aggregate offering amount from $1 million to $5 million and to add bad actor disqualifications from reliance on the rule; and (v) make technical conforming amendments to Rule 505.

Proposed Rule Amendments

The proposed amendments to Rule 147 will allow an issuer to engage in any form of general solicitation or general advertising, including the use of publicly accessible websites, to offer and sell its securities, so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located. Moreover, the offering must be either registered or exempt in the state in which all of the purchasers are resident, and the state registration or exemption provision must limit the amount of securities an issuer may sell to no more than $5 million in a twelve-month period. Furthermore, the state statue must impose an investment limitation on investors. The proposed amendments define an issuer’s principal place of business as the location in which the officers, partners, or managers of the issuer primarily direct, control and coordinate the activities of the issuer and further require the issuer to satisfy at least one of four threshold requirements that would help ensure the in-state nature of the issuer’s business.

Interestingly, by amending Rule 147 to allow issuers that are not incorporated in a particular state to participate in intrastate offerings, the rule will no longer comply with the statutory provisions of Section 3(a)(11). Rather than amend Section 3(a)(11), the SEC is relying on its general authority under Section 28 of the Securities Act and making Rule 147 a stand-alone intrastate offering exemption that would no longer be a safe harbor or promulgated under Section 3(a)(11).

Section 3(a)(11) will remain a separate exemption for companies that wish to rely on its provisions, though practically speaking, I believe it will likely be rarely used, if ever.

In its rule release, the SEC points out that if the new rule is adopted in its proposed form, most states will need to amend their current intrastate offering exemptions to fully avail themselves of the new rule. In doing so, the states would be free to impose additional requirements or restrictions as deemed necessary or appropriate to facilitate local capital formation and investor protection.

Amendment to “Offer” Restrictions

Currently Rule 147 does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule. One of the main concepts behind crowdfunding is the ability to use the internet and social media to solicit the crowd for an investment. Accordingly, state regulators and practitioners were concerned that internet advertisements made in accordance with state crowdfunding provisions would violate Rule 147.

To help alleviate the problem, the SEC issued guidance in its Compliance and Disclosure Interpretations (C&DI’s) addressing the ability to advertise using the internet or social media in a state crowdfunding offering; however, the “offer” restriction remained.

Rule 147 as amended requires issuers to limit sales to in-state residents but no longer limits offers to in-state residents. Amended Rule 147 will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon. As offers are not limited but sales are, all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state.

Determining Whether an Issuer is a “Resident” of, and Doing Business in, a Particular State

Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual.

This provision is problematic in today’s corporate world, where many entities decide to incorporate in a particular state, such as Nevada or Delaware, for valid business purposes, even though all of their operations and offices may be located in a different state. The SEC agrees that the state of entity formation should not affect the ability of an issuer to be considered a “resident” for purposes of an intrastate offering exemption at the federal level.

Accordingly, the proposed rule amendment eliminates the requirement related to state of incorporation while continuing to require that an issuer have its principal place of business in the offering state. In addition, the issuer must satisfy at least one of a list of four other requirements meant to satisfy the residence requirement. In particular, the issuer will need to meet one of the three 80% thresholds or the new majority-of-employees threshold test.

Under the current Rule 147, an issuer shall be deemed to be doing business within a state if the issuer meets ALL of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; and (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state. In addition, under the current rule, the principal office of the issuer must be located within that state.

The new rule retains the three 80% threshold tests and even adds a fourth threshold based on the location of a majority of the issuer’s employees. Presumably a majority is satisfied by a greater than 50% determination. However, instead of having to comply with all of the threshold tests, the issuer need only comply with one of the four tests, in addition to maintaining its principal place of business in the state.

The amended Rule 147 further simplifies the “doing business in” standard by only requiring that the issuer’s principal place of business be in the subject state regardless of where its principal office is located. An issuer’s “principal place of business” will be defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” Issuers will be required to either register the offering in the state where all the purchasers are located or rely on a state registration exemption that limits the amount of the offering to no more than $5 million in any 12-month period and imposes investment limitations on investors. I note that concurrent with the proposed Rule 147 rule release, the SEC has proposed to increase the offering limit under Rule 504 to $5 million, allowing Rule 147 and Rule 504 to work together as an Intrastate Offering Exemption.

As discussed below, securities will need to “come to rest” in the hands of purchasers before resales will be allowed. Similarly, if an issuer changes its principal place of business to a new state, it would not be able to conduct an intrastate offering in reliance on Rule 147 in the new state until the securities sold in the prior state had “come to rest” in the hands of the purchasers. The “come to rest” period, both for resales and for second intrastate offerings, shall be a period of 9 months.

As with all provisions of the new Rule 147, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

Currently under Rule 147, all offers, offers to sell, offers for sale and sales of securities in an intrastate-exempted offering must be made to residents of the state in which the offering is conducted. For the purpose of determining the residence of an offeree or purchaser: (i) a corporation, partnership, trust or other form of business organization shall be deemed to be a resident of a state if, at the time of the offer and sale, it has its principal office within such state; (ii) an individual shall be deemed to be a resident of a state if, at the time of the offer and sale, his or her principal residence is within that state; and (iii) a corporation partnership, trust or other form of business organization formed specifically to take part in an intrastate offering will not be resident of the state unless all of its beneficial owners are residents of that state.

The new proposed rule adds a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. In shifting the responsibility to require a reasonable belief as to residency, the SEC is eliminating the current requirement that the investor provide a written representation as to residency. The view is that a self-attestation from an investor, without more, is not enough to create a reasonable belief and so that technical requirement would not add to the rule, and in fact could deter as it would allow issuers to believe that they could rely on such written statement.

The SEC provides examples of proof of residency. For individuals, proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the Intrastate Offering. Market makers or dealers desiring to quote such securities after the nine-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information. Moreover, Rule 147 specifically requires the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Currently, in the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence.

The proposed new Rule 147 provides that for a period of nine months from the date of sale to a particular purchaser, any resale by that purchaser may be made only to persons resident with the state of the offering. Accordingly resales out of state may only be made after the nine-month holding period. To ensure enforcement, an issuer must place a legend on the securities and stop transfer instructions to the transfer agent.

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Current Rule 147(b)(2) provides an integration safe harbor. That is, offerings made under Section 3 or Section 4(a)(2) of the Securities Act or pursuant to a registration statement will not be integrated with an Intrastate Exemption offering if such offerings take place six months prior to the beginning or six months following the end of the Intrastate Exemption offering. To rely on this safe harbor, during the six-month periods, an issuer may not make any offers or sales of securities of the same class as those offering in the intrastate offering. Rule 147(b)(2) is merely a safe harbor. Issuers and practitioners may still conduct their own analysis in accordance with the five-factor test enumerated above.

The proposed new Rule 147 amends the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, under the proposed rule, offers and sales under Rule 147 would not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering. The rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test.

Disclosure/Legend Requirements

Current Rule 147 requires written disclosure on resale limitations and requires that stop transfer instructions be given to the issuer’s transfer agent. The new rule retains the requirement but provides more definitive instruction. In particular, a written disclosure would need to be given to each offeree and purchaser at the time of any offer or sale. However, the disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser.

The Author

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

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

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

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« Mergers And Acquisitions; Appraisal Rights SEC Advisory Committee Recommendations Related To Finders »

Mergers And Acquisitions; Appraisal Rights

Posted by Securities Attorney Laura Anthony | November 10, 2015 Tags: LawCast, LawCast Network, LawCast-2, lawcast-3, Merger Agreement, mergers & Acquisitions

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 to 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. As with all corporate law matters, the Delaware legislature and courts lead the way in setting standards and precedence.

Delaware Statutory Appraisal Rights

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.

Moreover, 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. The following is a high-level summary of the detailed procedures and process required by the company and stockholders where appraisal rights are available and where the stockholder desires to avail itself of such rights.

Except in share exchange transactions where all shareholders are a direct party to the transaction and transaction documents, stockholders of a corporation that is being acquired in a merger transaction have a statutory right to a court appraisal of the fair value of their shares. Dissenting stockholders may seek this judicial determination as an alternative to accepting the merger consideration being offered in the transaction negotiated by the company’s board of directors.

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.

Where an action allowing for appraisal rights is to be voted on by stockholders, the corporation must give written notice to its stockholders as of the meeting notice record date, not less than 20 days prior to the meeting. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must (i) deliver a written demand to the company for appraisal prior to the taking of the stockholder vote on the merger (or, in the case of a short-form merger or a merger approved by a written consent of stockholders, within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger), (ii) file a petition with the Delaware Court of Chancery within 120 days after the effective date of the merger, and (iii) serve a copy of such petition on the corporation surviving the merger. Within 10 days of the effective date of the merger, the surviving corporation must give each stockholder that has elected appraisal rights, and not thereafter voted for or consented to the merger, notice of such merger effective date.

Where an action allowing for appraisal rights is approved without a vote by stockholders, within 10 days of the approval the corporation shall notify each of the stockholders who are entitled to appraisal rights of the approval of the merger and that appraisal rights are available. If already completed, the notice shall include the effective date of the merger. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must deliver a written demand to the company for appraisal within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger. Thereafter the same procedures will apply as when approval was by a vote of stockholders.

At the hearing the court will determine the stockholders that have properly complied with the statute and are entitled to appraisal rights. Once it is determined which stockholders are entitled to an appraisal, the court will proceed with the substantive process of determining fair value. The statute requires that in determining such fair value, the court shall take into account all relevant factors (see the discussion below regarding the substantive fair value determinations).

Unless the court has good cause and determines otherwise, interest of 5% above the Federal Reserve discount rate shall accrue on the fair value of the shares from the date of the merger until the date paid. The court also has the statutory right to grant or deny the recovery of attorney’s fees and costs to a petitioning shareholder. From and after the effective date of the merger, stockholders who have demanded appraisal rights are not entitled to vote their shares or to receive any dividends or other distributions (including the merger consideration) on account of these shares unless they properly withdraw their demand for appraisal.

Dependent on the consideration to be received, appraisal rights are not available for (i) shares of the corporation surviving the merger if the merger does not require the approval of the stockholders of such corporation and (ii) shares of any class or series that is listed on any national security exchange or held of record by more than 2,000 holders. In particular, these exceptions do not apply if the holders of such shares are required to accept in the merger any consideration other than (i) shares of stock of the corporation surviving or resulting from the merger or consolidation, (ii) shares of stock of any other corporation that will be listed on a national securities exchange or held of record by more than 2,000 holders, (iii) cash in lieu of fractional shares, or (iv) any combination of the foregoing. In addition, these exceptions do not apply in respect of shares held by minority stockholders that are converted in a short-form parent subsidiary merger.

Section 262 of the DGCL also allows for a corporation to include in its certificate of incorporation the same merger appraisal rights for (i) amendments to the certificate of incorporation and (ii) the sale of all or substantially all of the assets of the corporation.

Determining Fair Value; The Longpath and Merion Capital Cases

On October 21, 2015, in Merion Capital LP v. BMC Software, Inc., the Delaware Court of Chancery rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. The Merion opinion is consistent with the June 30, 2015, Delaware Court of Chancery opinion which also rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. In Merion Capital and Longpath Capital, LLC v. Ramtron Int’l Corp., the Delaware court continued its recent consistent record of upholding 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. In this case, the merger price followed several rejected bids, an active solicitation of other potential buyers, and a three-month hard bargaining process.

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. Courts unanimously give greater, and usually 100%, weight to the merger price where the merger negotiation process was adequate.

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. In this case, the court rejected the DCF analysis presented by the parties’ experts in the litigation as based on unreliable management projections. Although a DCF analysis is often used in litigation to challenge the merger price, as with the Longpath case, the Delaware courts will not give much weight to a DCF model based on management-prepared projections where such projections are prepared outside the ordinary course of business such as in response to a hostile takeover bid, other potential transaction or for use in litigation. Moreover, even where management projections are prepared in the ordinary course, the courts will consider the process used, assumptions made and the experience of management in preparing such projections as well as other qualitative and quantitative standards as to their reliability.

In addition to being skeptical regarding the weight to be given a DCF analysis, courts will likewise be skeptical regarding comparable transactions. In reviewing comparable transactions, courts will consider the types of companies involved, multiples used in each industry, and basic business realities.

Prior to the recent slew of cases upholding merger price as the best indication of value, the seminal case on appraisal rights was Weinberger v. UOP, 457 A.2d 701 (Del. 1983), which held that a proper valuation approach “must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.” The Weinberger court also held that the valuation should include elements of future value that are known or susceptible to proof, excluding only speculative elements. Following Weinberger the DCF model gained in popularity with the Delaware courts. As discussed above, recently the DCF model has been losing ground in favor of the merger price itself where the price is achieved following a fair and adequate process in an arm’s length transaction.

Managing Risks Associated with Appraisal Rights

The best way to manage risks associated with the appraisal process, and all aspects of the merger itself, is to pay meticulous attention to the process. The board of directors should utilize legal and financial advisors and delve into information gathering, analytical and deliberative processes and the manner in which they are documented in order to ensure that a defensible record is produced. See also my blog related to directors’ responsibilities in the merger process and the importance of the process itself, HERE.

Careful attention must be paid to the disclosure documents provided to stockholders related to the transaction. The document should include a thorough description of all relevant facts that support the fairness of the merger consideration. Relevant facts include, among other matters, historical operating results and future prospects, competitive and other risks, levels of liquidity and capital resources, internal and external indicia of value, efforts to explore strategic alternatives and the results thereof, opportunities for interested parties to submit competing acquisition proposals, and fairness opinions obtained from financial advisors and supporting analyses. Of course, as with all anti-fraud considerations, the document cannot misstate or omit material facts and information.

Hedging in Merger Transactions

There has been a recent dramatic increase in appraisal rights actions filed by shareholders that purchase shares after the record date of the relevant transaction. That is, it appears that a group of investors are hedging on merger transactions and utilizing the appraisal process as part of their hedging strategy. An interesting paper and analysis by the The Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Appraisal Arbitrage – Is There a Delaware Advantage” sets forth a well thought out theory as to why this investment strategy may be profitable to arbitrageurs. Here is a brief summary of the theory and for those interested in learning more about this theory, I encourage reading the entire paper.

First, Delaware allows shareholders to pursue appraisal rights even if they purchase shares after the record date for voting on the transaction. Investors can delay their investment decision until they have a better idea of valuation of the target. Moreover, by delaying the investment decision to as close as possible to the closing date, investors can minimize or even eliminate the risk that the deal will not close.

Second, many courts give preference to the DCF analysis valuation method. However, investment bankers advising on M&A deals tend to be more conservative. The paper points out that in a review of sample deals, nearly two-thirds of the time there was a differential between valuation used by investment bankers in providing fairness opinions to parties in an M&A transaction and fair values determined by the Delaware Courts. Investors have an opportunity to take advantage of this spread.

Third, the Delaware statute requires the court to determine a point estimate rather than a range of fair value. Accordingly, transactions completed at the low end of the DCF value range have a greater chance of a court determining that the fair value is higher, even if only by a few points.

Finally, the Delaware statutory rate for successful petitioner in an appraisal rights action is higher than the current yield on U.S. Treasury Bonds, thus creating a potential economic incentive for arbitrageurs.

The Author

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

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

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« The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1 »

The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance

Posted by Securities Attorney Laura Anthony | November 3, 2015 Tags: fasb proposed guidance, materiality standard, nyse amends rules

The recent increase in regulatory activity and marketplace discussion on the topic of disclosure has not been limited to the small business arena or small cap marketplace. Effective September 28, 2015, the New York Stock Exchange (“NYSE”) amended its Rule 202.06 of the NYSE Listed Company Manual, which governs the procedures that listed companies must follow for the release of material information. Also, the Financial Accounting Standards Board (FASB) has issued two exposure drafts providing guidance and seeking comments on the use of materiality to help companies eliminate unnecessary disclosures in their financial statements and to determine what is “material” for inclusion in notes to the financial statements. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB.

NYSE Rule 202.06 Amendment

As published in the federal register, the NYSE proposes to amend Section 202.06 of the Manual to “(i) expand the premarket hours during which listed companies are required to notify the Exchange prior to disseminating material news, and (ii) provide the Exchange with authority to halt trading (a) during pre-market hours at the request of a listed company, (b) when the Exchange believes it is necessary to request certain information from listed companies, and (c) when an Exchange-listed security is also listed on another national or foreign securities exchange and such other exchange halts trading in such security for regulatory reasons. The Exchange also proposes to amend Section 202.06 of the Manual to provide guidance related to the release of material news after the close of trading on the Exchange.”

In particular, the amendment extends pre-market notification hour requirements to 7:00 a.m. Eastern Time prior to disseminating material news. Currently listed companies are only required to notify the NYSE a minimum of 10 minutes before they release material news “shortly before the opening or during market hours.” Market hours begin at 9:30 a.m. Eastern Time. With the amendment, a listed company will be required to comply with the “Material News Policy” and notify the NYSE at least 10 minutes before disseminating material news between 7:00 a.m. and 4:00 p.m. Eastern Time. The NYSE notes that most companies release news related to corporate actions and other material events between 7:00 a.m. and 9:30 a.m. Material news has the potential to cause volatility in both price and volume and accordingly, the purpose of the rule is to allow the NYSE the opportunity to halt trading in certain circumstances, including where it needs to obtain more information about the news release.

The amendment includes an advisory from the NYSE requesting that listed companies delay the release of material news after the close of trading until the earlier of (i) publication of the company’s official closing price on the NYSE or (ii) 15 minutes after the close of trading on the NYSE. This request is intended to facilitate an orderly closing process to trading on the NYSE. The advisory does not require that listed companies delay the release of material news but does make the advisory suggestion. Companies are still technically allowed to release news promptly at 4:00 p.m. upon market close when they deem appropriate.

Rule 202.06, as amended, will continue to require that listed companies release material news to the public by the “fastest available means.” The amendment contains a statement that listed companies generally will be required to either (i) include the news in a Form 8-K or other SEC filing or (ii) issue the news in a press release to major news wire services, including, at a minimum, Dow Jones & Company, Inc., Reuters Economic Services, and Bloomberg Business News. Listed companies that comply with current NYSE requirements should not need to change their practices for publicly releasing material information as a result of this clarification. The amendment also removes a variety of outdated references, such as references suggesting that telephone, fax, and hand delivery are acceptable means of releasing material news under NYSE rules.

The amendment also includes clarification as to the imposition of NYSE trading halts both during pre-market and regular market hours. The amendment will allow the NYSE to institute a trading halt before the opening of trading for the release of material news at the request of the listed company. It is believed that the company itself has the greatest insight as to whether a trading halt would be appropriate in light of the news it intends to release.

Although a pre-market trading halt may only be imposed at the request of the company, the amendment will also allow the NYSE to temporarily halt trading to facilitate an orderly opening process, if it appears that the dissemination of material news will not be complete prior to the opening of trading on the NYSE. Upon the NYSE’s implementation of a trading halt, other national securities exchanges, some of which maintain trading hours starting as early as 4 a.m., will also halt trading in the listed company’s security. Nasdaq Stock Market Rule 4120(a)(1) includes similar provisions with respect to trading halts between the hours of 4 a.m. and 9:30 a.m.

Moreover, the amendment will provide that if a listed company releases material information during NYSE trading hours, the NYSE may halt trading and may request additional information from the company relating to (i) the material news, (ii) the listed company’s compliance with NYSE continued listing requirements or (iii) any other information necessary to protect investors and the public interest. If the NYSE halts trading under these circumstances, it may continue the trading halt until it has received and evaluated the additional information provided by the company. Prior to the amendment, Rule 202.06 limited the NYSE’s authority to halt trading to situations in which a listed company intended to release material news during market hours. Nasdaq Stock Market Rule 4120(a)(5) is similar to this portion of Rule 202.06, as amended.

FASB GUIDANCE

FASB has issued two exposure drafts seeking comment and providing guidance on the use of materiality to help companies eliminate unnecessary disclosures in their financial statements and to determine what is “material” for inclusion in notes to the financial statements. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB.

Financial reporting concepts are complex and generally are determined with the guidance of the company’s Chief Financial Officer, outside accountant and ultimately with comment and input from the independent accountant/auditor. However, legal counsel often does and should advise on concepts and facts which underlie the disclosure decisions and help guide management in making appropriate determinations. Accordingly, it is important that public company legal counsel have an understanding of the basics of financial disclosure and underlying principles and concepts, including the basics of GAAP accounting. In fact, the exposure draft for Qualitative Characteristics of Useful Financial Information completely defers to legal concepts in determining materiality. This firm’s team is strong in that regard.

The first exposure draft is “Qualitative Characteristics of Useful Financial Information” and was issued September 24, 2015 with a comment cutoff date of December 8, 2015. The main purpose of the proposed amendments in this release is to ensure that the materiality concepts discussed by FASB align with the legal concept of materiality. In fact, the release defers the materiality concept to a question of legality rather than accounting.

In particular, the proposed amendment includes the addition of the following language:

“Materiality is a legal concept. In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality. Currently, the Board observes that the U.S. Supreme Court’s definition of materiality, in the context of the antifraud provisions of the U.S. securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information. [TSC Industries, Inc. v. Northway, Inc.] Consequently, the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.”

As can be seen, FASB is taking the approach of a complete deferral to the legal concept of materiality, including the U.S. Supreme Court’s interpretation.

The second exposure draft is “Notes to Financial Statements” and was issued September 24, 2015 with a comment cutoff date of December 8, 2015. The main purpose of the proposed amendments is to promote discretion on behalf of the board of directors of a reporting company in determining what disclosures are material and relevant to their particular company and circumstances. This release, together with the “Qualitative Characteristics of Useful Financial Information” discussed above, both further FASB’s recognition that (1) additional explanation about how to appropriately consider materiality or entity-specific relevance in deciding which information to provide in the notes could be effective in reducing or eliminating irrelevant disclosures; and (ii) a reduction in volume of immaterial information would improve the effectiveness of the notes to financial statements.

FASB is aware of the issues that either prevent or inhibit the reductions in disclosures—in particular: (i) the requirement to communicate omissions of immaterial disclosures as an “error” to the audit committee (and thus making it easier to disclose than defend non-disclosure); (ii) litigation concerns (especially from activist shareholder groups); (iii) possible internal control changes required to support added discretion on disclosure; and (iv) possible SEC comments (again making it easier to disclose than defend non-disclosure).

The proposed amendments in the exposure draft would (i) allow for quantitative and qualitative considerations of materiality in determining disclosures and recognizing that some, all or none of the requirements in a disclosure section may be material (or not) to a particular company; (ii) refer to materiality as a legal concept; and (iii) state specifically that an omission of immaterial information is not an accounting error. The proposed amendment would also make conforming changes to the Accounting Standards Codification, including cross-referencing updates.

General Commentary on Materiality

The disclosure requirements at the heart of the federal securities laws involve a delicate and complex balancing act. Too little information provides an inadequate basis for investment decisions; too much can muddle and diffuse disclosure and thereby lessen its usefulness. The legal concept of materiality provides the dividing line between what information companies must disclose, and must disclose correctly, and everything else. Materiality, however, is a highly subjective standard, often colored by a variety of factual presumptions.

The guiding purpose of the many and complex disclosure provisions of the federal securities laws is to promote “transparency” in the financial markets. However, the task of winnowing out the irrelevant, redundant and trivial from the potentially meaningful material falls on corporate executives and their professional advisors in the creation of corporate disclosure, and on investment advisors, stock analysts and individual investors in its interpretation. The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.

Only those misstatements and omissions that are material violate many provisions of the securities laws, including the bedrock provisions requiring accurate financial reporting. In 1976, the U.S. Supreme Court set the standard for a materiality evaluation, which standard remains today. In TSC Industries, Inc. v. Northway, Inc., the Supreme Court held that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public.

Despite this standard, the concept remains fact-driven and difficult to apply. There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available. Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure in light of the standard established by the Supreme Court in TSC Industries.

Generally, professionals and company management must look in the first instance at specific disclosure guidelines set out in the federal securities rules and regulations (such as Regulations S-X and S-K and Forms 10-Q, 10-K and 8-K). Second, professionals and company management must consider all facts presently affecting the company. For instance, a specific disclosure may be highly relevant in light of current economic conditions and of little importance in a different economic climate. Ethical issues are generally not considered material, unless specifically required by statute (such as the Foreign Corrupt Practices Act).

The SEC has issued guidance on materiality in Staff Accounting Bulletin No. 99 (SAB 99). Although SAB 99 is meant to clarify some materiality issues, many practitioners find that it confuses rather than clarifies. Really the guidance just reiterates that materiality cannot be defined by law or standards but must be determined anew for each fact and disclosure issue.

In determining materiality, practitioners should keep in mind Regulation FD, which prohibits the selective disclosure of material information. That is, Regulation FD requires that if material information is to be disclosed, it must be disclosed to the entire market, either through a press release or Form 8-K or both, and not selectively, such as to certain analysts or market professionals.

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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