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

SEC Small Business Advisory Committee Public Company Disclosure Recommendations

Posted by Securities Attorney Laura Anthony | October 27, 2015 Tags: Non-Accelerated Filer

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 changes to the disclosure requirements for smaller publicly traded companies.

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 topic of disclosure requirements for smaller public companies under the Securities Exchange Act of 1934 (“Exchange Act”) has come to the forefront over the past year. In early December the House passed the Disclosure Modernization and Simplification Act of 2014, but the bill was never passed by the Senate and died without further action.

In March of this year the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For a review of these recommendations see my blog Here.

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 SEC has provided for simplified disclosure for smaller reporting companies for over 30 years. Under the current rules a “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues. Similarly, a company is considered a non-accelerated filer if it has a public float of less than $75 million as of the last day of the most recently completely second fiscal quarter.

The JOBS Act, enacted on April 5, 2012, created a new category of company called an “emerging growth company” for which certain scaled-down disclosure requirements apply for up to 5 years after an initial IPO. An emerging growth company is one that has total annual gross revenues of less than $1 billion during its most recent completed fiscal year.

Emerging growth companies are provided with a number of other accommodations with respect to disclosure requirements that would also be beneficial to smaller reporting companies.

The Advisory Committee then made the following specific recommendations:

The SEC should revise the definition of “smaller reporting company” to include companies with a public float of up to $250 million. This will increase the class of companies benefitting from a broad range of benefits to smaller reporting companies, including (i) exemption from the pay ratio rule; (ii) exemption from the auditor attestation requirements; and (iii) exemption from providing a compensation discussion and analysis.

The SEC should revise its rules to align disclosure requirements for smaller reporting companies with those for emerging growth companies. These include (i) exemption from the requirement to conduct shareholder advisory votes on executive compensation and on the frequency of such votes; (ii) exemption from rules requiring mandatory audit firm rotation; (iii) exemption from pay versus performance disclosure; and (iv) allow compliance with new accounting standards on the date that private companies are required to comply.

The SEC should revise the definition of “accelerated filer” to include companies with a public float of $250 million or more but less than $700 million. As a result, the auditor attestation report under Section 404(b) of the Sarbanes Oxley Act would no longer apply to companies with a public float between $75 million and $250 million.

The SEC should exempt smaller reporting companies from XBRL tagging; and

The SEC should exempt smaller reporting companies from filing immaterial attachments to material contracts.

My Thoughts

I completely agree with the recommendations. The disclosure rules are complicated, and compliance is expensive. Moreover, the numerous new rules related to executive compensation including pay ratio, say on pay, pay vs. performance, executive clawback and compensation disclosure and analysis are a huge deterrent for companies that currently do not qualify as a smaller reporting company, but are still small in today’s financial world. These companies need an opportunity to grow and generate jobs while still providing meaningful disclosure to the marketplace and investors. The proposed changes in the definition of smaller reporting company to a much more modern reasonable $250 million will greatly assist in that regard.

I especially applaud the recommendation related to XBRL tagging. I firmly believe it is an analytic tool that is not used at all by smaller reporting companies or the small cap marketplace.

Refresher on Public Company Reporting Requirements

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Reports filed with the SEC can be viewed by the public on the SEC EDGAR website. The required reports include an annual Form 10-K, quarterly Form 10Q’s and current periodic Form 8-K, as well as proxy reports and certain shareholder and affiliate reporting requirements.

A company becomes subject to the Reporting Requirements by filing an Exchange Act Section 12 registration statement on either Form 10 or Form 8-A. A Section 12 registration statement may be filed voluntarily or per statutory requirement if the issuer’s securities are held by either (i) 2,000 persons or (ii) 500 persons who are not accredited investors and where the issuer’s total assets exceed $10 million. In addition, companies that file a Form S-1 registration statement under the Securities Act of 1933, as amended (“Securities Act”) become subject to Reporting Requirement; however, such obligation becomes voluntary in any fiscal year at the beginning of which the company has fewer than 300 shareholders.

A reporting company also has record-keeping requirements, must implement internal accounting controls and is subject to the Sarbanes-Oxley Act of 2002, including the CEO/CFO certifications requirements, prohibition on officer and director loans, and independent auditor requirements. Under the CEO/CFO certification requirement, the CEO and CFO must personally certify the content of the reports filed with the SEC and the procedures established by the issuer to report disclosures and prepare financial statements. For more information on that topic, see my blog Here.
All reports filed with the SEC are subject to SEC review and comment and, in fact, the Sarbanes-Oxley Act requires the SEC to undertake some level of review of every reporting company at least once every three years.

The following are the reports that generally make up a public company’s reporting requirements and which are applicable to smaller reporting companies. A “smaller reporting company” is an issuer that is not an investment company or asset-backed issuer or majority-owned subsidiary and that (i) had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter; or (ii) in the case of an initial registration statement, had a public float of less than $75 million as of a date within days of the filing of the registration statement; or (iii) in the case of an issuer whose public float as calculated by (i) or (ii) is zero, had annual revenues of less than $75 million during the most recently completed fiscal year for which audited financial statements are available.

Annual Reports on Form 10-K

All smaller reporting companies are required to file an annual report with the SEC on Form 10-K within 90 days of the end of its fiscal year. An extension of up to 15 calendar days is available for a Form 10-K as long as the extension notice on Form 12b-25 is filed no later than the next business day after the original filing deadline.

A Form 10-K includes the company’s audited annual financial statements, a discussion of the company’s business results, a summary of operations, a description of the overall business and its physical property, identification of any subsidiaries or affiliates, disclosure of the revenues contributed by major products or departments, and information on the number of shareholders, the management team and their salaries, and the interests of management and shareholders in certain transactions. A Form 10-K is substantially similar to a Form 10 registration statement and updates shareholders and the market on information previously filed in a registration statement, on an annual basis.

Quarterly Reports on Form 10-Q

All smaller reporting companies are required to file a quarterly report on Form 10-Q within 45 days of the end of each of its fiscal quarters. An extension of up to 5 calendar days is available for a Form 10-Q as long as the extension notice on Form 12b-25 is filed no later than the next business day after the original filing deadline.

The quarterly report includes unaudited financial statements and information about the company’s business and results for the previous three months and for the year to date. The quarterly report compares the company’s performance in the current quarter and year to date to the same periods in the previous year.

Current Reports on Form 8-K

Subject to certain exceptions, a Form 8-K must be filed within four (4) business days after the occurrence of the event being disclosed. No extension is available for an 8-K. Companies file this report with the SEC to announce major or extraordinary events that shareholders should know about, including entry into material agreements, mergers and acquisitions, change in control, changes in auditors, the issuance of unregistered securities, amendments in company articles or bylaws, company name changes, issues with reliance on previously issued financial statements, changes in officer or directors, bankruptcy proceedings, change in shell status regulation F-D disclosures and voluntary disclosures (voluntary disclosures have no filing deadline).

The Fair Disclosure Regulation, enacted in 2000 (“Regulation FD”), stipulates that publicly traded companies broadly and publicly disseminate information instead of distributing it selectively to certain analysts or investors only. Companies are encouraged to use several means of information dissemination including Form 8-K, news releases, Web sites or Web casts, and press releases. A Form 8-K under Regulation FD must be filed (i) simultaneously with the release of the material that is the subject of the filing (generally a press release); or (ii) the next trading day.

Other than when there has been a change of shell status, the financial statements of an acquired business must be filed no later than 71 calendar days after the date the initial Form 8-K was filed reporting the closing of the business acquisition (which initial Form 8-K is due with 4 days).

Consequences and Issues Related to Late Filing

Late filings carry severe consequences to small business issuers. Generally the shareholders of late filing issuers cannot rely on Rule 144 for the sale or transfer of securities while the issuer is delinquent in its filing requirements. Rule 144(c) requires that adequate current public information with respect to the company must be available. The current public information requirement is measured at the time of each sale of securities. That is, the issuer, whether reporting or non-reporting, must satisfy the current public information requirements as set forth in Rule 144(c) at the time that each resale of securities is made in reliance on Rule 144. For reporting issuers, adequate current public information is deemed available if the issuer is, and has been for a period of at least 90 days immediately before the sale, subject to the Exchange Act reporting requirements and has filed all required reports, other than Form 8-K, and has submitted electronically and posted on its website, if any, all XBRL data required to be submitted and posted.

An issuer that is late or has failed to maintain its reporting requirements is disqualified from use of Form S-3, which is needed to conduct at-the-market direct public offerings, shelf registrations and types of registered securities. Likewise, a Form S-8 cannot be filed while an issuer is either late or delinquent in its reporting requirements. Late or delinquent filings may also trigger a default in the terms of contracts, including corporate financing transactions. Finally, the SEC can bring enforcement proceedings against late filers, including actions to deregister the securities.

Proxy Statements

All companies with securities registered under the Exchange Act (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act proxy requirements found in Section 14 and the rules promulgated thereunder. Companies required to file reports as a result of an S-1 registration statement that have not separately registered under the Exchange Act are not subject to the proxy filing requirements. The proxy rules govern the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the approval of any corporate action requiring shareholder approval. The information contained in proxy materials must be filed with the SEC in advance of any solicitation to ensure compliance with the disclosure rules.

Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which shareholders are asked to vote. The disclosure information filed with the SEC and ultimately provided to the shareholders is enumerated in SEC Schedule 14A.

Where a shareholder vote is not being solicited, such as when a company has obtained shareholder approval through written consent in lieu of a meeting, a company may satisfy its Section 14 requirements by filing an information statement with the SEC and mailing such statement to its shareholders. In this case, the disclosure information filed with the SEC and mailed to shareholders is enumerated in SEC Schedule 14C. As with the proxy solicitation materials filed in Schedule 14A, a Schedule 14C Information Statement must be filed in advance of final mailing to the shareholder and is reviewed by the SEC to ensure that all important facts are disclosed. However, Schedule 14C does not solicit or request shareholder approval (or any other action, for that matter), but rather informs shareholders of an approval already obtained and corporate actions which are imminent.

In either case, a preliminary Schedule 14A or 14C is filed with the SEC, who then review and comment on the filing. Upon clearing comments, a definitive Schedule 14A or 14C is filed and mailed to the shareholders as of a certain record date.

Generally, the information requirements in Schedule 14C are less arduous than those in a Schedule 14A in that they do not include lengthy material regarding what a shareholder must do to vote or approve a matter. Moreover, the Schedule 14C process is much less time-consuming, as the shareholder approval has already been obtained. Accordingly, when possible, companies prefer to utilize the Schedule 14C Information Statement as opposed to the Schedule 14A Proxy Solicitation.

Reporting Requirements for Company Insiders

All executive officers and directors and 10%-or-more shareholders of a company with securities registered under the Exchange Act (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act Reporting Requirements related to the reporting of certain transactions. The initial filing is on Form 3 and is due no later than ten days of becoming an officer, director, or beneficial owner. Changes in ownership are reported on Form 4 and must be reported to the SEC within two business days. Insiders must file a Form 5 to report any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting. If a form must be filed, it is due 45 days after the end of the company’s fiscal year. For more information on these Section 16 reporting requirements, see my blog Here.

Additional Disclosures

Other federal securities laws and SEC rules require disclosures about a variety of events affecting the company. Under the Exchange Act, parties who will own more than five percent of a class of the company’s securities after making a tender offer for securities registered under the Exchange Act must file a Schedule TO with the SEC. The SEC also requires any person acquiring more than five percent of a voting class of a company’s Section 12 registered equity securities directly or by tender offer to file a Schedule 13D. Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D. For more information on Schedules 13D/G, see my blog Here.

Termination of Reporting Requirements

To deregister and suspend Reporting Requirements, an eligible issuer can file a Form 15. To qualify to file a Form 15, an issuer must either have (i) fewer than 300 shareholders; or (ii) fewer than 500 shareholders and the issuer’s assets do not exceed $10 million.

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.

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« Mergers And Acquisitions – The Merger Transaction The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance »

Mergers And Acquisitions – The Merger Transaction

Posted by Securities Attorney Laura Anthony | October 20, 2015 Tags: Mergers and Acquisitions, the merger transaction

Although I have written about document requirements in a merger transaction previously, with the recent booming M&A marketplace, it is worth revisiting. This blog only addresses friendly negotiated transactions achieved through share exchange or merger agreements. It does not address hostile takeovers.

A merger transaction can be structured as a straight acquisition with the acquiring company remaining in control, a reverse merger or a reverse triangular merger. In a reverse merger process, the target company shareholders exchange their shares for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the target company own a majority of the acquiring public company and the target company has become a wholly owned subsidiary of the public company. The public company assumes the operations of the target company.

A reverse merger is often structured as a reverse triangular merger. In that case, the acquiring company forms a new subsidiary which merges with the target company. The primary benefits of the reverse triangular merger include the ease of shareholder consent and certain perceived tax benefits. The specific form of the transaction should be determined considering the relevant tax, accounting and business objectives of the overall transaction.

An Outline of the Transaction Documents

The Confidentiality Agreement

Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.

In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality, such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

The Letter of Intent

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

Many clients ask me how to protect their interests while trying to negotiate a merger or acquisition. During the negotiation period, both sides will incur time and expense, and will provide the other with confidential information. The way to protect confidential information is through a confidentiality agreement, but that does not protect against wasted time and expense. Many other protections can be used to avoid wasted time and expense.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. That period of time may be set in calendar time, such as sixty days, or based on conditions, such as completion of an environmental study, or a combination of both.

A “window shop” provision allows for some level of third-party negotiation or inquiry. An example of a window shop provision may be that a party cannot solicit other similar transactions but is not prohibited from hearing out an unsolicited proposal. A window shop provision may also allow the board of directors of a party to shop for a better deal, while giving a right of first refusal if such better deal is indeed received. Window shop provisions generally provide for notice and disclosure of potential “better deals” and either matching or topping rights.

Generally, both no shop and window shop provisions provide for a termination fee or other detriment for early termination. The size of the termination fee varies; however, drafters of a letter of intent should be cognizant that if the fee is substantial, it likely triggers an SEC reporting and disclosure requirement, which in and of itself could be detrimental to the deal.

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

Another common deal protection is a standstill agreement. A standstill agreement prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning off subsidiaries, hiring or firing management teams and the like.

Finally, many companies protect their interests by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The Merger Agreement

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

The main components of the Merger Agreement and a brief description of each are as follows:

Representations and Warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The seller also represents and warrants its legal ability to enter into the agreement. Both parties represent as to the accuracy of public filings, financial statements, material contract, tax matters and organization and structure of the entity.

Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing and, if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.

Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Generally for public companies these conditions include the filing of appropriate shareholder proxy or information statements under Section 14 of the Securities Exchange Act of 1934 and complying with shareholder appraisal rights provisions. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.

Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.

Deal Protections – Like the LOI, the merger agreement itself will contain deal protection terms. These deal protection terms can include no shop or window shop provisions, requirements as to business operations by the parties prior to the closing; breakup fees; voting agreements and the like.

Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no shop provisions, breakup fees, non-compete and confidentiality provisions if not previously agreed to separately.

Disclosure Matters

In a merger or acquisition transaction, there are three basic steps that could invoke the disclosure requirements of the federal securities laws: (i) the negotiation period or pre-definitive agreement period; (ii) the definitive agreement; and (iii) closing.

(i) Negotiation Period (Pre-Definitive Agreement)

Generally speaking, the federal securities laws do not require the disclosure of a potential merger or acquisition until such time as the transaction has been reduced to a definitive agreement. Companies and individuals with information regarding non-public merger or acquisition transactions should be mindful of the rules and regulations preventing insider trading on such information. However, there are at least three cases where pre-definitive agreement disclosure may be necessary or mandated.

The first would be in the Management, Discussion and Analysis section of a company’s quarterly or annual report on Form 10-Q or 10-K, respectively. Item 303 of Regulation S-K, which governs the disclosure requirement for Management’s Discussion and Analysis of Financial Condition and Results of Operations, requires, as part of this disclosure, that the registrant identify any known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, the registrant’s liquidity increasing or decreasing in any material way. Furthermore, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the Instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”

It seems pretty clear that a potential merger or acquisition would fit firmly within the required MD&A discussion. However, realizing that disclosure of such negotiations and inclusion of such information could, and often would, jeopardize completing the transaction at all, the SEC has provided guidance. In SEC Release No. 33-6835 (1989), the SEC eliminated uncertainty regarding disclosure of preliminary merger negotiations by confirming that it did not intend for Item 303 to apply, and has not applied, and does not apply to preliminary merger negotiations. In general, the SEC’s recognition that companies have an interest in preserving the confidentiality of such negotiations is clearest in the context of a company’s continuous reporting obligations under the Exchange Act, where disclosure on Form 8-K of acquisitions or dispositions of assets not in the ordinary course of business is triggered by completion of the transaction (more on this below). Clearly, this is a perfect example and illustration of the importance of having competent legal counsel assist in interpreting and unraveling the numerous and complicated securities laws disclosure requirements.

In contrast, where a company registers securities for sale under the Securities Act, the SEC requires disclosure of material probable acquisitions and dispositions of businesses, including the financial statements of the business to be acquired or sold. Where the proceeds from the sale of the securities being registered are to be used to finance an acquisition of a business, the registration statement must disclose the intended use of proceeds. Again, accommodating the need for confidentiality of negotiations, registrants are specifically permitted not to disclose in registration statements the identity of the parties and the nature of the business sought if the acquisition is not yet probable and the board of directors determines that the acquisition would be jeopardized. Although beyond the scope of this blog, many merger and/or acquisition transactions require registration under Form S-4.

Accordingly, where disclosure is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the company’s view, inclusion of such information would jeopardize completion of the transaction. Where disclosure is otherwise required or has otherwise been made by or on behalf of the company, the interests in avoiding premature disclosure no longer exist. In such case, the negotiations would be subject to the same disclosure standards under Item 303 as any other known trend, demand, commitment, event or uncertainty.

The second would be in Form 8-K, Item 1.01 Entry into A Material Definitive Agreement. Yes, this is in the correct category; the material definitive agreement referred to here is a letter of intent or confidentiality agreement. Item 1.01 of Form 8-K requires a company to disclose the entry into a material definitive agreement outside of the ordinary course of business. A “material definitive agreement” is defined as “an agreement that provides for obligations that are material to and enforceable against the registrant or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions.” Agreements relating to a merger or acquisition are outside the ordinary course of business. Moreover, although most letters of intent are non-binding by their terms, many include certain binding provisions such as confidentiality provisions, non-compete or non-circumvent provisions, no shop and exclusivity provisions, due diligence provisions, breakup fees and the like. On its face, it appears that a letter of intent would fall within the disclosure requirements in Item 1.01.

Once again, the SEC has offered interpretative guidance. In its final rule release no. 33-8400, the SEC, recognizing that disclosure of letters of intent could result in destroying the underlying transaction as well as create unnecessary market speculation, specifically eliminated the requirement that non-binding letters of intent be disclosed. Moreover, the SEC has taken the position that the binding provisions of the letter, such as non-disclosure and confidentiality, are not necessarily “material” and thus do not require disclosure. However, it is important that legal counsel assist the company in drafting the letter, or in interpreting an existing letter to determine if the binding provisions reach the “materiality” standard and thus become reportable. For example, generally large breakup fees or extraordinary exclusivity provisions are reportable.

The third would be in response to a Regulation FD issue. Regulation FD or fair disclosure prevents selective disclosure of non-public information. Originally Regulation FD was enacted to prevent companies from selectively providing information to fund managers, big brokerage firms and other “large players” in advance of providing the same information to the investment public at large. Regulation FD requires that in the event of an unintentional selective disclosure of insider information, the company take measures to immediately make the disclosure to the public at large through both a Form 8-K and press release.

(ii) The Definitive Agreement

The definitive agreement is disclosable in all aspects. In addition to inclusion in Form 10-Q and 10-K, a definitive agreement must be disclosed in Form 8-K within four (4) days of signing in accordance with Item 1.01 as described above. Moreover, following the entry of a definitive agreement, completion of conditions, such as a shareholder vote, will require in-depth disclosures regarding the potential target company, including their financial statements.

(iii) The Closing

The Closing is disclosable in all aspects, as is the definitive agreement. Moreover, in addition to item 1.01, the Closing may require disclosures under several or even most of the Items in Form 8-K, such as Item 2.01 – Completion of disposal or acquisition of Assets; Item 3.02 – Unregistered sale of securities; Item 4.01 – Changes in Certifying Accountant; Item 5.01 Change in Control; Item 5.06 – Change in Shell Status, etc.

Due Diligence in a Merger Transaction

Due diligence refers to the legal, business and financial investigation of a business prior to entering into a transaction. Although the due diligence process can vary depending on the nature of a transaction (a relatively small acquisition vs. a going public reverse merger), it is arguably the most important component of a transaction (or at least equal with documentation).

At the outset, in addition to requesting copies of corporate records and documents, all contracts, asset chains of title documents, financial statements and the like, due diligence includes becoming familiar with the target’s business, including an understanding of how they make money, what assets are important in revenues, who are their commercial partners and suppliers, and common off-balance-sheet and other hidden arrangements in that business. It is important to have a basic understanding of the business in order to effectively review the documents and information once supplied, to know what to ask for and to isolate potential future problems.

In addition to determining whether the transaction as a whole is worth pursuing, proper due diligence will help in structuring the transaction and preparing the proper documentation to prevent post-closing issues (such as making sure all assignments of contracts are complete, or where an assignment isn’t possible, new contracts are prepared).

In addition to creating due diligence lists of documents and information to be supplied, counsel for parties should perform separate checks for publicly available information. In today’s internet world, this part of the process has become dramatically easier. Counsel should be careful not to miss the basics, such as UCC lien searches, judgment searches, recorded property title and regulatory issues with any of the principals or players involved in the deal, including any bad actor issues that could be problematic going forward.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
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« SEC Footnote 32 and Sham S-1 Registration Statements SEC Small Business Advisory Committee Public Company Disclosure Recommendations »

SEC Footnote 32 and Sham S-1 Registration Statements

Posted by Securities Attorney Laura Anthony | September 20, 2015 Tags: s-1 registration statement, sec footnote 32

Over the past several years, many direct public offering (DPO) S-1 registration statements have been filed for either shell or development-stage companies, claiming an intent to pursue and develop a particular business, when in fact, the promoter intends to create a public vehicle to be used for reverse merger transactions. For purposes of this blog, I will refer to these S-1 registration statements the same way the SEC now does, as “sham registrations.” I prefer the term “sham registrations” as it better describes the process than the other used industry term of art, “footnote 32 shells .”

Footnote 32 is part of the Securities Offering Reform Act of 2005 (“Securities Offering Reform Act”). In the final rule release for the Securities Offering Reform Act, the SEC included a footnote (number 32) which states:

“We have become aware of a practice in which the promoter of a company and/or affiliates of the promoter appear to place assets or operations within an entity with the intent of causing that entity to fall outside of the definition of blank check companies in Securities Act Rule 419. The promoter will then seek a business combination transaction for the company, with the assets or operations being returned to the promoter or affiliate upon the completion of that business combination transaction.

It is likely that similar schemes will be undertaken with the intention of evading the definition of shell company that we are adopting today. In our view, when promoters (or their affiliates) of a company that would otherwise be a shell company place assets or operations in that company and those assets or operations are returned to the promoter or to its affiliates (or an agreement is made to return those assets or operations to the promoter or its affiliates) before, upon completion of, or shortly after a business combination transaction by that company, those assets or operations would be considered ‘nominal’ for purposes of the definition of shell company.”

An entity created for the purposes of entering into a merger or acquisition transaction with an as of yet unidentified target, is called a “blank check company.” All registrations by blank check companies are required to comply with Rule 419 under the Securities Act of 1933, as amended (“Securities Act”). Further down in this blog, I have included a discussion of Rule 419, which requires that funds raised and securities sold be held in escrow until a merger or acquisition transaction is completed. An entity relying on Rule 419 would not receive a trading symbol or be able to apply for DTC eligibility until after it completes a merger or acquisition transaction.

A public vehicle with a trading symbol and DTC eligibility has greater value for a target asset or company, and accordingly, some unscrupulous industry players file sham registrations in an effort to avoid Rule 419.

As discussed further below, a shell company is one with no or nominal assets and operations. Although a DPO may legally be completed by a company that meets the definition of a “shell company,” a public vehicle which is not and never was a shell company is more valuable to a reverse merger or acquisition target. In particular, as I have written about many times, companies that are or ever were a “shell company” face prohibitions and ongoing limitations related to the use of Rule 144 (for further discussion on Rule 144 related to shell companies see my blog HERE. As with avoiding Rule 419, some unscrupulous industry players file sham registrations in an effort to avoid shell status.

Sham registrations have become increasingly prevalent with the newly public company being offered for sale and for use in reverse merger transactions. In a typical sham registration, 99.9% of the total issued and outstanding shares are offered for sale. Typically the company has a single (or possibly two) owner(s) of the control block and a single (or possibly two) person(s) serving in all officer and director roles. There are usually approximately 30 “free trading” shareholders offering to sell their shares as registered freely tradable shares, to a new group of shareholders associated with the reverse merger target. Generally, the only shares not offered in the transfer are a small number that have been deposited into DTC as part of the DTC application process.

From a legal perspective, the person(s) filing the sham registration is violating Section 17(a) of the Securities Act, which is the counterpart to Rule 10(b)(5) of the Securities Exchange Act of 1934. Section 17(a) prohibits, in conjunction with the offer or sale of securities: (i) the use of any device, scheme or artifice to defraud; or (ii) obtaining money or property using any untrue statement related to, or any omission of, a material fact; or (iii) engaging in any transaction, practice or course of business that would operate as a fraud or deceit on the purchaser. That is, the person(s) filing the sham registration are aware that there is no present intent to pursue the disclosed business, but rather the intent is to sell the public entity to a new business or group. In addition, the participants violate Rule 10(b)(5) of the Exchange Act and Exchange Act recordkeeping and internal control provisions.

Moreover, those involved would be liable for similar state securities law violations. In addition to an action by both the SEC and state regulatory agencies, the public company would be liable for civil actions against purchasers of securities. As with any securities fraud violation, egregious cases can be referred to the Department of Justice or State Attorney for criminal action.

Until now, the SEC has only taken action against the promoter, individual or group behind the sham registration and not the third-party reverse merger target, which has generally been a real business that has innocently purchased one of these public entities to be used in a reverse merger transaction. However, I believe that is about to change. These sham registration public companies are so blatant and easy to identify that a third party can no longer claim innocence in its purchase or use.

I believe the SEC is going to begin imposing trading suspensions and/or registration revocations against the public companies after a purchaser has taken over with a valid operating business. Industry insiders are aware that the SEC is taking action to prevent any active trading market from developing from these vehicles, and it is my belief that the SEC is gearing up to file an example-setting case that will include the purchaser of one of these sham public vehicles. The risk to the sham public vehicle purchaser goes beyond a trading suspension or registration revocation, and could include aiding and abetting liability for the sham registration itself.

Action to Prevent Active Trading Market

As I’ve blogged about many times, the SEC views broker-dealers as gatekeepers in the compliance with federal securities fraud. For more on this topic, see my blog HERE about the ongoing issues of depositing penny stocks with broker-dealers.

In the past few weeks, regulators have imposed a barrier to the deposit of securities purchased from a participant in a sham registration or issued by a company involved in a sham registration. Although I do not have a copy of the memo, based on a source, the SEC has provided certain penny stock broker-dealers with a memo outlining red flags indicating that a company may have been involved in a “sham registration” and warning against the deposit and offer of sale of shares issued by such company.

Sham registration red flags include:

A company formed immediately preceding filing a registration statement and commencing its public offering;

Proposed business consisting of actual activities in a described line of business, without concrete expenditures, contracts, operating assets, or other indicia of actual operations in that business;

A relatively small S-1 registered public offering—e.g., $40,000;

The registration statement prepared by legal counsel who has a history of several similar registration statements with similar business and offering profiles as set forth above;

Low costs of offering, including legal fees—e.g., $3,500 for the entire organization, audit, and SEC registration work;

Cash invested to organize and launch the offering but not enough to conduct substantial activities in the proposed business;

The entire offering sold offshore—e.g., Ukraine;

No actual business conducted after the offering to employ the offering proceeds in the proposed business;

A significant portion of the stock sold in the registered public offering sold back into the United States to U.S. residents, frequently at prices equal to, at a slight premium to, or a low multiple of the public offering price;

The terms, prices, and closing of the sale at the same terms or even closed through a common escrow stock back into the United States. The offshore “registered” stock flowing back into the US through some orchestrated mechanism (in some cases a single escrow closed simultaneously with, and contingent upon, the closing of the reverse merger) so that all or a substantial amount of the publicly sold stock passes to persons aware of or acting in concert with the group controlling the reverse merger company;

A reverse merger with an operating business in which the owners of the operating business take over management, acquire a substantial majority of the outstanding stock, and undertake only the business of the acquired enterprise, abandoning the proposed business activities initially described in the prospectus;

Without respect to when the stock was first DTC eligible, when it first obtained a trading symbol, or the date on which the public offering was completed, material public trading in the company’s securities does not commence with material volume until the reverse merger. Typically the stock sold in the offshore public offering is not traded in any public market that develops. Instead, the trading market is prepared to launch with DTC eligibility and trading symbol in place for trading to commence when the reverse merger is complete, using stock that has been acquired by US persons from the offshore initial purchasers in the registered offering; and

Stock acquired by US purchasers from the offshore investors now being presented for resale.

The SEC warns broker-dealers that even when the legitimacy of the current business is not an issue, any trading market established after a sham registration is at issue and that the fundamental free tradability of such shares is problematic. As a result, some broker-dealers are simply refusing to deposit and resell securities issued in companies with indicia of a sham registration.

Examples of SEC Enforcement Actions

On April 16, 2015, the SEC filed an action against 10 individuals involved in a scheme to manufacture at least 22 public companies without relying on Rule 419 or properly disclosing shell company status (the “McKelvey Case”). The number of provisions in which the SEC claimed violations, and therefore sought relief, included a full laundry list of any and all possible actions. The language in the McKelvey case was also much stronger than in prior actions filed by the SEC for similar violations.

On February 3, 2014, the SEC initiated administrative proceedings against 19 companies that had filed S-1 registration statements. The 19 registration statements were all filed within an approximate 2-month period around January 2013. Each of the companies claimed to be an exploration-stage entity in the mining business without known reserves, and each claimed that they had not yet begun actual mining. Each of the 19 entities used the same attorney. Each of the entities was incorporated at around the same time using the same registered agent service. Each of the 19 S-1’s read substantially the same.

Importantly, each of the 19 S-1’s lists a separate officer, director and sole shareholder, and each claims that this person is the sole control person. The SEC complains that contrary to the representations in the S-1, a separate single individual was the actual control person behind each of these 19 entities and that person is acting through straw individuals, as he is subject to a penny stock bar and other SEC injunctive orders which would prevent him from legally participating in these S-1 filings. In addition, the SEC alleges that the claims of a mining business were false. The SEC believes that the S-1’s were filed to create public companies to be used for either reverse merger transactions or worse, pump-and-dump schemes.

The SEC played hardball with this group, as well. An S-1 generally contains language that it may be amended or modified (or even withdrawn) until it is declared effective by the SEC. A pre-effective S-1 is not deemed filed by the SEC or a final prospectus for Section 5 of the Securities Act. Upon initiation of the SEC investigation, all 19 S-1 filers attempted to withdraw their S-1 registration statements. The SEC suggested that each withdraw their requests to withdraw the S-1 and cooperate fully with the investigation. The entities did not comply. Accordingly, in addition to claims related to the filing of false statements in the S-1, the SEC has also alleged that “Respondent’s seeking to withdraw its Registration Statement constitutes a failure to cooperate with, refusal to permit, and obstruction of the staff’s examination under Section 8(e) of the Securities Act.”

Separately on January 15, 2015, the SEC filed an action against the individual behind each of the sham registrations, the attorney and the auditing firm for “a scheme to create sham public shell companies.”

Sham registrations are not new, just more prevalent. In September 2012, the SEC filed an action against a group of promoters for creating 15 sham public companies. One-off actions are consistently being filed, as well.

Rule 419 and Blank Check Companies

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company. Rule 419 requires that the blank check company filing such registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger.

In addition, the registrant is required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement, upon the execution of an agreement for such acquisition or merger. The rule provides procedures for the release of the offering funds in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and resale or secondary offerings.

Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected not to remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon enough funds remaining in escrow to close the transaction.

The definition of “blank check company” as set forth in Rule 419 of the Securities Act is a company that:

Is a development-stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and

Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.

Shell Companies

The definition of “shell company” as set forth in Rule 405 of the Securities Act (and Rule 12b-2 of the Securities Exchange Act of 1934) means a company that has:

No or nominal operations; and

Either:

No or nominal assets;

Assets consisting solely of cash and cash equivalents; or

Assets consisting of any amount of cash and cash equivalents and nominal other assets.

Clearly the definitions are different. Although a shell company could also be a blank check company, it could be a development-stage company or start-up organization or an entity with a specific business plan but nominal operations. Until recently, however, the SEC has firmly held the position that Rule 419 applies equally to shell and development-stage companies.

In fact, the SEC Staff Observations in the Review of Smaller Reporting Company IPO’s published by the SEC Division of Corporate Finance contain the following comments:

“Rule 419 applies to any registered offering of securities of a blank check company where the securities fall within the definition of a penny stock under the Securities Exchange Act of 1934. We frequently reviewed registration statements of recently established development stage companies with a history of losses and an expectation of continuing losses and limited operations. These companies often stated that they may expand current operations through acquisitions of other businesses without specifying what kind of business or what kind of company. In other cases, the stage of a company’s development, when considered in relation to the surrounding facts and circumstances, may raise questions regarding the company’s disclosed business plan. We generally asked companies like these to review Rule 419 of Regulation C. We asked these companies either to revise their disclosure throughout the registration statement to comply with the disclosure and procedural requirements of Rule 419 or to provide us with an explanation of why Rule 419 did not apply.”

The SEC will now allow a shell company, as long as it is not also a blank check company, to embark on an offering using an S-1 registration statement without the necessity to comply with Rule 419. As noted above, an entity can be a shell company, but not a blank check company, as long as it has a specific business purpose and plan and is taking steps to move that plan forward, such as a start-up or development-stage entity.

Conclusion

I regularly caution reverse merger clients against companies that appear in violation of footnote 32 or appear to have originated via a sham registration. However, I continue to believe in reverse merger transactions, DPO’s for legitimate companies in all stages of their development and the overall small business public marketplace.

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

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« Finders- The Facts Related To Broker-Dealer Registration Requirements Mergers And Acquisitions – The Merger Transaction »

Finders- The Facts Related To Broker-Dealer Registration Requirements

Posted by Securities Attorney Laura Anthony | August 21, 2015 Tags: broker-dealer registration statements, Finders fees, Florida Corporate Statutes

Introduction

As a recurring topic, I discuss exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services. I have previously discussed the no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act and the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer. I have also previously published a blog on the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders. I’ve included links to each of these prior articles in the conclusion to this blog.

A related topic with a parallel analysis is the use of finders for investors and investor groups, an activity which has become prevalent in today’s marketplace. In that case the investor group utilizes the services of a finder to solicit issuers to sell securities (generally convertible notes) to the investment group. These finders may also solicit current shareholders or convertible note holders to sell such holdings to a new investor or investor group.

Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged.

Effective on July 1, 2013, FINRA updated the private placement form that firms must file with FINRA when acting as a placement agent for the private placement of securities. The updated form drills down on due diligence conducted by the firm in an effort to ensure heightened compliance procedures related to acting as a placement agent for private offerings. This information requirement adds a level of complexity and possible deterrent to broker-dealers when considering acting as a placement agent for a small private offering.

Effective August 24, 2015, FINRA has updated Rule 2040 “Payments to Unregistered Persons” governing the payment of transaction-based compensation by member firms to unregistered persons. FINRA Rule 2040 expressly correlates with Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”) as described below and prohibits the payment of transaction-related compensation unless a person is licensed or properly exempt from such licensing.

In addition, the Dodd-Frank Act has potentially increased liability for secondary participants through two provisions. These two provisions, which added Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934, dramatically change the liability exposure of intermediaries in the sale of securities, such as broker-dealers. In particular, Section 9(a)(4) of the 1934 Act makes it unlawful for any broker, dealer or other person selling or offering to sell (or purchasing or offering to purchase) any security other than a government security, “to make. . . for the purpose of inducing the purchase or sale of such security, . . . any statement which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which that person knew or had reasonable ground to believe was so false or misleading.” Previously, Section 9 of the 1934 Act applied only to securities traded on an exchange. Now it applies to any securities, excluding government securities—another change that was part of the Dodd-Frank Act. In other words, a broker-dealer can be liable for untrue statements or omissions in offering documents, including private placements and offering advertisements. Dodd-Frank also added Section 9(f) to the 1934 Act, which says that anyone who “willingly participates” in an act or transaction in violation of Section 9(a) above is liable to the person who bought the security.

FINRA scrutiny, together with the potential liability, have acted as a disincentive to broker-dealers to assist small companies in capital-raising efforts. Although the ability to advertise under 506(c) and the rise of 506(c) funding web portals has helped improve the private placement market somewhat, on a practical level, the assistance of finders often marks the difference between a successful or failed offering by a small or emerging company.

The SEC and state regulators recognize this reality and continue to explore the topic. FINRA had proposed rules for a Limited Corporate Financing Broker which would offer a license for private placement finders that do not engage in full broker-dealer services such as managing retail accounts. The proposed rule as written met with opposition as being too similar to full registration and too arduous with ongoing requirements. The comment period on the proposed rule expired April 28, 2014 without further action.

At their June 3, 2015 meeting, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) explored the topic of “finders,” including listening to a presentation by a firm on the subject.

Current Rules on Finder’s Fees

The Securities and Exchange Commission (SEC) generally prohibits the payments of commissions or other transaction-based compensation to individuals or entities that assist in effecting transactions in securities, including a capital raise, unless that entity is a licensed broker-dealer. The SEC considers the registration of broker-dealers as vital to protecting prospective purchasers of securities and the marketplace as a whole and actively pursues and prosecutes unlicensed activity. The registration process is arduous, including, for example, background checks, fingerprinting of personnel, minimum financial requirements, membership to SRO’s and ongoing regulatory and compliance requirements.

Over the years, a “finder’s” exemption has been fleshed out, mainly through SEC no-action letters and some court opinions. Bottom line, an individual or entity can collect compensation for acting as a finder as long as the finder’s role is limited to making an introduction. The mere providing of names or an introduction without more has consistently been upheld as falling outside of the registration requirements. The less contact with the potential investor, the more likely the finder is not required to be licensed.

The finder may not participate in negotiations, structuring or document preparation or execution. Moreover, if such finder is “engaged in the business of effecting transactions in securities,” they must be licensed. In most instances, a person that acts as a finder on multiple occasions will be deemed to be engaged in the business of effecting securities transactions, and needs to be licensed.

The SEC will also consider the compensation arrangement with transaction or success-based compensation weighing in favor of requiring registration. The compensation arrangement is often argued as the gating or deciding factor, with many commentators expressing that any success-based compensation requires registration. The reasoning is that transaction-based compensation encourages high-pressure sales tactics and other problematic behavior. However, the SEC itself has issued no-action letters supporting a finder where the fee was based on a percentage of the amount invested by the referred people (see Moana/Kauai Corp., SEC No-Action Letter, 1974).

More recently, the U.S. District court for the Middle District of Florida in SEC vs. Kramer found that compensation is just one of the many factual considerations and should not be given any “particular heavy emphasis” nor in itself result in a “significant indication of a person being engaged in the business of a broker.”

Where a person acts as a “consultant” providing such services as advising on offering structure, market and financial analysis, holding meetings with broker-dealers, preparing or supervising the preparation of business plans or offering documents, the SEC has consistently taken the position that registration is required if such consultant’s compensation is commission-, success- or transaction-based.

As pertains to finders that act on behalf of investors and investor groups, there is a lack of meaningful guidance. On a few occasions, the SEC has either denied no-action relief or concluded registration was required. However, the same basic principles apply, and it is my belief that as long as the finders limit their activity to providing names and/or introductions, without more, they are exempt from registration.

The federal laws related to broker-dealer registration do not pre-empt state law. Accordingly, a broker-dealer must be licensed by both the SEC and each state in which they conduct business. Likewise, an unlicensed individual relying on an exemption from broker-dealer registration, such as a finder, must assure themselves of the availability of both a federal and state exemption for their activities.

The Exchange Act – Broker-Dealer Registration Requirement

Section 15(a)(1) of the Exchange Act requires any “broker” that makes use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security) to register with the Commission.

The text of Section 15(a)(1) – Registration of all persons utilizing exchange facilities to effect transactions is as follows:

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.

Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flush out, with inconsistent and uncertain results. As a securities attorney, I always advise to err on the conservative side where the activity is at all questionable.

FINRA Rule 2040

Rule 2040 prohibits member firms from directly or indirectly paying any compensation, fees, concessions, discounts or commissions to:

(1) any person that is not registered as a broker-dealer under SEA Section 15(a) but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or

(2) any appropriately registered associated person, unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.

FINRA guidance on the Rule states that a member firm can (i) rely on published releases, no-action letters or interpretations from the SEC staff; (ii) seek SEC no-action relief; or (iii) obtain a legal opinion from an independent, reputable U.S. licensed attorney knowledgeable in the area. This list is not exclusive and FINRA specifically indicates that member firms can take any other reasonable inquiry or action in determining whether a transaction fee can be paid to an unlicensed person.

FINRA Rule 2040 specifically allows the payments of finder’s fees to unregistered foreign finders where the finder’s sole involvement is the initial referral to the member firm of non-U.S. customers and certain conditions are met, including but not limited to that (i) the person is not otherwise required to be registered as a broker-dealer in the U.S.; (ii) the compensation does not violate foreign law; (iii) the finder is a foreign national domiciled abroad; (iv) the customers are foreign nationals domiciled abroad; (v) the payment of the finder’s fee is disclosed to the customer; (vi) the customers provide written acknowledgment of receipt of the notice related to the payment of the fee; (vii) proper records regarding the payments are maintained; and (viii) each transaction confirm indicates that the finder’s fee is being paid.

SEC Guide to Broker-Dealer Registration

Periodically, and most recently in April 2008, the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. On a daily basis, hundreds if not thousands of individuals and entities offer to raise money for companies as “finders” in return for a “finder’s fee.” Other than as narrowly set forth above, such agreements and transactions are prohibited and carry regulatory penalties for both the company utilizing the finder’s services, and the finders.

Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):

“finders,” “business brokers,” and other individuals or entities that engage in the following activities:

Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;

Finding investment banking clients for registered broker-dealers;

Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;

Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;

Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);

investment advisers and financial consultants;

persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;

persons that act as “placement agents” for private placements of securities;

persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members;

persons that provide support services to registered broker-dealers; and

persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer (for information on “associated persons,” see below).

SEC Advisory Committee on Small and Emerging Companies is Exploring the Topic

At the June 3, 2015, meeting of the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”), the Advisory Committee explored the topic of “finders” including listening to a presentation by Shumaker, Loop & Kendrick (“SLK”) on the topic. I am hopeful that they will continue to investigate this important area affecting small and emerging growth companies and fashion a recommendation to the SEC.

The presentation to the Advisory Committee began with basic background on the importance of small and emerging companies to the U.S. economy and the facts related to reliance on private and exempt offerings of securities to fund these enterprises. SLK, citing a 2012 report by Vlad Ivanov and Scott Bauguess, notes that in 2011 the estimated amount of private capital raises in Regulation D exempt offerings was more than $1 trillion, about equal to the amount raised in public offerings in the same year. Citing a presentation by Rachita Gullapalli to the Advisory Committee on December 17, 2014, SLK states that in the 12-month period from September 23, 2013 (the day 506(c) was enacted into law) through September 22, 2014, there were nearly 15,000 new Regulation D offerings, 99% of which were completed under Rule 506. Citing a white paper available on the SEC website, SLK notes that only 13% of Regulation D offerings between 2009 and 2012 reported using a financial intermediary such as a broker-dealer or finder.

The presentation continued with a recitation of the current state of the law and historical efforts for change, including the American Bar Association’s position and efforts and M&A transaction carve-out, both of which I had previously written about.

SLK concluded with a recommendation for statutory exemption for private placement finders. SLK recommends, and I agree, that the exemption should be self-executing and include appropriate restrictions, including bad actor prohibitions.

State Law; The Florida Trap

Florida, however, gives us a reminder of the necessity to be extremely careful and mindful of state law ramifications. Florida Statute §475.41 specifically states that a contract by an unlicensed broker to sell or to negotiate the purchase or sale of a business for compensation is invalid and in particular:

No contract for a commission or compensation for any act or service enumerated in §475.01(3) is valid unless the broker or sales associate has complied with this chapter in regards to issuance and renewal of the license at the time the act or service was performed.

Fla. Stat.§475.01(3) defines “operating” as a broker as meaning “the commission of one or more acts described in this chapter as operating as a broker.” “Broker” is defined broadly in Fla. Stat.§475.01(1)(a) and includes, among other things:

… a person who, for another, and for compensation or valuable consideration directly or indirectly paid or promised, expressly or impliedly, or with an intent to collect or receive compensation or valuable consideration therefore… sells… or negotiate[s] the sale, exchange, purchase, or rental of business enterprises or business opportunities… or who advertises or holds out to the public by any oral or printed solicitation or representation that she or he is engaged in the business of appraising, auctioning, buying, selling, exchanging, leasing or renting business enterprises or business opportunities… or who directs or assists in the procuring of prospects or negotiation or closing of any transaction which does, or is calculated to, result in a sale, exchange, or leasing thereof, and who receives, expects, or is promised any compensation or valuable consideration, directly or indirectly… (emphasis added)

Relying on these provisions, Florida courts and arbitration panels have found consulting and finder arrangements related to mergers and acquisitions and other corporate finance transactions that would otherwise not require federal broker-dealer registration, to be unlawful.

In addition to the conflict with federal law, the Florida statute is particularly troubling for practitioners as it is not included in the Florida Securities and Investor Protection Act found in chapter 517 of Florida Statutes. Florida Statute §517.12 is the state equivalent to Section 15(a)(1) of the Exchange Act requiring broker-dealer registration. Like the Exchange Act, §517.12 requires registration as a broker or dealer for the sale or offer of any securities.

Section 475, on the other hand, is the Florida statute governing “Real Estate Brokers, Sales Associates, Schools and Appraisers.” Section 517 gives no reference to Section 475 and vice versa. Other than through research of case law, a practitioner would have no reason to research laws governing real estate transactions in association with business mergers and acquisitions and the payment of related finders’ fees.

The Florida provisions remind us of the complexities associated with providing advice and guidance to clients related to the payment of finders’ fees, and the necessity to seek competent legal counsel before agreeing to pay, or accept, such a fee.

Consequences for Violation

Other than the discussion above related to Florida law, I am not addressing the varied state law consequences in this blog.

The SEC is authorized to seek civil penalties and injunctions for violations of the broker-dealer registration requirements. Egregious violations can be referred to the attorney general or Department of Justice for criminal prosecution.

In addition to potential regulatory problems, using an unregistered person who does not qualify for either the statutory or another exemption to assist with the sale of securities may create a right of rescission in favor of the purchasers of those securities. That is a fancy way of saying they may ask for and receive their money back.

Section 29(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), provides in pertinent part:

Every contract made in violation of any provision of this title or of any rule or regulation thereunder… the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract…

In addition to providing a defense by the issuing company to paying the unlicensed person, the language can be interpreted as voiding the contract for the sale of the securities to investors introduced by the finder. The SEC interprets its rules and regulations very broadly, and accordingly so do the courts and state regulators. Under federal law the rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation. Accordingly, for a period of at least three years, an issuer that has utilized an unlicensed finder has a contingent liability on their books and as a disclosure item. The existence of this liability can deter potential investors and underwriters and create issues in any going public transaction.

In addition, SEC laws specifically require the disclosure of compensation and fees paid in connection with a capital raise. A failure to make such disclosure and to make it clearly and concisely is considered fraud under Section 10b-5 of the Securities Act of 1933 (see, for example, SEC vs. W.P. Carey & Co., SEC Litigation Release No. 20501). Fraud claims are generally brought against the issuing company and its participating officers and directors.

Moreover, most underwriters and serious investors require legal opinion letters at closing, in which the attorney for the company opines that all previously issued securities were issued legally and in accordance with state and federal securities laws and regulations. Obviously an attorney will not be able to issue such an opinion following the use of an unlicensed or non-exempted person. In addition to the legal ramifications themselves and even with full disclosure and the time for liability having passed, broker-dealers and underwriters may shy away from engaging in business transactions with an issuer with a history of overlooking or circumventing securities laws.

Historically, it was the person who had acted in an unlicensed capacity who faced the greatest regulatory liability; however, in the past ten years that has changed. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective and a better deterrent to prosecute the issuing company than an unlicensed person who is here today and gone tomorrow.

The violations often go beyond the unlicensed broker-dealer issue. Persons who do not comply with the statutory and regulatory requirements for assisting in fundraising generally engage in inappropriate solicitation of investors, generous representations and the like in efforts to raise money and earn a commission and therefore face claims for securities fraud.

Conclusion

The payment of finder’s fees is a complex topic requiring careful legal analysis on a case-by-case and state-by-state basis. No agreements for the payment or receipt of such fees should be entered into or performed without seeking the advice of competent legal counsel.

For reference, prior blogs on the topic of the broker-dealer registration requirements include (i) the no-action-letter-based exemption for M&A brokers http://securities-law-blog.com/2014/02/18/broker-dealer/ (ii) the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act http://securities-law-blog.com/2014/07/07/broker-dealer-exemption-funding-websites-including-case-study/; (iii) the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer http://securities-law-blog.com/2014/05/20/broker-dealer-registration-requirements/; and (iv) the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders http://securities-law-blog.com/2013/01/03/the-aba-pushes-to-allow-for-the-payment-of-finders-fees/.

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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« Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions SEC Footnote 32 and Sham S-1 Registration Statements »

Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions

Posted by Securities Attorney Laura Anthony | August 11, 2015

Although the federal government and FINRA have become increasingly active in matters of corporate governance, the states still remain the primary authority and regulator of corporate law. State corporation law is generally based on the Delaware Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters, considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances.

On June 24, 2015, Delaware amended the Delaware General Corporation Law (“DGCL”) to prohibit fee shifting provisions. The DGCL amendments also allow Delaware corporations to adopt exclusive (and non-exclusive) forum selection provisions in their corporate charters. The amendments went into effect August 1, 2015.

Fee Shifting Provisions

As a result of increasing shareholder activism and filed or threatened shareholder lawsuits, corporations have started adding provisions in their corporate charters (articles and/or bylaws) whereby the non-prevailing party in an inter-company lawsuit must pay the prevailing parties’ attorneys’ fees. Prevailing party attorney’s fees provisions are standard in contracts. In adding such provisions to corporate charter documents, a corporation is taking the position that if a person becomes a shareholder of the corporation, they are agreeing to be bound by the terms of the corporate charter documents, much like being bound by a contract, including the prevailing party attorney fee provision.

Absent a contractual (or statutory) prevailing party fee provision, parties to litigation are required to each pay their own attorneys’ fees. The prevailing party fee provision acts to shift the fees to the shareholder/plaintiff in the event they are not successful. In addition, the fee-shifting provisions define “successful” in most cases as the substantial achievement, in substance and amount, of the full remedy sought. For example, a plaintiff can ask for $1,000,000, win $750,000 and be a non-prevailing party under a fee-shifting provision. Typically, the fee-shifting provisions extend beyond just the plaintiff to all those with a financial interest in the outcome, or those which assist the plaintiff. With such a broad extension, the plaintiff’s attorneys could find themselves also directly responsible for the defendant’s attorney’s fees in the event the plaintiff is not successful.

Much like an anti-takeover poison pill, these fee-shifting provisions are an anti-shareholder-lawsuit poison pill. Not only do such provisions apply to standard derivative lawsuits for such matters as a corporate breach of fiduciary duty, but they can be broadly applied to inter-company lawsuits, including those involving claims of securities law violations.

The legal basis relied upon by corporations for adding such a provision is that when a shareholder buys stock, they are agreeing to be bound by the corporate charter documents. This theory is not far-fetched and is actually supported by a broad array of legal dicta. For instance, when a shareholder buys stock in a company, they are agreeing to be bound by the voting rights (including number of votes, notice and similar provisions related to shareholder and director meetings), information rights, dividend and participation rights, liquidation rights, and recently choice of law and jurisdiction provisions. It seemed a natural progression to add other standard contractual provisions to such corporate charter documents, but the fee-shifting provisions were instantly met with a great deal of opposition, including by the Delaware legislature.

In May 2014, the fee-shifting provision was challenged and the Delaware Supreme Court upheld the provision as valid, at least in that case. The court did note that the validity of the provision included an analysis of the “circumstances surrounding its adoption and use” and whether it was “adopted or used for an inequitable purpose.” The intent to deter litigation is not an improper purpose.

The court ruling faced a great deal of opposition, including from the Delaware corporate bar and the Delaware legislature.

The Delaware legislature in turn drafted a bill to make it unlawful to include fee-shifting provisions in corporate charters and bylaws. The bill was tabled until January 2015 and finally was passed into law on June 24, 2015. The two primary proxy advisory firms, Institutional Shareholder Services, Inc., and Glass Lewis & Co., both recommended that shareholders vote against fee-shifting provisions and generally against forum selection provisions subject to a consideration of certain facts related to the company’s rationale and history with shareholder lawsuits.

The DGCL amendment adds new Sections 102(f) and 115, and amends current section 109(b) to invalidate any provision in the certificate of incorporation or bylaws that shifts the corporation’s or any other party’s attorney’s fees or expenses to the shareholder in an “internal corporate claim.” New Section 115 defines an “internal corporate claim” as “claims including claims in the right of the corporation, (i) that are based upon a violation of a duty by a current or former director of officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.”

My Thoughts on Fee Shifting

I agreed with the Delaware Supreme court and think the provisions should be allowed, though their scope may have needed an adjustment. Shareholder lawsuits have become so commonplace that they are practically a method of communication—sue now, talk later. Predatory plaintiffs’ attorneys comb for pending merger transactions and/or decreases in stock prices and then solicit shareholders looking for a plaintiff or representative plaintiff for a class action. Whether there has actually been a corporate wrongdoing is secondary and often not even a consideration. As a transactional attorney, I think litigation should be a last, not first, option.

I’m not insensitive to the counter-argument. Fee-shifting provisions can have a chilling effect on valid cases to enforce real securities law violations or breaches of corporate fiduciary duty. Broad provisions that include potential attorneys’ fee liability for plaintiffs’ counsel and expert witnesses could effectively wipe out private lawsuits against Delaware corporations.

However, by narrowing the scope of allowable fee-shifting provisions to limit liable non-prevailing parties to the parties themselves, or their counsel only in egregious cases, and by limiting the definition of “success,” a balance could be reached.

Some opponents of the fee-shifting provisions called for SEC intervention. Professor John Coffee and Professor Lawrence Hammermesh both gave testimony to the SEC’s Investor Advisory Committee pushing for SEC action. In other words, some called for greater federal regulation of corporate law. I disagree with this approach. Over the years the federal government, or quasi-governmental regulators, has enacted regulations that have the effect of imposing on state corporate law. The result has been a piecemeal corporate federalism, often with unintended results. A prime example is illustrated in my blog regarding FINRA’s Rule 6490, which can be read HERE.

The amendments to the DGCL take the issue out of the hands of the courts (absent a challenge to the amendment itself) and the SEC. However, corporations resorted to these provisions for a reason, and that reason still exists. I’m interested to see what the next defensive measure brings.

Forum Selection

A forum selection clause limits the jurisdiction in which a corporation can sue or be sued in certain types of actions, including but not limited to (i) derivative actions or proceedings brought on behalf of the corporation, (ii) actions asserting a claim of breach of fiduciary duty owed by a director, officer or other employee of the corporation to the corporation or its shareholders, (iii) actions asserting a claim under the applicable state corporate law, or (iv) actions asserting a claim governed by the internal affairs doctrine.

In 2013, the Delaware Chancery Court found that forum selection provisions are facially valid and may be adopted unilaterally by a board of directors as long as they are reasonable and fair. The court concluded that enforceability should be assessed on a case-by-case basis using a reasonableness standard of analysis.

The newly enacted legislation will allow Delaware corporations to include a Delaware choice of law provision in their certificates of incorporation and bylaws provided that a Delaware corporation cannot designate a state other than Delaware as the exclusive forum for an internal corporate claim. In particular, the DGCL amendment includes a provision in new Section 115 that “the certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State, and no provision of the certificate of incorporation or the bylaws may prohibit bringing such claims in the courts of this State.”

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 Proposed Executive Compensation Clawback Rules Finders- The Facts Related To Broker-Dealer Registration Requirements »

SEC Proposed Executive Compensation Clawback Rules

Posted by Securities Attorney Laura Anthony | August 3, 2015

On July 1, 2015 , the SEC published the anticipated executive compensation clawback rules (“Clawback Rules”). The rules are in the comment period and will not be effective until the SEC publishes final rules. The proposed rules require national exchanges to enact rules and listing standards requiring exchange listed companies to adopt and enforce policies requiring the clawback of certain incentive-based compensation from current and former executive officers in the event of an accounting restatement.

In particular, the proposed rules implement Section 10D of the Securities Exchange Act of 1934, as amended (“Exchange Act”) and as added by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Section 10D requires the SEC to adopt rules directing national exchanges to prohibit the listing of any security of an issuer that is not in compliance with Section 10D’s requirements for (i) disclosure of the company’s policy on incentive-based compensation that is based on financial statement results and (ii) recovery of incentive-based compensation in the event of an accounting restatement due to the company’s material noncompliance with any financial reporting requirement and which recovery is in an amount that is the excess between the compensation paid and what would have been received under the restated financial statements, without regard to any taxes paid.

In other words, the Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement would be prohibited.

There are currently existing rules which require the recovery of executive compensation and disclosure of such policies. In particular, Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) requires the CEO and CFO to reimburse the company for any bonus or other incentive-based or equity compensation for the prior 12 months, and any profits received from the sale of securities in that time period, if a company is required to prepare a restatement as a result of the misconduct related to financial reporting. The Compensation Discussion and Analysis (CD&A) required by Item 402(b) requires an explanation of “all material elements of the registrant’s compensation of the named executive officers” and requires general discussions of performance including disclosure of any bonus structures and performance-based compensation and company policies and decisions regarding the adjustment or recovery of awards and payments to such named executive officers.

In addition to requiring companies to adopt written policies and procedures and to disclose same, the new Clawback Rules remove fault from the consideration of recovery, broaden the effected executives to include all named executive officers and extend the existing look-back period.

Definition of Incentive-Based Compensation

“Incentive-based compensation” would be defined as any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure, which includes measures presented in an issuer’s financial statements, as well as stock price and total shareholder return. Salaries and bonuses not tied to financial performance are not included in the recovery rules.

The Clawback Rules require the recovery of “incentive-based compensation (including stock options awarded as compensation)” that is received, based on the erroneous data, in “excess of what would have been paid to the executive officer under the accounting restatement.” The amounts recovered are determined without regard to any taxes paid.

Issuers and Securities Subject to the Clawback Rules

The Clawback Rules apply to all listed issuers and all securities, with limited exceptions. The proposed rules’ limited exemptions include security future products, standardized options and the securities of certain registered investment companies.

Restatements Triggering Application of Recovery Policy

The Clawback Rules require issuers to adopt and comply with policies that require recovery “in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.” The SEC includes any error that is material to the financial statements as “material noncompliance”. Accordingly, the Clawback Rules provide that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy.

The SEC clarifies that the following changes to financial statements would not trigger the recovery policy: (i) the retrospective application of a change in accounting policy; (ii) retrospective revision to a reportable division due to a company’s internal reorganization; (iii) retrospective reclassification due to a discontinued operation; (iv) retrospective application of a change in reporting entity such as from a reorganization or change in control; (v) retrospective adjustment to provisional amounts in connection with a prior business combination; or (vi) retrospective revision for stock splits.

Applicable Date and Time Period

The Clawback Rules would require the recovery of incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The date on which the company is required to prepare an accounting restatement is the earlier of (i) the date the board of directors or officers of the company, if board authorization is not required, conclude that the company’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

Executive Officers Subject to Recovery Policy

The SEC has proposed a broad definition for “executive officers” subject to clawback that is modeled after the definition used in the regulations implementing the short-swing profit rules set forth in Section 16 of the Securities Exchange Act of 1934, as amended. “Executive officers” subject to the Clawback Rules would include a listed company’s president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function, and any other person who performs a policy making function for the company, and would apply to both current and former executive officers during the three years preceding the date of the required restatement.

Determination of Recovery Obligation

The Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement would be prohibited. The recovery, as proposed, is bright line and not based on “fault” or other subjective measures. Executive officers would be required to return incentive-based compensation regardless of misconduct or responsibility for the accounting errors. Indemnification or insurance reimbursement would be prohibited.

Board Discretion Regarding Whether to Seek Recovery

The Clawback Rules as proposed allow a board of directors’ discretion to determine not to pursue recovery in certain instances, such as when it would be impracticable or impose undue costs on the company or its shareholders or would violate home country law.

Disclosure Requirements

A company listed on any national exchange is required to file its clawback policy as an exhibit to its annual report on Form 10-K. Moreover, in the event of a restatement and necessary clawback efforts, the company must disclose its recovery efforts in its proxy statement, including the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount of incentive-based compensation that remained outstanding at the end of the last completed fiscal year. Both Form 10-K and Schedule 14A will be amended to include the disclosure and exhibit requirements.

Compliance with Recovery Policy

Under the proposed Clawback Rules, a company would be subject to delisting if it does not (i) adopt a compensation recovery policy that complies with the rules; (ii) disclose the policy in accordance with the rules, including XBRL tagging; and (iii) comply with its written compensation recovery policy.

Transition and Timing

The Clawback Rules would require that each national exchange propose new listing standards implementing the rules no later than 90 days following SEC publication of final rules; that such standards take effect no later than one year following SEC publication of final rules; and that each company adopt the recovery policy required by the rules no later than 60 days following the date on which the exchanges’ rules become effective.

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 Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156 Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions »

OTC Markets Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156

Posted by Securities Attorney Laura Anthony | July 29, 2015 Tags: LawCast, OTC Law Firm, OTC Law Firms, OTC Lawyers, OTC Market Attorneys, OTC Markets Attorneys, OTC Securities Attorneys

On July 10, 2013, the SEC issued proposed rules further amending Regulation D, Form D and Rule 156. On September 23, 2013 the OTC Markets Group published a letter responding to the SEC’s request for comments on the proposed rules. The entire OTC Markets comment letter is available on both the OTC Markets website and the SEC website. The OTC Markets Group, through OTC Link, owns and operates OTC Markets and its quotation platforms including OTCQX, OTCQB and pink sheets.

Summary of Proposed Rule Changes

The proposed amendments will (i) require the filing of a Form D to be made before the Issuer engages in any general solicitation or advertising in a Rule 506(c) offering and require the filing of a closing amendment to the Form D at the termination of the offering; (ii) require that all written general solicitation material used in a Rule 506(c) offering include certain legends and disclosures; (iii) require that all written material used in general solicitation and advertising be submitted to the SEC; (iv) disqualify an Issuer from relying on Rule 506 for one year for future offerings if the Issuer, or any predecessor or affiliate of the Issuer, failed to comply with the Form D filing requirements for a Rule 506 offering in the last five years; (v) amend the Form D to include additional information about offerings; and (vi) amend Rule 156 to extend the antifraud guidance in the rule to include sales literature of private funds (hedge funds). In addition, as part of the proposed rule release, the SEC is seeking comments from the public on the definition of “Accredited Investor.”

On August 20, 2013, I published a blog detailing the proposed rule changes related to Form D and Rule 507, which can be viewed here. On August 27, 2013, I published a blog detailing the remainder of the proposed rule changes including the proposed amendments to general solicitation materials and the temporary requirement that all such materials be submitted to the SEC, which can be viewed here.

OTC Markets Comment Letter

OTC Markets has been vocal about its support of the lifting of the ban on general solicitation and advertising, and it continues to be so in its comment letter. However, OTC Markets is not supportive of the proposed new rules and, in fact, is concerned that the rules “would counteract the positive impact of the new general solicitation and advertising rules, contradict the intent of the JOBS Act, and ultimately harm small capital formation.” The OTC Market’s biggest concern is the proposed advance Form D filing requirement.

OTC Markets Comments Related to the Proposed Advance Form D Requirement

Currently, an Issuer must file a Form 15 within 15 days of the first sale of securities in a Regulation D offering. An Issuer must file an amendment if there is a material change to the information filed in the original Form D. The proposed rule would require the Issuer to file an advance Form D with the SEC at least 15 days prior to using advertising or general solicitation in conjunction with the new 506(c) offering exemption. OTC Markets has many issues with the proposed new filing requirement.

First, OTC Markets is concerned that the advance filing requirement will chill communications between Issuers and potential investors. It is unclear what constitutes general solicitation and advertising or non-confidential information. This lack of clarity will likely result in confusion by Issuers as to when or if an advance Form D is required. Moreover, the lack of clarity could cause Issuers to err on the cautious side and instead of providing more information to the public, maintain such information as confidential. One of the underlying intents of the JOBS Act was to increase the amount of publicly available information about Issuers.

OTC Markets points out that “[F]or many small companies, the fear of violating the Advance Form D requirement will cause them to keep information confidential. Investors, employees, the press and regulators would be deprived of valuable company information, leading to unreliable price discovery, a lack of market efficiency, reduced incentive to participate in private offerings, and less capital raising by small companies.” OTC Markets goes further to conclude that “the Advance Form D requirement may completely frustrate the Congressional intent behind the JOBS Act and make the end of the ban on general solicitation and advertising a non-event for small companies.”

In addition, OTC Markets takes issue with the SEC’s reasoning behind the proposed advance Form D requirement. In particular, the SEC has indicated that the requirement will help it analyze and better understand the market for Rule 506(c) private placements. The SEC does not offer a rationale as to how an advance Form D would provide information not already provided by the current Form D. Moreover, the SEC has access to documents submitted to FINRA by broker dealers acting as placement agent or participating in private placements. The current Form D filing requirement together with FINRA information already provides the SEC with enough data to analyze any market impact of 506(c) offerings without the negative effect of chilling small companies’ communications and capital raising efforts.

In a point very well taken, the OTC Markets states, “[T]he capital formation process would be much better served if the SEC engaged in thoughtful private placement rulemaking 12 months from now after conducting a thorough analysis of the impact of the new general solicitation rules on the private placement market. Implementing the Advance Form D requirement simultaneously with the end of the ban on general solicitation and advertising deprives the markets of the opportunity to properly evaluate the impact of the JOBS Act on small company capital formation.”

OTC Markets Comments – the Benefits of Adequate Current Public Information

OTC Markets advocates full public disclosure by all Issuers, especially those engaging in private placement offerings. The OTC Markets comment letter advocates “mandatory public disclosure of the information required under Securities Act Rule 144 in connection with any Rule 506(c) offering that utilizes general solicitation and advertising.” Rule 144 requires adequate current public information as a prerequisite to the sale of securities under the Rule. For a reporting company, the current public information requirement is met by being current in its reporting requirements with the SEC. For a non-reporting company, the current public information requirement is met by having all the information required by SEC Rule 15c2-11 made publicly available. Generally, this information is uploaded onto the OTC Markets website.

OTC Markets points out that prior to the new Rule 506(c), Regulation D required that information be kept confidential and not publicly available. OTC Markets sees the new rule as an opportunity for the SEC to increase and encourage public information by Issuers.

Although OTC Markets does not address this in its letter, one of the SEC’s reasons behind previously prohibiting public information was to ensure that only qualified investors had access to such information. However, in the proverbial “throw the bath water out with the baby,” the result was an influx of private secondary markets (such as pre-IPO Facebook) where everyone could see the trading of a security but only a qualified few could access information related to the Issuer. The new 506(c) is a tremendous shift whereby everyone can access the public information but only a qualified investor can make the actual investment.

OTC Markets rightfully points out that “[Public] availability of company information builds trust in our capital markets and provides vital protection against fraud.”

OTC Markets Comments on Proposed 506 Ban for Form D Noncompliance

The SEC has proposed a rule whereby Issuers would be banned from Rule 506 offerings for one year if that Issuer has failed to comply with the Form D filing requirements within the past 5 years. OTC Markets points out—and I couldn’t agree more—that the complexity of the Form D filing requirements, especially if the advance Form D is required, will lead to substantial technical noncompliance by well-intentioned Issuers. The one-year penalty is an overly severe punishment, especially in the environment of changing rules and regulations.

The Author

Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys

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 Ms. Anthony has structured her securities law practice 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. Ms. Anthony’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 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 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 host of LawCast.com, the securities law network.

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« SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies SEC Proposed Executive Compensation Clawback Rules »

SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies

Posted by Securities Attorney Laura Anthony | July 29, 2015 Tags: Going public attorneys-2, LawCast-2, OTC Attorneys, OTC Law Firm, OTC Law firm-2, OTC Law Firms, OTC Lawyers, OTC Market Attorneys, OTC Markets Attorneys, otc markets attorneys-2, OTC Securities Attorneys, OTC Securities Attorneys-2, Reverse Merger Attorneys, Reverse merger attorneys-2, Reverse Mergers Attorneys, Securities Attorneys

On May 6, 2015 the SEC approved a two-year pilot program with FINRA and the national securities exchanges that will widen the minimum quoting and trading increments, commonly referred to as tick sizes, for the stocks of smaller public companies. The goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks.

The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. The other side of the coin is that larger spreads and more profit for the traders equates to increased costs to the investors whose accounts are being traded.

The tick size program includes companies that meet the following $3 billion or less in market capitalization, an average trading volume of one million shares or less, and a volume weighted average price of at least $2.00 for every trading day. The pilot study group includes a control group of 1400 securities and three test groups with 400 securities in each. Notably, the tick size program will not include micro-cap securities with a weighted average price of less than $2.00 per day.

During the pilot the control group will be quoted at the current tick size increment of $.01 per share and will trade at the currently permitted increments. The first test group will be quoted in increments of $.05 but will continue to trade at any price increment that is currently permitted. The second test group will be quoted in increments of $.05 and will also trade at $.05 minimum increments subject to certain exceptions. The third test group will be quoted in increments of $.05 and will be subject to an additional “trade at” requirement to prevent price matching. The third test group will have the same exceptions as the second and an additional block size exception.

Background and Reasoning for the Program

Since the inception of decimalization in 2001 and minimum price variation of one penny for exchange-traded companies, there has been a significant change in the nature of trading and role of market participants. Many market participants believe that underwriters and market makers have lost their incentive to make markets and produce research for micro-, small- and mid-capitalization companies.

The JOBS Act directed the SEC to conduct a study and report to Congress on how decimalization affected the number of IPO’s and the liquidity and trading of stock in smaller public companies. The JOBS Act also gives the SEC the authority to designate a minimum increment for the trading of emerging growth companies that is more than $.01 but less than $.10. In July 2012 the SEC submitted the “Decimalization Report” to Congress, failing to reach a firm conclusion and instead realizing further research was needed, including by pursuing a pilot program to study the impact of wider tick sizes. The SEC believes that the current approved tick size pilot program will provide the necessary information to determine whether to permanently change tick sizes for these smaller companies.

As mentioned, the goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks. The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. Moreover, additional market makers may enter the market as they see an opportunity to earn value. Additional market makers will equate to additional liquidity, which in turn attract more investors.

Issuers benefit from increased liquidity and market activity and quality in several ways. More trading activity and increased investor awareness could reduce the company’s cost of capital and improve opportunities to attract capital. That is, more investors will be willing to invest directly into the company, through PIPE transactions, registered secondary offerings, equity lines and the like as they will see a strong exit strategy. Moreover, with higher liquidity and market value, the ultimate exit by these investors will have less of a downward impact on trading price. Where the investment instrument was convertible (such as convertible debt, warrants and options) using a market price formula, less downward pressure on trading price will mean fewer shares will need to be issued in the conversion and the existing shareholders will suffer less dilution.

In addition, one of the main purposes of going public is to use capital stock as currency in making acquisitions and attracting key executives. Where the company has an active trading market, market maker support and strong liquidity, the value of the capital stock is likewise higher. Not only will the capital cost of making stock-based acquisitions and attracting and retaining high-quality key executives be reduced but for some issuers, it will make the difference of being able to utilize this benefit of being public at all.

Although there is no doubt that improved liquidity, market activity and market maker and underwriter support is extremely beneficial to all public companies, and in serious need for improvement for smaller public companies, it is not known whether the increased tick size will have the desired outcome.

The other side of the coin is that larger spreads and more profit for the traders with the increased tick size equates to increased costs to the investors whose accounts are being traded. Moreover, the program itself will be complex and costly to implement for market participants. Market participants have stringent rules to follow for each test group to ensure a valid test result. Each participant must adopt written policies and procedures and monitor and report results.

Conclusion

It is important that the SEC and market participants actively seek to improve the market quality for smaller public companies, and this is just one measure in that wheelhouse. However, it is a two-year program. I’m anxious to see more timely efforts in this arena, such as through the launch of venture exchanges.

The Author

Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys

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 Ms. Anthony has structured her securities law practice 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. Ms. Anthony’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 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 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 host of LawCast.com, the securities law network.

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

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« The ECOS Matter; When Is A Reverse Split Effective? OTC Markets Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156 »

The ECOS Matter; When Is A Reverse Split Effective?

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Duty of Care, Finra, Going Public Attorneys, OTC Attorneys, OTC Marketplace, OTC Markets Attorneys, Reverse Merger Attorneys, Reverse Mergers Attorneys, Reverse split, Rule 10b-17, Rule 6490

In what was presumably an unintended consequence, the application of an SEC- approved FINRA regulation has resulted in a conflict between state and federal corporate law for a small publicly traded company.

On September 16, 2014, Ecolocap Solutions, Inc. (“ECOS”) filed a Form 8-K in which it disclosed that FINRA had refused to process its 1-for-2,000 reverse split. At the time of the FINRA refusal, ECOS had already received board and shareholder approval and had filed the necessary amended articles with the State of Nevada, legally effectuating the reverse split in accordance with state law. Moreover, ECOS is subject to the reporting requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and had filed a preliminary and then definitive 14C information statement with the SEC, reporting the shareholder approval of the split.

The ECOS 8-K attached a copy of the FINRA denial letter, which can be viewed HERE. In support of its denial of the reverse split, FINRA relied upon its discretion under FINRA Rule 6490 and the existence of a previous SEC action against an individual who is the principal of an entity that is a convertible note holder of ECOS. In particular, FINRA cited an SEC order issued on November 25, 2013 against Curt Kramer, Mazuma Corporation, Mazuma Funding Corporation and Mazuma Holding Corporation involving violations of Section 5 of the Securities Act of 1933 and Rule 504. FINRA cited that Curt Kramer is a principal of Asher Enterprises and that Asher Enterprises, in turn, is a convertible note holder in ECOS and therefore FINRA was refusing to process the reverse split.

In its 8-K filing, ECOS took a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate. In support of their position, ECOS sets forth that the subject reverse split was already legally effective in accordance with state law and therefore FINRA’s refusal to reflect such capital change in ECOS trading quotation results in public misinformation regarding the company’s capitalization. ECOS also objected to FINRA’s application of Rule 6490 in this case by denying that either Mr. Kramer or Asher Enterprises is “connected” with the company as contemplated by the Rule. Furthermore, they stated that the subject SEC action was completely unrelated to ECOS or the reverse split.

Although FINRA has not issued a responsive statement, one of its mandates is to protect investors and maintain fair and orderly markets. In this instance, the Company’s stock is actively trading at $.0001 per share. The Company’s total outstanding shares increased from 893,615,983 one year ago to 6,865,010,372 as of April 2014. ECOS has been in the development stage since January 1, 2007 and has not reported any revenues since September, 2010. The overwhelming majority of the increase in outstanding stock is the result of the conversion of convertible debt, and most of funds received by the company from the note holders was used for salaries, as well as interest on the convertible debt and fees for staying a publicly-traded company (such as satisfying reporting obligations). Although the information in the Company’s filings as to its business operations is sparse, it has been in the same business with the same management since 2007, without any financial success. As of June 30, 2014, the Company had approximately $664,000 in convertible outstanding notes payable. The Company intends to complete a 1:2000 reverse split, which will reduce the total outstanding shares to 3.9 million and presumably increase the share price to $.20.

However, the Company’s new, higher share price will likely be temporary due to the lack of any underlying business success to create support for a higher market valuation. In addition, FINRA realizes that in all probability, upon enactment of the inflated share price, existing note holders have an increased incentive to convert their debt into freely tradable shares and may begin selling these shares in the market. Should such selling pressure occur, and the new share price decrease, any shareholder that purchased at $.20 will most likely suffer a loss. Should the cycle of selling continue, the outstanding shares will increase, potentially into the billions, until the share price is once again $.0001. Taking this into account, FINRA’s concerns are self-evident.

There clearly exists a fundamental conflict between federal and state law and the ability to regulate corporate actions. It raises the basic question of “When is a reverse split effective?” If pursued, this action opens the door for court interpretation of FINRA’s authority under Rule 6490 in general.

Rule 6490

Effective September 27, 2010, the SEC approved FINRA Rule 6490 (Processing of Company Related Actions). Rule 6490 requires that corporations whose securities are trading on the over-the-counter market (OTCQX, OTCQB, OTCBB or pinksheets) timely notify FINRA of certain corporate actions, such as dividends, forward or reverse splits, rights or subscription offerings, and name changes. The Rule grants FINRA discretionary power when processing documents related to the announcements.

Rule 6490 works in conjunction with Exchange Act Rule 10b-17. Rule 10b-17 provides that “it shall constitute a manipulative or deceptive device or contrivance as used in section 10(b) of the Act for any issuer of a class of securities publicly traded… to fail to give notice in accordance with paragraph (b) of this section of the following actions relating to such class of securities: (1) a dividend or other distribution in cash or in kind… (2) a stock split or reverse split; or (3) a rights or other subscription offering.” Section (b) requires that notice be given to FINRA “no later than 10 days prior to the record date involved.”

FINRA also issues trading symbols to over-the-counter traded issuers and maintains a database of trading symbols for issuers. When FINRA completes the processing of a corporate action, OTC marketplace is notified of such changes and actions. Most commonly, changes and actions include the re-pricing of securities after a forward or reverse split and the issuance of a new trading symbol following a name change or merger.

Prior to 2010, FINRA’s role has been predominantly ministerial due to their limited jurisdictional ability to impose informational or other regulatory requirements, and fundamental lack of power to reject requested changes. However, since the SEC began expressing concern that entities were using FINRA to assist in fraudulent activities, Rule 6490 was created.

The Rule codifies FINRA’s authority to conduct in-depth reviews of company-related actions and equips the staff with discretion to refuse the processing of such actions in situations when the information or requisite forms are incomplete or when certain indicators of potential fraud exist. FINRA staff now possesses broad discretion to request additional documents and supporting evidence to verify the accuracy of submitted information.

Rule 6490(d)(3) provides:

(3) Deficiency Determination

In circumstances where an SEA Rule 10b-17 Action or Other Company-Related Action is deemed deficient, the Department may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets, that documentation related to such SEA Rule 10b-17 Action or Other Company-Related Action will not be processed. In instances where the Department makes such a deficiency determination, the request to process documentation related to the SEA Rule 10b-17 Action or Other Company-Related Action, as applicable, will be closed, subject to paragraphs (d)(4) and (e) of this Rule. The Department shall make such deficiency determinations solely on the basis of one or more of the following factors: (1) FINRA staff reasonably believes the forms and all supporting documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements, if applicable, to the SEC or other regulatory authority; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security. (emphasis added)

Exchange Act Rule 10b-17 appears to be limited to notice and allows the SEC to pursue an enforcement action for the failure to give such notice in a timely manner. Rule 6490 goes further, stating a corporation action “will not be processed” if FINRA makes a “deficiency determination.” Clearly subsections (3) and (4) give broad discretionary authority to FINRA to render such a deficiency determination and refuse to process an action.

Further exacerbating the existing conflict between the application of state and federal law is the fact that FINRA requires that a Company submit the file-stamped amendments to its corporate charter as part of their review process. Simply stated, the FINRA corporate action process requires that a Company legally completes the corporate action (reverse split, name change, etc.) on the state level prior to issuing a determination as to whether it will process the already-completed change with the marketplace.

State vs. Federal Regulation of Corporate Law

Historically the regulation of corporate law has been firmly within the power and authority of the states. However, over the past few decades the federal government has become increasingly active in matters of corporate governance. In waves, typically following a period of scandal in business or financial markets, the federal government has enacted regulation either directly or indirectly imposing upon state corporate regulations. The predominant method of federal regulation of corporate governance is through the enactment of mandatory terms that either reverse or preempt state law rules on the same point.

State corporation law is generally based on the Delaware and Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances. The traditional fiduciary duties that govern state corporations laws include the duties of care and loyalty and are tempered by the business judgment rule.

The duty of care requires that directors exercise the same level of care that would be expected from an ordinarily prudent person in the conduct of his or her own affairs. This includes making an informed decision, seeking the advice of experts when necessary, and considering both the positive and negative impacts of a decision. The duty of loyalty is essentially a proscription against conflict of interest and self-dealing. The business judgment rule basically says that if a director follows both his duty of loyalty and duty of care, then the decision should be deferred to.

Director actions that result in a fraud upon shareholders and investors is actionable under federal (and state) securities laws. Both the state and federal securities regulators are charged with preventing fraud on the markets and protecting the integrity of the trading markets in general.

Conclusion

The ECOS matter has raised heated debate on whether FINRA fairly applied its authority in this case and as to the meaning of “connected.” Publicly traded companies, by nature, have ever-evolving shareholders and investors, the identities of which are often not in the power or control of the company itself. Stock is personal property that generally may be freely transferred by its owners (which should not be confused with suggesting that such transferred stock is always freely tradable on a public market). Debt instruments are negotiable instruments and generally transferrable by the debt holder. The sale and transfer of such debt instruments is common. In the small cap world, changes in management and control are fairly commonplace, as is the change in the business direction of a company.

Regulators are tasked with the job of supporting these changes in the small and micro-cap space and giving every entrepreneur a fair shot while preventing abuses in the system and what such as in this case, they ultimately see, as crossing the line.

Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux. What is the capitalization of ECOS? In accordance with state law, the company has approximately 3.4 million shares issued and outstanding; however, according to the over-the-counter marketplace, the company has approximately 6.8 billion shares outstanding. Legally it seems that the company has 3.4 million shares of stock outstanding at a trading price of $.0001 and that FINRA’s refusal to process relates solely to a refusal to re-price the stock as a result of the reverse split and not a broader refusal to recognize the validly of the share reduction itself.

However, many people in the industry are debating the impact and meaning of the decision with divergent views and conclusions, including the legal effect of the reverse split.

A discussion of federal law pre-emption is beyond the scope of this blog. However, even if I did include a treatise on the subject, the answer would be difficult. As an attorney I could write a very good argument that state law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply), and I could also write a very good argument that federal law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply except where there is a competing strong federal policy – such as the regulation of public markets). I could argue that the federal government has no right to stop a corporation from effectuating a name change or reverse split but only the power to prosecute the failure to provide adequate notice of same. I could also argue that the federal government has the right to take actions that may prevent fraud being committed on public markets, including by refusing to allow a name change or reverse split.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Securities, Reverse Merger and Corporate 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 Ms. Anthony has structured her securities law practice 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. Ms. Anthony’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 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 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.

Contact Legal & Compliance LLC. Inquiries of a technical nature are always encouraged.

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« Insider Trading- A Case Study SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies »

Insider Trading- A Case Study

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Control Block Purchaser, effective s-1 registration statement, Insider Trading, Insider Trading Violations, Misappropriation theory, probability-magnitude test, Section 10(b), temporary insider

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Any and all persons that buy and sell stock may be subject to insider trading liability. This blog sets forth a particular hypothetical fact scenario and analyzes the associated insider trading implications.

Hypothetical Fact Pattern: Company X (the “Company”) sells shares to a group of 35 unaffiliated shareholders pursuant to an effective S-1 registration statement. These same 35 unaffiliated shareholders (the “Sellers”) sell their registered stock to a group of 35 unaffiliated purchasers (the Buyers”) in a private transaction (the “Transaction”). At or near the same time as the Transaction, the control block consisting of restricted shares of common stock is sold to a different purchaser (“Control Block Purchaser”) in a private transaction (collectively, the “Transactions”). The Transactions result in a complete change of control and shareholder base in the Company. The Buyers are known by the Control Block Purchaser and are introduced to the Transactions by the Control Block Purchaser. The Buyers and the Control Block Purchaser are aware of nonpublic information at the time of the Transactions. In particular, after the Transactions are completed, there will be either a reverse merger transaction with a previously identified operating business, or a complete change in direction of the Company’s current business. In addition, the Buyers are aware that a change of control transaction will occur contemporaneously with their Transaction. After the Transactions are complete, a reverse merger and/or complete change in direction of the Company’s business occurs, most likely resulting in an increase in value of the common stock of the Company.

Analysis and discussion:

Insider trading is prohibited by the general anti-fraud provisions and in particular Section 10(b) of the Securities Exchange Act of 1934, as amended and Rule 10b-5 thereunder. There are three main theories on which insider trading is based: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory.

Section 10(b) of the Exchange Act makes it unlawful for any person to, directly or indirectly, “use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Rule 10b-5, promulgated under Section 10(b), provides that “[I]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

The elements of a Section 10(b) and Rule 10b-5 claim include:

(i) Misrepresentation or Omission of a Material Fact – the key point here being “material.” A fact is material if, in light of the totality of information, it is substantially likely it would impact a reasonable person’s investment decision. The test is based on a reasonable person’s perspective, not necessarily the investor making the claim.

(ii) Scienter/State of Mind – Rule 10b-5 requires that the defendant be aware of the fraud. Awareness can be established either by actual awareness (defendant states that they have 5 contracts when there are only 3) or by showing that the defendant should have been aware with reasonable inquiry and diligence (defendant knew that the Control Block Purchaser owned and operated a separate business that he intended to bring public, but never asked if he was purchasing this particular control block for that purpose).

(iii) Reliance – An investment decision must have been made in reliance on the misinformation or lack of information. In other words, there must be a link between the alleged fraud and the investment decision. It is presumed, when material information is withheld, that there is reliance. The presumption of reliance can be rebutted by showing that the claimant’s decision to purchase or sell shares was not influenced by the alleged fraud, or that the alleged fraud did not alter or change the stock price.

(iv) Causation – the plaintiff in a 10b-5 claim must show that the fraud caused damages. Damages are a calculation of the monetary loss of the claimant or monetary gain by the defendant, and such damages must be linked to the fraud.

(v) Damages – in addition to linking the damages to the fraud, actual damages must exist.

Classical Theory

Rule description: Under the classical theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer. The “on the basis of” standard is met if the purchaser or seller is aware of the material nonpublic information at the time of the purchase or sale. Materiality is generally measured by whether there is a substantial likelihood that the material nonpublic information would have been viewed by a reasonable investor as having significantly altered the total mix of information currently available and influenced the investment decision. When forward-looking information is involved, including a potential reverse merger and/or future change in the direction of the Company’s business, a secondary layer of materiality is triggered, which is termed the probability-magnitude test. Under the probability-magnitude test, you must also weigh the likelihood that the future event will occur and the magnitude of the effect of the future event on the Company.

Nonpublic information is any information that is not generally disseminated to the investing public. A duty of trust or confidence arises when the person is a “corporate insider” or a “temporary insider.” A corporate insider is generally an officer, director, or employee of the Company. A temporary insider relationship arises when a special confidential relationship is established between the person and the Company in the conduct of business, and that person is given access to material nonpublic information solely for corporate purposes. A temporary insider is generally an accountant, attorney, underwriter, consultant, and directors or executives of another company that are engaged in merger talks with the Company. It is important to note that the insider trading rules under the classical theory require an insider to disclose or abstain from trading. This means that the insider must abstain from trading or disclose (disseminate) to the Company and the Company’s shareholders that the insider intends to trade on the material non-public information, and describe the information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the Company and the Company’s shareholders. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Under the classical theory, the Buyers would not be considered a corporate or temporary insider, since they are not affiliated with the Company at all and a special confidential relationship has not been created between any of the Buyers and the Company. Thus, even if every other element was met, an insider trading case under the classical theory would not be brought against Buyers. Under the classical theory, the previously unaffiliated Control Block Purchaser would not be considered a corporate insider until after the purchase of the control block. However, the Control Block Purchaser could be deemed a temporary insider of the Company if the Control Block Purchaser was an officer or director of the target company that was engaged in reverse merger talks with the Company before the purchase of the control block. If it could be shown that the Control Block Purchaser was a temporary insider of the Company, then there could be liability under the classical theory unless the Control Block Purchaser disclosed their intention to trade on the information. However, in our fact scenario, the Control Block Purchaser purchases restricted stock that is not eligible to trade. In the event that the same Control Block Purchaser bought or sold stock in open market transactions, such Control Block Purchaser would be subject to insider trading liability under the classical theory.

Misappropriation Theory

Rule Description: Under the misappropriation theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed to any other person who is the source of the material nonpublic information. The previous description of “on the basis of,” materiality, and nonpublic information apply under the misappropriation theory as well. Under Rule 10b5-2(b), a duty of trust or confidence owed to the source of the information generally arises when (a) a recipient agrees with the source to maintain the information in confidence (and it is implied that the person will not trade), (b) the recipient and the source have a history, pattern, or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the source expects the recipient will maintain confidentiality, or (c) when the recipient is a close family member (spouse, parents, children, siblings) of the source. It is important to note that the insider trading rules under the misappropriation theory require the recipient to disclose or abstain from trading. This means that the recipient must abstain from trading or disclose to the source that the recipient intends to trade on the material non-public information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the source. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Let us assume that before the Transaction, the Control Block Purchaser gave the Buyers information regarding an upcoming reverse merger and/or complete change in direction of the Company’s business, which we will also assume is material and non-public information. Under the misappropriation theory, the Buyers may have a duty of trust or confidence that is owed to the Control Block Purchaser. However, it is highly unlikely that the Buyers would have agreed to maintain the information in confidence or that the Buyers and the Control Block Purchaser had a history, pattern, or practice of sharing confidences and confidentiality was expected. However, the Control Block Purchaser was most likely informed by the Buyers that the Buyers intended to purchase the Company’s shares based on the material nonpublic information, which would eliminate any deception. The Buyers, however, would need to refrain from re-selling the shares while in possession of the material non-public information, as any subsequent purchaser could claim a deceit. As long as the Buyers refrained from any public trading in the shares while in possession of the material non-public information, an insider trading case under the misappropriation theory would most likely fail.

The Control Block Purchaser would also have exposure for insider trading liability under this theory. If the Control Block Purchaser knew of the merger talks (confidence with the target company) and engaged in public trading of the stock, the Control Block Purchaser would have violated its duty of confidence to such target company.

Tipper / Tippee Theory

Rule Description: This theory is utilized when a tipper gives material nonpublic information to a tippee (recipient) in breach of a duty of trust or confidence that is owed by the tipper. Under the tipper/tippee theory, the tippee assumes the duty to disclose their intent to trade on material nonpublic information to the Company, and/or the Company’s shareholders, and/or the original source of the information, which is derivative of the duty of a corporate insider, temporary insider, or a person who owes a duty to the original source of the information as detailed in Rule 10b5-2(b) under the misappropriation theory. It must be established that the tipper breached a duty of trust or confidence when the tipper disclosed the material nonpublic information to the tippee. Generally, that breach is established when the tipper directly or indirectly benefited personally from the disclosure of the nonpublic material information to the tippee (the tipper received money or reputational benefit, or if the tipper disclosed the information to repay a debt to a relative or friend). It also must be established that the tippee knew or should have known (reckless in not knowing) that the tipper had breached their duty. Furthermore, the other elements of Section 10(b) and/or Rule 10b-5 must be established as well.

Analysis: In this case, the Control Block Purchaser may be a tipper if the Control Block Purchaser buys the control block before the Transaction, and is deemed to be a corporate or temporary insider of the Company or to have a duty of trust or confidence with the potential reverse merger candidate. It would have to be established that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders by disclosing material nonpublic information (reverse merger and/or complete change in direction of the Company’s business) about the Company to the Buyers. In the alternative, it would have to be established that the Control Block Purchaser breached their duty of trust or confidence to the potential reverse merger candidate, by disclosing material nonpublic information about the upcoming reverse merger. Some personal benefit that the Control Block Purchaser received by disclosing the material nonpublic information would have to be established. The Buyers could be considered tippees, and it could be alleged that the Buyers knew or should have known that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders.

Defenses

The most common defenses to an insider trading claim are that the information is not material, the information is already publicly known or disseminated among the investing public, and/or that there is no intent to deceive because the requisite public disclosure was made before trading.

In a situation where the Control Block Purchaser obtains the control block in the Company before the Buyers purchase their shares, it is recommended that disclosure be made, such as the filing of a Form 8-K, which discloses the anticipated reverse merger and/or complete change in direction of the Company’s business. This would make the information publicly known, and generally eliminate any exposure for insider trading.

As a safe harbor from insider trading liability, Rule 10b5-1 provides that a purchase or sale of securities will not be deemed to be on the basis of material nonpublic information if it is pursuant to a contract, instruction or plan that (i) was entered into before the person became aware of the information; (ii) specifies the amounts, prices, and dates for transactions under the plan (or includes a formula for determining them); and (iii) does not later allow the person to influence how, when or whether transactions will occur.

Conclusion

Both the Control Block Purchaser and the Buyers have exposure for insider trading liability, and each should be aware and cautioned not to publicly trade in the stock of the Company until such information is made public. However, as long as all parties are aware of the material non-public information, there is likely no cause for insider trading from the Transactions themselves.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Securities, Reverse Merger and Corporate 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 Ms. Anthony has structured her securities law practice 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. Ms. Anthony’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 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 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.

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