OTC PINK Companies Now Qualify For Equity Line Financing
Posted by Securities Attorney Laura Anthony | August 29, 2021

Without fanfare, the issuance of guidance, or any other formal notice, the SEC quietly changed its policy related to the filing of an at-the-market resale registration statement for an equity line financing by OTC Pink listed companies.  To be clear, an OTC Pink listed company may now utilize a re-sale registration statement on Form S-1 for an equity line financing transaction, pursuant to which the securities may be sold by the investor, into the market, at market price.  This results in a dramatic shift, for the better, for OTC Pink companies in the world of capital markets.

Background

Rule 415 sets forth the requirements for engaging in a delayed offering or offering on a continuous basis.  Under Rule 415 a re-sale offering may be made on a delayed or continuous basis other than at a fixed price (i.e., it may be priced at the market).  It is axiomatic that for a security to be sold at market price, there must be a market.  Generally, and historically, a company that trades on the OTC Pink market may not rely on Rule 415 to file a re-sale registration statement whereby the selling shareholders can sell securities into the market at market price.  That is, until recently all registration statements, whether re-sale, primary or indirect primary, must be at a fixed price unless the issuer is trading on the OTCQB or higher.

As there is no actual rule that identifies what is a market for purposes of Rule 415, the SEC has looked to Item 501(b)(3) of Regulation S-K.  Item 501 provides the requirements for disclosing the offering price of securities on the forepart of a registration statement and outside front cover page of a prospectus.  Item 501 requires that either a fixed price be disclosed or a formula or other method to determine the offering price based on market price.  The SEC uses this rule to require a fixed price where a company trades on the OTC Pink since there is no identifiable “market” to tie a price to.

There was a time when the SEC refused to recognize any of the tiers of OTC Markets, as a “market” for purposes of at-the-market offerings.  On May 16, 2013, the SEC issued a C&DI recognizing the OTCQB and OTCQX as markets for purposes of filing and pricing a re-sale registration statement.  See HERE ). That C&DI specifically referred to the filing of a resale registration statement for an equity line financing, but the SEC and practitioners relied on the C&DI to allow the filing of an at the market resale registration statement by an OTC Markets traded company, in all circumstances, as long as the company traded on the OTCQB or OTCQX.

Of course, the re-sale registration statement would need to be a true re-sale and not an indirect primary offering.  The SEC generally views the registration of more than one-third (33.33%) of the company’s pre-transaction total shares outstanding, held by non-affiliates, as an indirect primary offering.  An indirect primary offering is treated the same as a primary offering and could not rely on Rule 415 to sell securities at other than a fixed price.

Equity Line Transactions:An equity line financing is a transaction whereby a company enters an investment contract to put shares to an investor (the equity line provider) at a price, generally determined by a formula based on a discount to market price.  The company generally has the right to require the investor to buy securities over a set period of time, subject to specific terms in the contract.  Assuming the contract terms are satisfied, the investor has no right to decline to purchase the securities (or a limited right to decline). The dollar value of the equity line is set in the written agreement, but the number of securities varies based on a formula tied to the market price of the securities at the time of each “put.”

Most equity line financing arrangements are similar to a PIPE (private investment into public entity) transaction such that the company relies on the private placement exemption from registration to sell the securities under the equity line and then files a registration statement for the resale of such securities by the investor.  However, whereas in a PIPE transaction the investor bears the risk, in an equity line transaction the investor often bears little risk due to the delayed nature of the puts coupled with the price of the securities being a formula tied to market price.  Accordingly, the SEC views equity line financing registrations as indirect primary offerings.

Over the years the SEC issued various guidance on equity line financings and the ability to file a re-sale registration statement for the financing, despite the fact that the securities would not have been issued at the time of filing the registration statement.  In May 2013, the SEC issued a new C&DI which was, until November 2020, the operative guida for equity line transactions.

In particular:

“Question: When may a company file a registration statement for the resale by the investors of securities sold in a private equity line financing?

Answer: In many equity line financings, the company will rely on the private placement exemption from registration to sell the securities under the equity line and will then register the ‘resale’ of the securities sold in the equity line financing. In these types of equity line financings, the delayed nature of the puts and the lack of market risk resulting from the formula price differentiate private equity line financings from financing PIPEs (private investment, public equity). We, therefore, analyze private equity line financings as indirect primary offerings.

While we analyze private equity line financings as indirect primary offerings, we recognize that the ‘resale’ form of registration is sought in these financings. As such, we will permit the company to register the ‘resale’ of the securities prior to its exercise of the put if the transactions meet the following conditions:

  • the company must have ‘completed’ the private transaction of all of the securities it is registering for ‘resale’ prior to the filing of the registration statement;
  • the ‘resale’ registration statement must be on the form that the company is eligible to use for a primary offering; and
  • in the prospectus, the investor(s) must be identified as underwriter(s), as well as selling shareholder(s).

We will not object that a private transaction is not ‘completed’ based on the lack of a fixed price if the agreement provides for pricing based on a formula tied to market price and there is an existing market for the securities as evidenced by trading on a national securities exchange or through the facilities of the OTC Bulletin Board or the OTCQX or OTCQB marketplaces of OTC Link ATS.  [May 16, 2013]”

In November 2008, the SEC issued a series of C&DI providing guidance as to when the private offering part of an equity line transaction could be considered “completed.”   This guidance was not changed by the March 2013 new C&DI (which only added the OTCQB and OTCQX as recognized markets).  In accordance with the November 2008 guidance, the SEC would allow the filing of resale type registrations if the following conditions are met:

  • The Issuer must have completed the private transaction prior to filing the registration statement (i.e., both parties must be fully contractually bound, with all material points agreed upon);
  • The “resale” registration statement must be on the form that the Issuer is eligible to use for a primary offering; and
  • In the prospectus, the investors must be identified as both underwriter(s) and selling shareholder(s).

For the first condition to be met, the investor must be irrevocably bound to purchase all the securities.  That is, only the issuer can have the right to exercise the put and, except for conditions outside the investor’s control, the investor must be irrevocably bound to purchase the securities once the Issuer exercises the put.  In addition, the obligations of the investor must be non-assignable to meet the “irrevocably bound” condition.

Moreover, if the investor has the ability to make investment-related decisions under the terms of the contract, they will not be deemed to be irrevocably bound allowing for the filing of a resale registration statement.  Examples of investment decisions that would be viewed by the SEC as creating a continuing transaction (and not a completed transaction allowing for the filing of a registration statement) include:

  • Agreements that give the investor the right to acquire additional securities (including through warrants) at the same time or after the Issuer exercises a put;
  • Agreements that permit the investor to decide when or at what price to purchase the securities underlying the put;
  • Agreements with termination provisions that have the effect of causing the investor to no longer be irrevocably bound to purchase the securities; and
  • Agreements that allow the Investor to exercise a “due diligence out.”

However, the agreements may allow for customary “bring-downs” as conditions to closing such as customary representations and warranties and customary clauses regarding no material adverse changes affecting the issuer that would be within the investor’s control.

On November 13, 2020, the SEC amended the C&DI it had issued in March 2013 and withdrew the five from November 2008 as moot.  The November 2020 C&DI provides:

“C&DI 139.13 Question: In many equity line financings, the company will rely on the private placement exemption from registration to sell the securities under the equity line and will then seek to register the “resale” of the securities sold in the equity line financing. When may a company file a registration statement for the resale by the investors of securities sold in a private equity line financing?

Answer: In these types of equity line financings, the company’s right to put shares to the investor in the future and the lack of market risk resulting from the formula price differentiate private equity line financings from financing PIPEs (private investment, public equity). We, therefore, analyze private equity line financings as indirect primary offerings, even though the “resale” form of registration is sought in these financings.

The at-the-market limitations contained in Rule 415(a)(4) would otherwise prohibit market-based formula pricing for issuers that are not eligible to conduct primary offerings on Form S-3 or Form F-3. Nevertheless, we will not object to such companies registering the “resale” of the securities prior to the exercise of the equity line put if the transactions meet the following conditions:

  • the company and the investor have entered into a binding agreement with respect to the private equity line financing at the time the registration statement is filed;
  • the “resale” registration statement is on a form that the company is eligible to use for a primary offering;
  • there is an existing market for the securities, as evidenced by trading on a national securities exchange or alternative trading system, which is a registered broker-dealer and has an active Form ATS on file with the Commission; and
  • the equity line investor is identified in the prospectus as an underwriter, as well as a selling shareholder.

We will not object to the filing of a registration statement for a private equity line financing prior to the issuance of securities by the company under the equity line even when there are contingencies attached to the investor’s obligation to accept a put of shares from the company, as long as the above conditions are satisfied and the following terms of the investment have been agreed upon by both parties and disclosed by the company at the time that the resale registration statement is filed:

  • the number of shares registered for resale;
  • the maximum principal amount available under the equity line agreement;
  • the term of the agreement; and
  • the full discounted price (or formula for determining it) at which the investor will receive the shares.”

The new C&DI succinctly combined the previous ones.  I thought it was interesting that the SEC had eliminated a reference to the OTCQB and OTCQX; however, equity line registrations filed shortly after the new C&DI for an OTC Pink entity were still required to be at a fixed price.

Recently, however, the SEC has confirmed that it will allow an equity line re-sale registration statement to be filed by an OTC Pink company and priced at the market if all the requirements of C&DI 139.13 have been satisfied.  In that regard, our firm has cleared at least one re-sale S-1 for an OTC Pink company in the past month.

Interestingly, the SEC is now clearly taking the position that the OTC Pink is an “existing market for the securities, as evidenced by trading on a national securities exchange or alternative trading system, which is a registered broker-dealer and has an active Form ATS on file with the Commission” for purposes of equity line financings, but has not yet expanded that view for purposes of straight re-sale registration statements.

I am hopeful that with the new 15c2-11 rules together with OTC Markets incredible job at regulating the marketplace, the OTC Pink will soon be recognized as an “existing market” for securities across the board.

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SEC Denies Expert Market – For Now
Posted by Securities Attorney Laura Anthony | August 22, 2021 Tags: ,

As the compliance date for the new 15c2-11 rules looms near, on August 2, 2021, in a very short statement, the SEC shot down any near-term hope for an OTC Markets operated “expert market.”  The SEC short statement indicated that a review of the proposed exemptive order that would allow the expert market is not on its agenda in the short term.  The SEC continued that “[A]ccordingly, on September 28, 2021, the compliance date for the amendments to Rule 15c2-11, we expect that broker-dealers will no longer be able to publish proprietary quotations for the securities of any issuer for which there is no current and publicly available information, unless an existing exception to Rule 15c2-11 applies.”

The statement acts as a great segue for a review as to just what those exceptions may be.  In addition, this blog will discuss the OTC Markets proposed expert market and finish with a broader refresher on the new 211 rules including the current public information requirements for each class of issuer.  For an in-depth discussion of the amended rules, see HERE.

Also, importantly, even for companies that believe they are current in their OTC Markets Alternative Reporting requirements, OTC Markets requires that the company profile be verified through the OTCIQ system as part of the 211 compliance process.  OTC Markets has indicated that profiles must be updated by August 9 to ensure their compliance team has sufficient time to confirm the availability of current public information and update company information prior to the rule’s September effective date.

As more fully described below, current information works on a 180-day timeline from the date of the end of a reporting period.  Since most companies have a calendar year reporting period, the SEC picked September 28th as the compliance deadline because that is exactly 181 days from March 31st.  Assuming a report is filed for the March 31st quarter end, the company will remain piggyback qualified from April 1st through September 27th inclusive.  If the Company does not file its June 30th report, it will lose qualification on September 28th (the compliance date) because the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.

Adding pressure to the thousands of companies that will be impacted by the new rules, on July 20, TD Ameritrade published a 162-page list of over 6,000 companies that do not have current public information, for which it will accept liquidating orders only, beginning mid-August.  That list was reduced to 3,500 companies by August 2nd and as of today, TD Ameritrade has suspended its plans to cease trading for the time being as companies continue to get up.

15c2-11 Exceptions

  1. Piggyback Exception

Under the new rules, the SEC is requiring that a company’s current publicly available information be timely filed or filed within 180 calendar days from a specified date, depending on the category of company, for a broker-dealer to rely on the piggyback exemption to publish quotations.  The chart below summarizes the filing requirements.  The 180-day period begins on the date that a reporting period ends.  Accordingly, for example, if a SEC reporting issuer has a December 31 year-end and filed a report for that period, quotations for the period January 1 – June 29 inclusive, would be covered by the piggyback exception.  If the same issuer filed its quarterly reports for March 31, June 30 and September 30, the 180-day period would extend from each of those dates (until April 30 of the following year).  However, if the same issuer failed to file its September 30 10Q, it would no longer be able to rely on the piggyback exception beginning December 28 (180 days following June 30) because following that date, the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.

In making the calculation for an alternative reporting (catch-all) company, a broker-dealer must ensure that current information is dated within 12 months of the publication of the quotation and that the balance sheet is less than 16 months old.  Accordingly, for example, if the alternative reporting company has a December 31 year-end, and filed its annual report for December 31, 2020 including all the required information (with a balance sheet dated after September 1, 2019 and a profit and loss for the 12 months preceding that period), a broker-dealer could continue to rely on the piggyback exception until December 31, 2021.

Of course, maintaining current information requires more than just financial statements.  As further discussed below, where SEC or other regulatory requirements prescribe the information that must be reported (such as for a foreign private issuer), Rule 15c2-11 does not require different information.  The Rule, however, does prescribe the information required by a catch-all company.  The OTC Markets has updated its current information reporting requirements to encompass all of the information and requirements in the new Rule.

The amended rule adds a 15-day conditional grace period from the date of a publicly available determination that a company no longer has current information within the 180-day specified period as set forth in the chart below, for a broker-dealer to continue to quote the particular security. The purpose of the grace period is to give the markets notice that the company is in danger of no longer being quoted and provide investors with an opportunity to liquidate positions.  In order to use the grace period, three conditions must be met: (i) OTC Markets or FINRA must make a public determination that current public information is no longer available within 4 business days of the information no longer being available (i.e., expiration of the time periods in the chart); this could be by, for example, a tag on the quote page or added letter to the ticker symbol; (ii) all other conditions for reliance on the piggyback exception must be effective (such as a one way quote); and (iii) the grace period ended on the earliest of the company once again making current information publicly available or the 14th calendar day after OTC Markets or FINRA makes the public determination in (i) above.  I note that once OTC Markets has made a publicly available determination that a broker-dealer may rely on the piggyback exception, it has an affirmative duty to make a publicly available determination that the same company no longer has publicly available current information as required by the rule.

The SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggyback exception; rather, the amended rule provides for a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations.  A broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period.  Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter-end.  Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility.  Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility.

To reduce some of the added burdens of the rule change, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the piggyback exception have been met.  To be able to properly keep track of piggyback exception eligibility, OTC Markets will need to establish, maintain, and enforce reasonably designed written policies and procedures to determine, on an ongoing basis, whether the documents and information are, depending on the type of company, filed within the prescribed time periods.

The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:

Category of Company 15c2-11 Current Information
Exchange Act reporting company Filed within 180 days following end of a reporting period.
Regulation A reporting company Filed within 120 days of fiscal year-end and 90 days of semi-annual period end
Regulation Crowdfunding filer Filed within 120 days of fiscal year-end.
Foreign Private Issuer Since first day of most recent completed fiscal year, has filed information required to be filed by the laws of home country or principal exchange traded on.
Catch-all company Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet.

Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e., approximately 2 years and 2 months).  A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date.

 

In addition to the current publicly available information requirement, to rely on the piggyback exception, the new rules require: (i) at least a one-way priced quotation at a specified price (either bid or ask); and (ii) that no more than 4 days in succession have elapsed without a quotation (frequency of quotation requirement).  Although the priced quotation must be at a specified price, there is no minimum threshold (for example, it does not have to be above $0.01).  For a broker-dealer to rely on the piggyback exception, a quoted OTC security of an issuer would need to be the subject of a bid or offer quotation, at a specified price, with no more than four business days in succession without such a quotation.

The initial rule proposal contained a provision that would have eliminated the piggyback exception altogether for shell companies.  This provision received significant pushback and would have had a huge chilling effect on reverse merger transactions in the OTC Markets.  In response to the pushback, the final rule allows for broker-dealers to rely on the piggyback exception to publish quotations for shell companies for a period of 18 months following the initial priced quotation on OTC Markets.  In essence, a shell company is being granted 18 months to complete a reverse merger with an operating business, or in the alternative, to organically begin operations itself.  The amended rules only allow the piggyback exception for a period of 18 months following the initial quotation.   The first 18-month period for a shell company will begin on September 18, the compliance date for the new rules.   If a company remains a shell at the end of the 18-month period, it will lose piggyback eligibility and a new 211 compliance review would be necessary.

The rule adopts a definition of shell company that tracks Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2, but also adds a “reasonable basis” qualifier to help broker-dealers and OTC Markets make determinations.  A shell company is defined as any issuer, other than a business combination related shell company as defined in Rule 405 or asset backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents.  A company will not be considered a shell simply because it is a start-up or has limited operating history.  To have a reasonable basis for its shell company determination, a broker-dealer or the OTC Markets can review public filings, financial statements, business descriptions, etc.

In addition, a broker-dealer may not rely on the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act.

Understanding the dramatic change and impact the new rules will have on the OTC Market place, the SEC will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule.  In a request for relief, the SEC will consider all facts and circumstances including whether based on information provided, the issuer or securities are less susceptible to fraud or manipulation.   The SEC may consider securities that have an established prior history of regular quoting and trading activity; companies that do not have an adverse regulatory history; companies that have complied with any applicable state or local disclosure regulations that require that the company provide its financial information to its shareholders on a regular basis, such as annually; companies that have complied with any tax obligations as of the most recent tax year; companies that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors.  At the time of the rule release, the SEC suggested that requests for relief be submitted as soon as possible to prevent a quotation interruption prior to the rule’s implementation.  At the time of publication of this blog, I am unsure if the SEC could entertain such a request prior to the September 28 deadline.

  1. Unsolicited Quotation Exception

Rule 15c2-11 has an unsolicited quotation exception.  That is, a broker-dealer may issue a quote where such quotation represents unsolicited customer orders.  The Rule requires a broker-dealer that is presented with an unsolicited quotation to determine whether there is current publicly available information.  If no current available information exists, the unsolicited quotation exception is not available for company insiders or affiliates.  The Rule defines “affiliate” using the same language as Rule 144 and in particular “[A]n affiliate of an issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.”  This definition encompasses officers and directors and presumptively covers shareholders owning 10% or more of the outstanding securities.

A broker-dealer may rely on a written representation from a customer’s broker that such customer is not a company insider or an affiliate.  The written representation must be received before and on the day of a quotation.  Also, the broker-dealer must have a reasonable basis for believing the customer’s broker is a reliable source including, for example, obtaining information on what due diligence the broker conducted.  Like the piggyback exception, a broker-dealer will be able to rely on a qualified IDQS (OTC Markets) or a national securities association (FINRA) determination that there is current publicly available information.

  1. ADTV and Asset Test Exception

Rule 15c2-11 has an ADTV and asset test exception for securities that are considered lower-risk.  To rely on this exception, the security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”).

The ADTV test requires that the security have a worldwide reported ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation.  To satisfy the final ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade)

The asset test requires that the company have at least $50 million in total assets and stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end.  This would cover both domestic and foreign issuers.

The rule also creates an exception for a company who has another security concurrently being quoted on a national securities exchange.  For example, some companies quote their warrants or rights on OTC Markets following a unit IPO offering onto a national exchange.

Like the piggyback exception, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the ADTV and asset test or the exchange-traded security exception have been met.  Conversely, if OTC Markets or FINRA is publishing the availability of an exception, they will also need to publish when such exception is no longer available.

  1. Underwritten Offering Exception

The Rule has an exception to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This change may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.  This exception requires that the broker-dealer have the 211 current information in its possession and have a reasonable basis for believing the information is accurate and the sources of information are reliable.

OTC Markets Request for Exemptive Order for Expert Market

OTC Markets requested an exemptive order with the SEC to permit broker-dealers to publish or submit proprietary quotations for securities, on a continuous basis, in a market where the distribution of such quotations is restricted to sophisticated or professional investors, without complying with the information review and recordkeeping requirements of amended Rule 15c2-11.  The SEC published the proposed exemptive order and requested public comment.

OTC Markets currently maintains an expert market which allows broker-dealer subscribers to, among other things, find price transparency in certain securities that may not be eligible or suitable for retail investors.  The request for exemptive relief would modify that expert market to provide greater access to certain retail investors.  An expanded expert market is intended to provide a marketplace, limited to sophisticated or professional investors, for grey market securities or small companies seeking growth opportunities that might prefer to be quoted in a more limited market.

Under the proposed conditional exemptive order, OTC Markets Group would authorize market data distributors, including Subscribers, to be eligible to receive quotations published or submitted on the Expert Market and to distribute such data to Subscribers who comply with certain obligations and restrictions on data access set forth in a Market Data Distribution Agreement (“MDDA”).  The MDDA would, among other things, restrict end users and the distribution to any third parties that do not qualify as a permitted recipient, and would require that the distributor or subscriber report all end users to OTC Markets.

Permitted recipients (“Qualified Experts”) or expert market users would include: (i) any qualified institutional buyer as defined in Rule 144A (generally must own and invest $100 million in securities); (ii) any accredited investor as defined in Rule 501(a) (see HERE); and (iii) any qualified purchaser as defined in Section 2 of the Investment Company Act of 1940 (generally have $5 million or more in securities).

Qualified securities on the expert market would include: (i) companies that are currently quoted under the piggyback exception and lose qualification on the compliance date for the amended rules (September 28); (ii) companies that lose 211 compliance in the future due to a lack of current public information, shell status or failure to meet the frequency of quotation requirement; and (iii) any security that is issued in conjunction with a Chapter 11 bankruptcy plan under Section 1145 of the Bankruptcy Code.  Securities that had been subject to a registration revocation or defunct companies would not be able to be quoted.

In operating the expert market under the proposed exemptive relief, OTC Markets would establish, maintain, and enforce written policies and procedures that are reasonably designed to allow only permitted recipients to view, and to prevent the general public from viewing, quotations published or submitted on the expert market. OTC Markets would also establish procedures to surveil the use of the expert market to ensure compliance with the MDDA.

As noted at the beginning of this blog, the SEC has taken any action on this Order off the table, at least in the near term.

More on Amended Rule 15c2-11

Amended Rule 15c2-11: (i) requires that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limits certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduces regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allows OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamlines the rule and eliminate obsolete provisions.

The amended Rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security.  The rule release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout.  The only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.  However, if new IDQS platforms or national securities associations develop, they would also be covered by the Rule.

A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review.  Keeping the rule’s current 3-business-day requirement, a broker-dealer’s quotation must be published or submitted within 3 business days after the qualified IDQS (OTC Markets) makes a publicly available determination.

Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies to file Forms 211 with FINRA.  I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews.

Current Public Information Requirements

The amended Rule (i) requires that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permits additional market participants to perform the required review (i.e., OTC Markets); and (iii) expands some categories of information required to be reviewed.

To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation.  The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation.

The catch-all category encompasses companies that alternatively report on OTC Markets, as well as companies that are delinquent in their SEC reporting obligations – provided, however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggyback exception.

For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence.  The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet.

Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied.  In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension.  The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggyback exception, for continued quotations.

Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.  In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information.  Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.

The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available.  Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security.  The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.

Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present.  Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application.  I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements.

Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer.  The posted information must not be password-protected or otherwise user-restricted.  A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.

Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame as laid out in the chart above. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation.  A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.

The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category.  A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet.  However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.  A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet.

The categories of information required to be reviewed will also expand.  For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officers, and directors.  In addition, records must be reviewed, and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.  As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10%-or-greater shareholders unless the company has current publicly available information.

The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets.  In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system.  If OTC Markets completes the 211 review, the broker-dealer, upon confirming that the 211 information is current and publicly available, is excepted from performing a separate review and can proceed to quote that security.

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SPAC Nasdaq Listing Standards
Posted by Securities Attorney Laura Anthony | August 15, 2021 Tags:

I’ve written quite a bit about SPAC’s recently, but the last time I wrote about SPAC Nasdaq listing requirements, or any attempted changes thereto, was back in 2018 (see HERE).  Since that time, Nasdaq has a win and recently a loss in its ongoing efforts to attract SPAC listings.

Background on SPACs

Without reiterating my lengthy blogs on SPACs and SPAC structures (see, for example, HERE and HERE), a special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company.

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company that is issuing securities which fall within the definition of a penny stock. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of this Rule 419 discussion, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

Rule 419 requires that a blank check company filing a 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. The securities of a blank check company which is required to comply with Rule 419 are not eligible to trade, but rather must remain in escrow.

A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of the SPAC, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

Accordingly, to derive the value that SPACs have in the marketplace (according to one source, $111 billion so far in 2021 alone), the SPAC must not be a penny stock, or put another way, must be priced over $5 and list and trade on a registered stock exchange such as Nasdaq.  Nasdaq, in turn, is motivated to attract these relatively plain vanilla blank check companies and the potential for a continued listing business combination entity.

SPAC Nasdaq Listing Requirements

Generally speaking, a SPAC must meet the same listing requirements as an operating entity.  For a review of the Nasdaq Capital Market’s current initial listing standards, see HERE.  Back in July 2019, Nasdaq amended its listing standard to exclude restricted securities from its calculations of a company’s publicly held shares, market value of publicly held shares and round lot holders (“Initial Liquidity Calculations”) and to impose a new requirement that at least 50% of a company’s round lot holders must each hold shares with a market value of at least $2,500 (see HERE).

Over the past couple of years, Nasdaq has successfully implemented and unsuccessfully tried to implement modifications to its listing rules to make it easier for SPACs to list and maintain a listing in a business combination transaction.  In addition, Nasdaq has several pending SEC rule amendment applications.

Round Lot Holders – Approved Rule Change

On January 26, 2021, the SEC approved a rule change from the Nasdaq listing requirements for SPACs to exclude the requirement that at least 50% of a company’s round lot holders each hold unrestricted securities with a market value of at least $2,500.  The rule requirement was initially meant to ensure that at least 50% of the required minimum number of shareholders hold a meaningful value of unrestricted securities and that a company has sufficient investor interest to support an exchange listing.  Prior to enacting the rule change, Nasdaq noticed that many companies seeded a shareholder base prior to the listing with shareholders holding exactly 100 shares often received for no or nominal value, and that these investors, were not supportive of liquidity and trading volume.

Nasdaq does not believe that this qualification requirement, and its underlying purpose, is relevant to SPACs.  Typically, the only investors holding shares in a SPAC prior to an IPO are its founders and that all other round lot holders generally represent new investors in the SPAC’s IPO.  SPACs do not present a similar risk as operating companies of circumventing the round lot holder requirement through share transfers for no value.  Also, shareholders of SPACs are afforded the opportunity to redeem or tender their shares for a pro rata portion of the value of the IPO proceeds maintained in a trust account in connection with the SPAC’s business combination, which must occur within 36 months of the IPO, and therefore, the SPAC structure provides an alternative liquidity mechanism that operating companies do not offer.

The rule change notes that at the time of the business combination, in order to remain listed, the combined company must meet Nasdaq’s initial listing requirements, which includes the required minimum amount of round lot holders and that at least 50% of the required amount hold shares valued at $2,500 or more.

Round Lot Holders – Disapproved Rule Change

On May 20, 2021, the SEC denied a rule change request from Nasdaq that would have allowed SPACs 15 calendar days following the closing of a business combination to demonstrate that the SPAC had satisfied the applicable round lot shareholder requirement.  Following each business combination, the combined company must meet the requirements for initial listing on Nasdaq including those requiring a minimum number of round lot shareholders.  If the combined company does not meet all the initial listing requirements following a business combination, Nasdaq will issue a delisting determination.

The current rule requires that the combined company meet the shareholder requirements (and all listing requirements) but does not provide a timetable to satisfy those requirements.  The proposed rule change would have provided a SPAC with a 15-day grace period to satisfy the round lot holder requirements and would have required an 8-K publicly announcing that it had not yet satisfied the requirement and relying on the grace period.  If the SPAC did not meet the requirement after the 15 days, it would halt trading on Nasdaq.

Nasdaq wanted to provide the 15 days because it can be difficult for a SPAC to know its round lot holders prior to closing of a business combination.  Shareholders in a SPAC may redeem or tender their shares until just before the time of the business combination, and the SPAC may not know how many shareholders will choose to redeem until very close to the consummation of the business combination.  Under the proposal, the SPAC must still demonstrate that it satisfied the round lot shareholder requirement immediately following the business combination, and the proposal merely would give the SPAC 15 calendar days to provide evidence that it had met the requirement.

In denying the proposed rule change, the SEC noted that it has consistently recognized the importance of the minimum number of holders and other similar requirements stating that such listing standards help ensure that exchange listed securities have sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly markets.  The SEC is concerned that rather than provide additional time to provide evidence of timely compliance, the change would, in fact, allow a SPAC more time to actually comply with the rule (such as by adding last-minute shareholders, or working to reduce redemptions during the 15-day period).

Further, the SEC sees a risk that as result of the change, non-compliant companies will continue to trade on the Exchange when they should not be allowed. In such circumstances, a SPAC could complete a business combination and very soon thereafter be subject to delisting proceedings, and during such time its securities may continue to trade with a number of holders that is substantially less than the required minimum raising concerns about the maintenance of fair and orderly markets and investor protection.

SPAC Spin-Offs – Enabling More than One Acquisition

Nasdaq has issued a proposed rule change that would permit a SPAC to contribute a portion of the amount held in its deposit account to a deposit account of a new SPAC and spin off the new SPAC to its shareholders, thereby enabling multiple business combinations to benefit the same shareholder base. The filing, pending SEC approval, will provide shareholders the right to redeem all of their holdings prior to the first transaction, similar to existing SPACs.

Generally, Nasdaq rules prohibit the listing of blank check companies, unless they meet certain requirements for a “special purpose acquisition company” or “SPAC.”  The requirements include, among other things, that at least 90% of the gross proceeds from the initial public offering be deposited  in an escrow account, and that the SPAC complete within 36 months, or a shorter period identified by the SPAC, one or more business combinations having an aggregate fair market value of at least 80% of  the value of the escrow account at the time of the agreement to enter into the initial combination.

Nasdaq has noticed cases where SPAC sponsors create multiple SPACs of different sizes at the same time, with the intention to use the SPAC that is closest in size to the amount a particular target’s needs.   This practice creates the potential for conflicts between the multiple SPACs (each of which has different shareholders) and still fails to optimize the amount of capital that would benefit the SPAC’s public shareholders and a business combination target.  The system is also inefficient in as much as the multiple SPACs are each filing separate registration statements and SEC reports, have separate boards of directors, multiple audits and multiple listing fees.

The proposed new rule would allow a SPAC to raise the maximum amount of capital it thinks it needs, then spin off any balance after a first acquisition into a new SPAC for future acquisitions.  The spin-off SPAC would need to file a separate registration statement and continue with its own listing.  The public shareholders would have a right to redeem as part of any business combination whether in the original SPAC or a new spin-off.  All other features would work the same as existing SPACs.  The spun-off SPAC would need to meet the initial listing requirements and would be subject to the same escrow rules as any SPAC including the 36-month period in which to complete a business combination.  Moreover, each initial acquisition, whether in the original or spin-off SPAC would need to meet the 80% requirement.

I see the benefit to an existing shareholder base; however, when multiple acquisitions of different values present themselves at the same time (like in a hot market), it seems a sponsor would want multiple SPACs at the ready instead of waiting for the spin-off process to be completed, by which time the opportunity may have passed.

Regardless of whether the SEC approves this rule proposal, I believe we will be seeing more and more of attempted deviations from the cookie-cutter SPAC structure and business combination process.  Recently, Bill Ackman attempted such divergence by proposing that his SPAC, Pershing Square Tontine Holdings Ltd., purchase a 10% interest in music giant Universal Music Group, then spin off that 10% to the SPAC shareholders, creating a separate public company and continuing to search for future business combinations with the balance.  As part of the process, Ackman asserted that the initial 10% acquisition would satisfy the acquisition time limits required for SPACs and remove any future pressure to close another acquisition within a particular period of time.

Ackman ultimately abandoned the plan after failing to obtain SEC and NYSE approval.  Although he cited that the regulators found a number of issues without specifying what these issues were, the most obvious to me is that upon purchasing the 10% interest in Universal Music, the SPAC would become an investment company subject to the Investment Company Act of 1940.  Also, since the plan was to purchase the interest and spin it off without a holding period, the transaction would likely have tax implications to the SPAC shareholders.  In any event, I expect more creativity in this arena.

Waiver of Annual Fee for Nasdaq Global Market

On July 7, 2021, the SEC approved a Nasdaq rule change that waives the annual fee for companies that complete a business combination with a SPAC that is listed on another tier of the Exchange and move the post business combination entity to a higher tier.  In particular, many SPACs list on the Nasdaq Capital Markets to save fees, and because they do not have a need for the added services of the higher tiers.  Upon closing a business combination, the company may wish to list on the Nasdaq Global Market.  Likewise, Nasdaq will provide a reduced fee to SPACs that this directly on the Nasdaq Global Market as these companies require fewer regulatory resources than operating companies.

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Digital Asset Securities – Progress For Broker Dealers
Posted by Securities Attorney Laura Anthony | August 15, 2021 Tags:

In December 2020, the SEC issued a statement and request for comment regarding the custody of digital asset securities by broker-dealers.  The Statement and request for comment sets forth suggestions for complying with the Customer Protection Rule and lists certain requirements that a broker-dealer could comply with to ensure that it would not be subject to an enforcement proceeding for violation of the Customer Protection Rule.

Two months later, in February 2021, the SEC Division of Examinations issued a risk alert focused on digital asset securities.  These statements were the first hitting head on the topic of digital asset custody since an August 2019 joint statement by the SEC and FINRA on the custody of digital assets (see HERE) and October 2019 joint statement by the SEC, FinCEN and the CFTC (see HERE).

The SEC and FINRA have been discussing issues of custody related to tokens and digital assets for years.  For example, issues surrounding the custody of digital assets have been continuously cited by the SEC as one of the reasons for the failure to approve a cryptocurrency ETF.  The SEC defines a digital asset as an asset that is issued and/or transferred using distributed ledger or blockchain technology (“distributed ledger technology”), including, but not limited to, “virtual currencies,” “coins,” and “tokens.”

Any entity that transacts business in digital asset securities must comply with the federal securities laws.  An entity that buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers will be required to register with the SEC as a broker-dealer and become a member of and comply with the rules of FINRA.  Likewise, entities that make markets in securities (i.e., buy or sell for their own account) may also need to be registered as a broker-dealer. However, historical rules do not adequately cover the complex issues related to digital assets, including rules related to the loss or theft of a security.

Since the SEC issued its Section 21(a) Report on the DAO investigation, finding that digital assets and cryptocurrencies are, in most instances, securities, there has been a significant rise in the number of SEC applications for broker-dealer registration and membership applications with FINRA.  There has also been a large increase in applications to FINRA by existing members to expand their business operations to include digital assets.   On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens, and to continue to update FINRA on such activities through July 31, 2019.  FINRA subsequently extended to the time to require firms to report activity through July 31, 2020.

Statement and Request for Comment

The SEC is looking into innovating the Customer Protection Rule to encompass digital assets. Broker-dealers that hold funds and securities must comply with Exchange Act Rule 15c3-3 (the “Customer Protection Rule”), which generally requires the broker to obtain and thereafter maintain physical possession or control over the customer’s fully paid and excess margin securities it carries for the account of customers. Where funds and securities are purely digital, consideration needs to be made over how they are accounted for and who has the obligation. In addition, certain activities and access levels could amount to “receiving, delivering, holding or controlling customer assets,” such as having access to a private key code for a customer.

The purpose of the Customer Protection Rule is to protect the customer funds, provide for processes in the event of a broker-dealer’s failure, and put systems in place so that the SEC can oversee and monitor business practices.  Like attorney escrow accounts, a broker-dealer must keep the customer’s assets segregated from their own and properly labeled and tracked as that customer’s property.

To satisfy the Customer Protection Rule, most broker-dealers use a third party, such as the Depository Trust Company (DTC), a clearing firm or a transfer agent (for book entry or DRS securities) as the actual custodian of the securities.  Using a third party creates a check and balance, eliminating the risk of comingling or the loss of the security in the event the broker-dealer fails, and allowing for the reversal or cancellation of a mistaken or unauthorized transaction.  Simply, a broker-dealer’s employees, regulators, and outside auditors can contact these third parties to confirm that the broker-dealer is, in fact, holding the traditional securities reflected on its books and records and financial statements.

Digital assets are unique in that the way they are issued, held, and transferred is different from other securities up to this point.  One of the principal concerns with the custody of digital assets relates to cybersecurity.  The issue is prolific for all companies, but even more so for those working with cyber assets.   Another unique concern with digital assets relates to the ramifications if a broker-dealer or customer loses their “private key” necessary to transfer a client’s digital asset securities.  If a private key is lost, there is no method for retrieving the information and the digital assets could be lost forever.  Likewise, if digital assets are unintentionally or fraudulently transferred to an unknown or unintended address, there would be no meaningful recourse to invalidate the fraudulent transactions, recover or replace lost property, or correct errors.

In addition to these real-world issues, technical compliance with the Customer Protection Rule is not easy with digital assets.  The rule requires that “not later than the next business day, a broker-dealer, as of the close of the preceding business day, shall determine the quantity of fully paid securities and excess margin securities in its possession or control and the quantity of such securities not in its possession or control.”  If possession and control results from possession of a customer’s private key and the ability to transfer digital assets using the private key, it may be difficult to establish that no other party has a copy of the private key and could therefore also exercise possession and control over the assets.  However, to satisfy the Rule’s requirements, a broker-dealer to solve this problem.  In that regard, the SEC has made suggestions for controls and procedures that are discussed below.

With that said, the SEC realizes that it is only a matter of time before broker-dealers are providing a full set of functions with respect to digital assets, including maintaining custody of the assets in a way that addresses the unique attributes of digital asset securities and minimizes risk to investors and other market participants.  In order to accomplish these goals, a broker-dealer would need to have policies and procedures in place to be able to assess a particular digital asset’s distributed ledger technology and to be able to protect the private keys of holders.

Moreover, the Customer Protection Rule only covers cash and securities.  If a customer has digital assets held at a broker that are not securities (such as bitcoin), the potential liability from a cyber-theft or loss of those assets could be catastrophic to the broker-dealer and therefore all its customers.  SIPC would not cover such a loss.

In a striking development since its 2019 statements, the SEC December 2020 statement asserts an outright position of support for innovation in the digital asset securities market to develop its infrastructure.   The SEC further asserts that, for a period of five years, it will not initiate enforcement action against a broker-dealer that claims to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities for the purposes of the Customer Protection Rule.   The five-year period is designed to provide market participants with an opportunity to develop practices and processes that will enhance their ability to demonstrate possession or control over digital asset securities. It also will provide the SEC with experience in overseeing broker-dealer custody of digital asset securities to inform further action in this area.  The statement and SEC’s position related to enforcement, relate solely to the Customer Protection Rule and not other obligations of broker-dealers.

Enforcement Protection

The SEC states that it will not recommend enforcement proceedings against a broker-dealer related to the Customer Protection Rule when it holds and transacts business in digital assets, in the following circumstances:

  • The broker-dealer has access to the digital asset securities and the capability to transfer them on the associated distributed ledger technology;
  • The broker-dealer limits its business to dealing in, effecting transactions in, maintaining custody of, and/or operating an alternative trading system for digital asset securities. In this case, the broker-dealer may hold positions in traditional assets for purposes of meeting the firm’s minimum net capital requirements and for hedging.  Although not required by the SEC for enforcement protection a broker-dealer could refuse to hold or engage in transactions involving non-security digital assets (such as cryptocurrencies and some NFTs);
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies and procedures to conduct and document an analysis of whether a particular digital asset is a security offered and sold pursuant to an effective registration statement or an available exemption from registration, and whether the broker-dealer meets its requirements to comply with the federal securities laws with respect to effecting transactions in the digital asset security, before undertaking to effect transactions in and maintain custody of the digital asset security;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies and procedures to conduct and document an assessment of the characteristics of a digital asset security’s distributed ledger technology and associated network prior to undertaking to maintain custody of the digital asset security and at reasonable intervals thereafter. Such a review should include an examination of: (i) performance (i.e., does it work and will it continue to work as intended); (ii) transaction speed and throughput; (iii) scalability; (iv) resiliency (can it absorb the impact of a problem in one or more parts of its system and continue processing transactions without data loss or corruption); (v) security and relevant consensus mechanism (can it detect and defend against malicious attacks); (vi) complexity (can it be understood, maintained and improved); (vii) extensibility (can it have new functions added); and (viii) visibility (are its associated code, standards, applications, and data publicly available and well documented);
  • The broker dealer will not maintain custody of a digital asset security if the firm is aware of any material security or operational problems or weaknesses with the distributed ledger technology and associated network used to access and transfer the digital asset security, or is aware of other material risks posed to the broker-dealer’s business by the digital asset security;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies, procedures, and controls that are consistent with industry best practices to demonstrate the broker-dealer has exclusive control over the digital asset securities it holds in custody and to protect against the theft, loss, and unauthorized and accidental use of the private keys necessary to access and transfer the digital asset securities the broker-dealer holds in custody. These policies and procedures should address: (i) the on-boarding of a digital asset security such that the broker-dealer can associate the digital asset security to a private key over which it can reasonably demonstrate exclusive physical possession or control; (ii) the processes, software and hardware systems, and any other formats or systems utilized to create, store, or use private keys and any security or operational vulnerabilities of those systems and formats; (iii) the establishment of private key generation processes that are secure and produce a cryptographically strong private key that is compatible with the distributed ledger technology and associated network and that is not susceptible to being discovered by unauthorized persons during the generation process or thereafter; (iv) measures to protect private keys from being used to make an unauthorized or accidental transfer of a digital asset security held in custody by the broker-dealer; and (v) measures that protect private keys from being corrupted, lost or destroyed, that back-up the private key in a manner that does not compromise the security of the private key, and that otherwise preserve the ability of the firm to access and transfer a digital asset security it holds in the event a facility, software, or hardware system, or other format or system on which the private keys are stored and/or used is disrupted or destroyed;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies, procedures, and arrangements to: (i) the steps and responses to events such as blockchain malfunctions, attacks, hard forks and airdrops; (ii) to allow the broker-dealer to comply with a court-ordered freeze or seizure; and (iii) to allow the transfer of the digital asset securities held by it to another special-purpose broker-dealer, a trustee, receiver, liquidator, a person performing a similar function, or another appropriate person, in the event the broker-dealer can no longer continue as a going concern and self-liquidates or is subject to a formal bankruptcy, receivership, liquidation, or similar proceeding;
  • The broker-dealer provides written disclosures to prospective customers, including: (i) explaining how SIPA defines securities and that digital assets, even those that are investment contracts under Howey may be excluded from the definition and therefore not covered by SIPC in the event of a loss; (ii) a description of the risks of fraud, manipulation, theft, and loss associated with digital asset securities; (iii) a description of the risks relating to valuation, price volatility, and liquidity associated with digital asset securities; and (iv) a description of the processes, software and hardware systems, and any other formats or systems utilized by the broker-dealer to create, store, or use the private keys and protect them from loss, theft, or unauthorized or accidental use; and
  • The broker-dealer enters into a written agreement with each customer that sets forth the terms and conditions for receiving, purchasing, holding, safekeeping, selling, transferring, exchanging, custodying, liquidating, and otherwise transacting in digital asset securities on behalf of the customer.

Request for Comments

The SEC also specifically requests comments on:

  • What are industry best practices with respect to protecting against theft, loss, and unauthorized or accidental use of private keys necessary for accessing and transferring digital asset securities? What are industry best practices for generating, safekeeping, and using private keys?
  • What are industry best practices to address events that could affect a broker-dealer’s custody of digital asset securities such as a hard fork, airdrop, or 51% attack?
  • What are the processes, software and hardware systems, or other formats or systems that are currently available to broker-dealers to create, store, or use private keys and protect them from loss, theft, or unauthorized or accidental use?
  • What are accepted practices (or model language) with respect to disclosing the risks of digital asset securities and the use of private keys? Have these practices or the model language been utilized with customers?
  • Should the SEC expand this position in the future to include other businesses such as traditional securities and/or non-security digital assets? Should this position be expanded to include the use of non-security digital assets as a means of payment for digital asset securities, such as by incorporating a de minimis threshold for non-security digital assets?
  • What differences are there in the clearance and settlement of traditional securities and digital assets that could lead to higher or lower clearance and settlement risks for digital assets as compared to traditional securities?
  • What specific benefits and/or risks are implicated in a broker-dealer operating a digital asset alternative trading system that the Commission should consider for any future measures it may take?

SEC Risk Alert

In February 2021, the SEC Division of Examinations issued a risk alert focused on digital asset securities.  The risk alert highlights observations made by SEC staff during examinations of investment advisers, broker-dealers, and transfer agents regarding digital asset securities that may assist firms in developing and enhancing their compliance practices.  These observations also provide a view of future regulatory focus in examinations.

Specifically related to investment advisers that are managing digital assets securities, either directly or through pooled vehicles, the SEC will focus on:

  • Portfolio management – whether digital assets are classified as securities; due diligence including that the adviser understands the digital assets, wallets and other devices or software used in the network; Evaluation and mitigation of risks related to trading venues and trade execution or settlement facilities, including KYC/AML procedures; management of risks and complexities associated with forks and airdrops; and fulfillment of fiduciary duties.
  • Books and Records – are advisers keeping accurate books and records. Digital asset trading platforms vary in reliability and consistency with regard to order execution, settlement methods, and post-trade recordation and notification, which an adviser should consider when designing its recordkeeping practices.
  • Custody – unauthorized transactions, including theft of digital assets; controls around safekeeping of assets; business continuity plans where personnel have access to private keys; how the adviser evaluates harm due to loss of private keys; reliability of software; storage of digital assets; and security procedures for software and hardware wallets.
  • Disclosures – disclosure to investors regarding the unique risks of digital assets.
  • Pricing Client Portfolios – valuation methods for digital assets.
  • Registration Issues – how the investment adviser calculates its regulatory assets under management and characterizes digital assets in pooled vehicles.

Specifically related to broker-dealers that are transacting in digital assets securities, the SEC will focus on:

  • Safekeeping of funds and operations – considering unique safety and custody issues of digital assets.
  • Registration requirements – including activities by affiliates.
  • Anti-money laundering – general AML procedures that take into account digital assets including routine searches to check against the Specially Designated Nationals list maintained by the Office of Foreign Assets Control (“OFAC”) at the U.S. Department of the Treasury.
  • Offerings – including disclosure and due diligence obligations.
  • Disclosure of conflicts of interest – including compliance policies and procedures.
  • Outside Business Activities – FINRA-member broker-dealers must evaluate the activities of their registered persons to determine whether such activity constitutes outside business activities or an outside securities activity and therefore should be subjected to the approval, supervision, and recordation of the broker-dealer.

Specifically related to National Securities Exchanges that are transacting in digital assets securities, the SEC will focus on:

  • Exchange Registration – the staff will examine platforms that facilitate trading in Digital Asset Securities and review whether they meet the definition of an exchange.
  • Compliance with Regulation ATS – Examinations will include a review of whether an ATS that trades Digital Asset Securities is operating in compliance with Regulation ATS, including, among other things, whether the ATS has accurately and timely disclosed information on Form ATS and Form ATS-R, and has adequate safeguards and procedures to protect confidential subscriber trading information.

Finally, related to transfer agents that are transacting in digital assets securities, the SEC will focus on:

  • Compliance with Transfer Agent Rules – the staff will focus on prompt and accurate clearance and settlement of securities transactions.
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SEC Spring 2021 Regulatory Agenda
Posted by Securities Attorney Laura Anthony | July 30, 2021 Tags:

The first version of the SEC’s semiannual regulatory agenda and plans for rulemaking under the current administration has been published in the federal register.  The Spring 2021 Agenda (“Agenda”) is current through April 2021 and contains many notable pivots from the previous SEC regime’s focus.  The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.

The Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions.  The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that.  The number of items to be completed in a 12-month time frame jumped up to 45 items since Fall, which had only 32 items.  Some of the new items are a revisit of previously passed rule changes.  Although a big jump from Fall 2020, 45 is in line with prior years.  The Spring 2019 Agenda had 42 and the Fall 2019 had 47 on the list.

Items on the Agenda can move from one category to the next or be dropped off altogether.  New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.

Four items appear in the pre-rule stage including prohibition against fraud, manipulation, and deception in connection with security-based swaps which was also on the Fall Agenda.  Added to the list are exempt offerings, third-party service providers and gamification.    Third-party service providers refer to the asset management industry and includes services such as index and model providers.  Under the gamification category, the SEC is considering seeking public comment on potential rules gamification, behavioral prompts, predictive analytics, and differential marketing.  Gary Gensler talked about gamification issues in a recent speech – see HERE

Interestingly, the SEC HERE; offering communications (HERE); amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (HERE); Regulation A (HERE); and Regulation CF (HERE).

The Agenda indicates that the SEC is now planning on seeking public comment on ways to further updated the SEC rules for exempt offerings “to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.”  All of these were points of contention during the rule amendment process.  Also in August 2020, the SEC updated the definition of an accredited investor and specifically decided not to increase the financial thresholds (see HERE).  Seems we could be going back to the beginning in this whole process.  As a practitioner I am frustrated by the idea that the SEC’s rulemaking could be so partisan-driven.  Historically, that was not the case.  Certainly, we have seen a different focus with new administrations but not a seesaw of rulemaking.

Thirty-six items are included in the proposed rule stage, up from just 16 on the Fall 2020 list, and include plenty of brand-new interesting topics.  New to the proposed rule list are ESG related items including climate change and human capital disclosure.  In addition to many public announcements on the topic of climate change, in March, the SEC issued a statement requesting public input on climate change disclosure with a focus on enhancing and updating the prior 2010 guidance (see HERE), it is now considering rule amendments to further enhance the disclosure requirements. Further proposed items in the ESG category are rules related to investment companies and investments advisors addressing environmental, social and governance factors.

Also new to the list is special purpose acquisition companies (SPACs) which could include a plethora of potential rule changes such as specific exclusion from the protections of Private Securities Litigation Reform Act (PSLRA), enhanced disclosure requirements, amendments to Exchange listing requirements and changes to accounting treatment, among others (see HERE).  Rule 10b5-1 and in particular, a review of affirmative defenses available for insider trading cases, has been added to the proposed rule list.  This is a topic Gary Gensler and the current SEC top brass have been vocal about in public speeches.  Similarly, potential changes to Section 10 liability provisions surrounding loans or the borrowing of securities now appear on the proposed rule list.

Another hot topic amongst the SEC and marketplace has been share repurchase programs by public companies, including the potential they unfairly benefit insiders selling into the upmarket created by the repurchase programs.  Share repurchase disclosure modernization has been added to the proposed rule list. Likewise, market structure reform including related to payment for order flow, best execution and market concentration are new to the Agenda in the proposed rule category.  Gary Gensler gave a heads-up that this was a priority in his May 6, 2021 speech to the House Financial Services Committee (see HERE).  Keeping in the market structure category, the SEC is considering amending the rules to shorten the standard settlement cycle.  The historical t+3 was shortened to t+2 back in March 2017 (see HERE) and many believe that technology can currently handle t+1 with a goal of reaching simultaneous settlement (t+0).

Rounding out new items on the Agenda appearing on the proposed rule list include disclosure regarding beneficial ownership of swaps including interests in security-based swaps; cybersecurity risk governance which could enhance company disclosure requirements regarding cybersecurity risk; electronic submission of applicators for orders under the Advisors Act, confidential treatment requests for filings on Form 13F, and ADV-NR; open-end fund liquidity and dilution management; incentive-based compensation arrangements at certain financial institutions that have $1 billion or more in total assets; and portfolio margining of uncleared swaps and non-cleared security-based swaps.

Many items remain on the proposed list including mandated electronic filings increasing the number of filings that are required to be made electronically; potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and records to be preserved by certain exchange members, brokers and dealers.

Amendments to the transfer agent rules still remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE).  Former SEC top brass suggested that it would finally be pushed over the finish line last year, but so far it remains stalled (see, for example, HERE).

Another controversial item still appearing on the proposed rule stage list is enhanced listing standards for access to audit work papers and improvements to the rules related to access to audit work papers and co-audit standards.  In June 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market” (see HERE).

Bolstering Nasdaq’s position, the Division of Trading and Markets and the Office of the Chief Accountant are considering jointly recommending (i) amendments to Rule 2-01(a) of Regulation S-X to provide that only U.S. registered public accounting firms will be recognized by the SEC as a qualified auditor of an issuer incorporated or domiciled in non-cooperating jurisdictions for purposes of the federal securities laws, and (ii) rule amendments to enhance listing standards of U.S. national securities exchanges to prohibit the initial and continued listing of issuers that fail to timely file with the SEC all required reports and other documents, or file a report or document with a material deficiency, which includes financial statements not prepared by a U.S. registered public accounting firm recognized by the SEC as a qualified auditor.

It is not just the pre-rule stage that reflects a re-do of recently enacted rules.  The disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE and finalized in December 2020 (see HERE) is now on the proposed rule list to determine if additional amendments might be appropriate.  Keeping with a seeming willingness to subject the marketplace to continued regulatory uncertainty, back on the proposed list is amendments to the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8.  After years of discussion and debate, the SEC adopted much-needed rule changes in September 2020 (see HERE) which are now apparently back on the table. The complete proxy advisory rule changes (see HERE) are also back in play on the proposed rule list.  Finally, amendments to the whistleblower program which had dropped off the list as completed, are now back on for further review.

Several items have moved from long term actions to the proposed rule stage.  Executive compensation clawback (see HERE), which had been on the proposed rule list in Spring 2020 and then moved to long-term action, is back on the proposed list.  Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.  This topic has been batting around since 2015.  Also, clawbacks of incentive compensation at financial institutions moved from long-term to proposed.

Also moved up from long-term action to proposed is corporate board diversity (although nothing has been proposed, it is a hot topic); reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); amendments to the custody rules for investment advisors (which was moved from proposed to long term and now back to proposed); money market fund reforms; registration and regulation of security-based swap execution facilities; prohibitions of conflicts of interest relating to certain securitizations; broker-dealer liquidity stress testing, early warning, and account transfer requirements; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and short sale disclosure reforms.

Bouncing back to the proposed list from the long-term list in Fall after spending one semi-annual period on the proposed rule list are amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons.

Nine items are included in the final rule stage, down from 14 on the Fall Agenda, none of which are new to the Agenda.  Implementation of Dodd-Frank’s pay for performance jumped from the long-term list where it had sat for years, to the final rule stage (see HERE).  Establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC also jumped from a long-term action item to the proposed rule list. Likewise, amendments to the NMS Plan for the consolidated audit trail data security have been added.

Investment company summary shareholder report and modernization of certain investment company disclosures moved from the proposed to final rule stage, as did amendments to Regulation ATS for the registration of and reporting by alternative trading systems (ATS) for government securities.

Moving quickly from the proposed rule stage to final rule stage are the controversial amendments to the Rule 144 holding period and Form 144 filings.  In December 2020, the SEC surprised the marketplace by proposing amendment to Rule 144, which would prohibit the tacking of a holding period upon the conversion of variably priced securities (see HERE.  The responsive comments have been overwhelmingly opposed to the change, with only a small few in support and those few work together in plaintiff’s litigation against many variably priced investors.  Many of the opposition comment letters are very well thought out and illustrate that the proposed change by the SEC may have been a knee-jerk reaction to a perceived problem in the penny stock marketplace.  I wholly oppose the rule change and hope the SEC does not move forward.  For more on my thoughts on the damage this change can cause, see HERE.

Still listed in the final rule stage is universal proxy process.  Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.  The SEC re-opened comments on the rule proposal in April 2021 (see HERE).  Although things can change, final action is currently slated for October 2021.

Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); and an amendment to the definition of clearing agency for certain activities of security-based swaps dealers.

Seventeen items are listed as long-term actions, down from the 32 that were on the Fall list, including many that have been sitting on the list for years and one that is new.  Although the already implemented amendments to the proxy process and rules are under new review as discussed above, additional proxy process amendments dropped from the proposed list to a long-term action item. New to the list in long-term action is investment company securities lending arrangements.

Continuing their tenure on the long-term list is conflict minerals amendments; stress testing for large asset managers; custody rules for investment companies; requests for comments on fund names; amendments to improve fund proxy systems; end user exception to mandatory clearing of security-based swaps; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.

Several items have dropped off the Agenda as they have now been implemented and completed, including amendments to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation; use of derivatives by registered investment companies and business development companies; market data infrastructure, including market data distribution and market access; and amendments to the SEC’s Rules of Practice.

Moved from the proposed rule stage to a long-term action item are proposed changes to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies).  In May 2018, SEC amended the rules and issued a concept release (see HERE and HERE).  In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy.  This no longer seems to be a priority.

Dropped from the Agenda are amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years.  Surprisingly, the proposal was met with overwhelming pushback from market participants.  There were 2,238 comment letters opposing the change and only 24 in support.  Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other, more pressing matters.

Other items dropped from the Agenda without action include amendments to asset-backed securities disclosures (last amended in 2014); earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020 back down to long-term in Fall 2020 and now has been dropped altogether.  The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority.

Also dropped without action is amendments to Guide 5 on real estate offerings and Form S-11 (though some changes were made in relation to the acquisition of businesses by blind pools); and amendments to the family office rule (though I expect this will be partly covered by the item on the proposed list related to disclosure regarding beneficial ownership of swaps including interests in security-based swaps).

Disappointingly still not on the Agenda is Regulation Finders.  Although the SEC proposed a conditional exemption for finders (see HERE), it does not go far enough, and again is not a priority.

The Author

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NYSE Annual Compliance Guidance Memo And Amended Rules
Posted by Securities Attorney Laura Anthony | July 22, 2021 Tags: ,

In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies.  Although we are already halfway through the year, the annual letter has useful information that remains timely.  As discussed in the Compliance Memo, the NYSE sought SEC approval to permanently change its shareholder approval rules in accordance with the temporary rules enacting to provide relief to listed companies during Covid.  The SEC approved the amended rules on April 2, 2021.

Amendment to Shareholder Approval Rules

The SEC has approved NYSE rule changes to the shareholder approval requirements in Sections 312.03 and 312.04 of the NYSE Listed Company Manual (“Manual”) and the Section 314 related party transaction requirements.  The rule changes permanently align the rules with the temporary relief provided to listed companies during Covid (for more on the temporary relief, see HERE

Prior to the amendment, Section 312.03 of the Manual prohibited certain issuances to (i) directors, officers or substantial shareholders (related parties), (ii) a subsidiary, affiliate, or other closely related person of a related party; or (iii) any company or entity in which a related party has a substantial direct or indirect interest.  In particular, related party issuances were prohibited if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance.  The rule had limited exception if the issuances were for cash, above a minimum price, no more than 5% of the outstanding common stock and the related party was a related party solely because it is a substantial shareholder of the company.

The amended rules modify the class of persons for which shareholder approval would be required prior to an issuance.  The amended rules only require shareholder approval prior to issuances to directors, officers and substantial shareholders.  The restriction on a subsidiary, affiliate, or other closely related person of a related party or any company or entity in which a related party has a substantial direct or indirect interest has been removed.  In addition, the amended rule broadens the exception such that all cash sales at or above the minimum price would be exempted.    Other provisions of the NYSE rules may still require shareholder approval prior to issuances to officers and directors, such as the equity compensation rules that require shareholder approval for issuances to employees, officers, directors and service providers.

The amendment also adds a provision whereby shareholder approval is required prior to any acquisition transaction or series of related transactions in which any related party has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in either the number of shares of common stock or voting power outstanding of 5% or more before the issuance.

The amendments more closely align the NYSE rules with those of the NYSE American and Nasdaq.  For a review of the NYSE American and Nasdaq rules for affiliate issuances associated with acquisitions, see HERE.  For a review of the NYSE American and Nasdaq rules governing equity compensation shareholder approval requirements, see HERE.

The NYSE has also amended its 20% Rule.  In particular, NYSE Section 312.03(c) requires shareholder approval of any transaction relating to 20% or more of the company’s outstanding common stock or voting power outstanding before such issuance but provides the following exceptions: (i) any public offering for cash; and (ii) any bona fide private financing involving a cash sale of the company’s securities that comply with the minimum price requirement.  A “bona fide private financing” referred to a sale in which either: (i) a registered broker-dealer purchases the securities from the issuer with a view to the private sale of such securities to one or more purchasers; or (ii) the issuer sells the securities to multiple purchasers, and no one such purchaser, or group of related purchasers, acquires, or has the right to acquire upon exercise or conversion of the securities, more than 5% of the shares of the issuer’s common stock or voting power before the sale.

Under the amended rules, the NYSE has replaced the term “bona fide financing” with “other financing (that is not a public offering for cash) in which the company is selling securities for cash.”  This change eliminated the requirement that the issuer sell the securities to multiple purchasers, and that no one such purchaser, or group of related purchasers, acquires more than 5% of the issuer’s common stock or voting power.  Also, under the rule change, the provision related to broker-dealer purchases becomes moot.

Of course, the new rules would not eliminate shareholder voting requirements under other NYSE rules such as the acquisition rules where the issuance equals or exceeds 20% of the common stock or voting power.  Like the affiliate rule change, the amendment is meant to further align NYSE rules with those of the NYSE American and Nasdaq.  For a review of the NYSE American and Nasdaq 20% rules, see HERE.

The NYSE has also made a change to Section 314 of the Manual requiring related party transactions to be reviewed by the audit committee.  The Exchange has updated the definition of “related party” from officers, directors and principal shareholders to align with the definition provided in Item 404 of Regulation S-K of the Exchange Act.

Annual Compliance Guidance Memo

The NYSE Memo provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news.  Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FD compliant method.  For news being released between 7:00 a.m. and 4:00 p.m. EST, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email.

For news releases outside the hours of 7:00 a.m. and 4:00 p.m. EST companies are generally not required to call the Exchange in advance of issuing news, although companies should still provide a copy of material news once it is disclosed, by submitting it electronically through Listing Manager or via e-mail to nysealert@nyse.com.  Where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement either by a call within operating hours or in writing after hours.

The requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference.  In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.

Between the hours of 9:25 a.m. and 4:00 p.m. EST, NYSE will determine if a temporary trading halt should be implemented to allow the market time to fully absorb the news.  Between the hours of 7:00 a.m. and 9:25 a.m. EST, NYSE will implement news pending trading halts only at the request of the company.

Companies are prohibited from publishing material news after the official closing time for the NYSE’s trading session until the earlier of 4:05 p.m. EST or the publication of the official closing price of the listed company’s security. This requirement is designed to alleviate confusion caused by price discrepancies between trading prices on other markets after the NYSE official closing time, which is generally 4:00 p.m. EST, and the NYSE closing price upon completion of the auction, which can be after 4:00 p.m. EST.

NYSE notes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination. The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information.

The compliance letter also addresses the following matters:

Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 302 of the Manual, which requires that a company hold an annual meeting during each fiscal year.

Record Date Notification – To participate in shareholder meetings as well as receive company distributions and other important communications, investors must hold their securities on the relevant record date established by the listed company. For this reason, the NYSE disseminates record date information to the marketplace so that investors can plan their holdings accordingly.  Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date.  Record dates should be set for business days.  A press release or filing with the SEC cannot satisfy the notice requirements.  The NYSE has no power to waive these requirements and so, if notice is not provided to NYSE as required, a record date may have to be reset.

Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security.  The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards.  Also, the NYSE relies on a listed company’s transfer agent or depositary bank to report share information. Transfer agents are required to report shares no later than the 10th day following the end of each calendar quarter.

Annual Report Website Posting Requirement – Section 203.01 of the Manual requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC.  A listed company that is not required to comply with the SEC proxy rules (such as foreign issuers) must also post a prominent undertaking on its website to provide all holders the ability, upon request, to receive a hard copy of the complete audited financial statements free of charge; and issue a press release that discloses that the Form 10-K, 20-F, 40-F or N-CSR has been filed with the SEC, includes the company’s website, and indicates that shareholders have the ability to receive hard copy of the complete audited financial statements free of charge upon request.

Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements.  The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC.  In addition, a listed company must file an Interim Written Affirmation promptly (within 5 business days) after any triggering event specified on that form. Domestic companies are not required to submit an Interim Written Affirmation for changes that occur within 30 days after the annual meeting, as these can be included in the Annual Written Affirmation.

Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants).  No additional securities can be issued until the NYSE authorizes the LAS.  Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date.  Authorization takes approximately 2 weeks.

Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners.  The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed.  The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.

NYSE Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions.  The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.

Shareholder Approval and Voting Rights Requirements – Sections 303A.08 and 312.03 of the Manual outline the Exchange’s shareholder approval requirements including the 20% rules.  Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).

Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.

Voting Requirements for Proposals at Shareholder Meetings – Section 312.07 of the Manual provides that, where shareholder approval is required under NYSE rules, the minimum vote that constitutes approval for such purposes is approval by a majority of votes cast (i.e., the number of votes cast in favor of the proposal exceeds the aggregate of votes cast against the proposal plus abstentions).

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Nasdaq Board Diversity Proposal
Posted by Securities Attorney Laura Anthony | July 16, 2021 Tags: ,

Nasdaq has long been a proponent of environmental, social and governance (ESG) disclosures and initiatives, having published a guide for listed companies on the subject over six years ago (see HERE).  In December 2020, Nasdaq took it a step further and proposed a rule which would require listed companies to have at least one woman on their boards, in addition to a director who is a racial minority or one who self-identifies as lesbian, gay, bisexual, transgender or queer. Companies that don’t meet the standard would be required to justify their decision to remain listed on Nasdaq.  To help facilitate the proposed rule, Nasdaq has also proposed to offer a complimentary board recruiting solution. A final decision on the proposals is expected this summer.

The SEC recently extended the consideration period and will either approve or disapprove the proposal by August 8, 2021.  The newest Regulatory Flex Agenda which was published last week and will be a topic of a future blog, included the subject in proposed rule making stage with action slated by October 2021.  Its anyone’s call where this will land.  The current SEC regime is more likely to pass a rule than previous administrations but there is still significant pushback.  The SEC could also kick the can down the road and ask Nasdaq to strengthen the data backing its proposal.

Nasdaq Proposed Board Diversity Rule

Nasdaq proposes to adopt Rule 5605(f) to the corporate governance requirements for listing and continued listing which would require Nasdaq listed companies, subject to certain exceptions, to: (i) to have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.

Nasdaq also proposed to add to its list of services for listed companies to provide a complimentary board recruiting solution to help advance diversity on company boards.  The service would provide companies that have not yet achieved a certain level of diversity with one-year complimentary access for two users to a board recruiting solution, which will provide access to a network of board-ready diverse candidates, allowing companies to identify and evaluate diverse board candidates, and a tool to support board benchmarking.  To access the service a listed company must make a request on or before December 1, 2022.

The rule would also require Nasdaq listed companies to disclose statistical information regarding its board’s diversity.  Statistical information will be required in an annual report or proxy statement, or on the company’s website.  Although not required, the proposed rule encourages disclosure of other diverse attributes such as nationality, disability or veteran status.  It could be that a company’s reasoning for not having board members that specifically fit the diverse attributes in the rule, is that it has otherwise a diverse board composition based on other considerations.  Under the proposed rule Nasdaq will not assess the substance of an explanation but would just verify that the company has provided one.

Foreign issuers will be required to disclose the gender of board members; voluntary disclosure of LGBTQ+ status; and information regarding underrepresented groups in their home jurisdiction.  Also, foreign issuers will be required to have at least two diverse directors including at least one female.  Both foreign issuers and smaller reporting companies may satisfy the two diverse director requirements by having two female directors.

The following types of companies would be exempt from the requirements: (i) SPACs; (ii) asset backed issuers; (iii) cooperatives; (iv) limited partnerships; (v) management investment companies; (vi) issuers of non-voting preferred securities, debt securities or derivative securities; and (vii) ETFs and similar funds.

If adopted, the Rule would provide each company with one calendar year from adoption to comply with the Rule’s requirement to provide statistical information disclosures.   A company that goes public via a business combination with a SPAC, an IPO, a direct listing, a transfer from another exchange or an uplisting from the OTC Markets would have one year to comply with the disclosure requirements.  Failure to provide the disclosure would result in a listing deficiency with the ability to submit a plan for cure and to cure within 180 days.  Ultimate non-compliance could result in delisting.

A company would have two calendar years to have, or explain why it does not have, at least one diverse director.  A Nasdaq Global Select or Global Market listed company would then have four calendar years to either have, or explain why it does not have, at least two diverse directors and a Nasdaq Capital Markets listed company would have five calendar years.

Purpose of the Proposed Rule

Simply put, Nasdaq is of the view that diversity in the board room equates to good corporate governance.  They believe that increased diversity brings fresh perspectives, improved decision making and oversight and strengthened internal controls.  Further, Nasdaq asserts that the increased focus on diversity by companies, investors, legislators and corporate governance organizations provides evidence that investor confidence is enhanced by greater board diversity.  In conducting an internal study on diversity amongst listed companies, Nasdaq found they fell short and that a regulatory impetus would help.

Nasdaq’s rule proposal indicates it conducted extensive research including reviewing a substantial body of third-party research and conducting interviews.  Among the questions it sought to answer were (i) whether there is empirical evidence to support the proposition that board diversity increases shareholder value, investor protections and board decision-making; (ii) investors interest in board diversity information; (iii) the current state of board diversity and disclosure; (iv) causes of underrepresentation; (v) various approaches to encourage board diversity; and (vi) the success of approaches taken by other groups, both domestic and foreign.

Clearly Nasdaq is confident that the answers to these questions support not only the value of board diversity and related disclosure, but the value of regulations requiring same.  In addition to the results of its studies, Nasdaq cites the increasing call for diversity by large institutional investors such as Vanguard and BlackRock in their corporate engagement and proxy guidelines.  Nasdaq also believes that the SEC disclosure regime supports disclosure requirements in this context.

The 127-page Nasdaq proposed rule release contains an in-depth discussion of Nasdaq’s research, findings, and conclusions.  Nasdaq also presents counter-information.  There is a lack of studies or information of the association between LGBTQ+ diversity and board representation, stock or other financial performance.    Many studies support a correlation between women on the board and increased earnings and other financial metric performance, but some also show a lack of correlation between the two.  Studies which include other factors, such as strong shareholder rights, show a decreasing impact of diversity to performance.

Interestingly, I believe it is the non-financial aspects, including investor protections (through increased internal controls, public disclosure and management oversight) and confidence, that are compelling Nasdaq to put forth the proposed rule.  As it states in its release “[A]t a minimum, Nasdaq believes that the academic studies support the conclusion that board diversity does not have adverse effects on company financial performance.”   Moreover, as most directors are chosen from the current directors and C-Suite executive’s social and business network, without a compelling reason to search elsewhere, such as regulatory compliance, a natural impediment to increased diversity will remain.

Although Nasdaq’s finding and arguments are compelling, I remain on the fence as to whether regulatory action setting quotas is appropriate.  Certainly, in today’s environment, there is a strong faction of support for the rule and for improvement in diversity in business as a whole.  As a woman, I of course support diversity in business and the boardroom.  Where I am on the fence regarding the quota issue, I support the disclosure aspects of the proposed rule.  Transparency and disclosure on the topic will only provide better information to make sound decisions moving forward.

Board Diversity – Beyond Nasdaq

Putting aside Nasdaq’s rule publication, a lot of groups and thought leaders have been tackling the question of whether board diversity is a benefit or detriment to corporations with thorough arguments to support both sides of the fence.  Board composition is consistently one of the most important topics on the agenda for shareholder engagement, and voting.

Harvard Law Professor Jesse Fried has publicly questioned the empirical value of Nasdaq’s board diversity proposal.  Also, University of MN Law Professor and former chief White House ethics lawyer Richard Painter wrote a thorough rebuttal to Nasdaq’s findings.  That rebuttal was met with its own rebuttal’s pointing out the lack of, and age, of the data presented.  It seems one of the best sources of information is California which imposed a board diversity obligation on corporations domiciled in the state two years ago.  Since enactment of the statute there has been a significant increase of women on the boards of California entities, though other minorities, including women of color, continue to lag.

Getting ahead of this year’s proxy season, Glass Lewis published an in-depth report on Board Gender Diversity with an overview of where things stand in the U.S. and internationally, investor and state efforts to promote balance in the boardroom, and academic research on the benefits of diversity. Glass Lewis recognizes the complexity of the issue and the recruiting involved to find uniquely qualified directors who bring a breadth of experience and insight to the board table.  Simply adding women to the board for diversity’s sake and without careful consideration of qualifications and experience is unlikely to automatically effect any positive corporate change.  With that said, the report also concludes that bringing women and diverse board members will add to the overall viewpoints and knowledge base of a board thereby improving corporate performance.

Many companies are not waiting for a rule to increase diversity disclosure.  To help stakeholders compare disclosure practices, KPMG recently launched a free new web-based tool that tracks disclosure about board diversity.  The software compares disclosure practices by sector, index (Russell 3000 and S&P 500) and company size.  There are several comparative publications as well with one by Deloitte and the Alliance for Board Diversity including information through 2020.

The voluntary increase in disclosure comes, at least partially, from pressure by institutional investors which have been vocal on the subject.  In 2020 many of those entities promised to put their views to action by increasing diversity in their own house.  The data is not in yet as to whether specific vocal proponents of diversity have made significant internal changes, but some are putting on a better show than others.  The Carlyle Group announced a new policy calling for at least one candidate who is Black, Latino, Pacific Islander or Native American to be interviewed for every new position and that at least 30% of its portfolio companies will have ethnic diversity on the board of directors.

Besides investor financial incentives, D&O insurers have started to include diversity practices among the many considerations in granting and pricing liability policies.

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SEC Rules Requiring Disclosures for Resource Extraction Companies
Posted by Securities Attorney Laura Anthony | July 9, 2021 Tags: ,

As required by the Dodd-Frank Act, in December 2020, the SEC adopted final rules requiring require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals.  The last version of the proposed rules were published in  December 2019 (see HERE )The rules have an interesting history.  In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court.  In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress.  In December 2019, the SEC took its third pass at the rules that were ultimately adopted.

The final rules require resource extraction companies that are required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) to disclose payments made by it or any of its subsidiaries or controlled entities, to the U.S. federal government or foreign governments for the commercial development of oil, natural gas, or minerals.

FINAL RULES

The Dodd-Frank Act added Section 13(q) to the Exchange Act directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.

As noted above, the first two passes at the rules by the SEC were rejected.  The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects.  In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors.  The rules were also thought to exceed the SEC authority.

The final rules make many significant changes to the rejected 2016 rules.  In particular, the final rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) amend the definition of “not de minimis” to mean any payment or series of related payments that equals or exceeds $100,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made but require disclosure of aggregated amounts for each subnational government payee and identify each subnational government payee; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.

The rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q).  Under the rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F.  Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered.  Moreover, smaller reporting companies and emerging growth companies are exempted.  However, if the SRC or EGC is subject to disclosure requirements by an alternative reporting regime will have to report on a scaled basis.

The rules define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity.  The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development.  The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development.  The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.

Likewise, the definitions of “extraction” and “processing” are narrowly defined and do not include downstream activities such as refining or smelting.  “Export” is defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource.  Companies that provide transportation services, without an ownership interest in the resource, are not covered.

Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits.  The rules define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure.  Furthermore, an anti-evasion provision is included such that the rules require disclosure with respect to an activity or payment that, although not within the categories included in the rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).

A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place.  A resource extraction issuer will have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral.  The disclosure would be at the broad level without the need to drill down further on the type of resource.  The second prong requires a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining.  Again, additional details are not required.  The third prong requires an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.

Under the rules, a “foreign government” is defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” includes a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government.  On the other hand, “federal government” refers to the government of the U.S. and does not include subnational governments such as states or municipalities.

The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate.  Under the rules, Form SD expressly states that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited.  The report covers the company’s fiscal year and needs to be filed no later than nine months following the fiscal year-end.  The Form SD must include XBRL tagging.

As noted above, the rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts.  In addition, the rules contain a targeted exemption for payment related to exploratory activities.  Under this targeted exemption, companies will not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year.  The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.

Finally, the rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO.  When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year.  Similarly, companies that complete an IPO do not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.

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ESG – The Disclosure Debate Continues
Posted by Securities Attorney Laura Anthony | July 2, 2021 Tags:

The ESG debate continues, including within the SEC and amongst other regulators and industry participants.  Firmly in support of ESG disclosures, and especially climate change matters, is SEC Chair Gary Gensler and Commissioner Allison Herren Lee, while opposing additional regulation is Commissioners Eliad L. Roisman and Hester M. Peirce.  Regardless of whether new regulations are enacted (I firmly believe they are forthcoming), like all SEC disclosure items, the extent of disclosure will depend upon materiality.

Materiality

The U.S. Supreme Court’s definition of materiality is that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public [TSC Industries, Inc. v. Northway, Inc.].  The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.

Rule 405 of the Securities Act defines “material” as “[T]he term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”

Despite the case law and statutory definition, the concept remains fact-driven and difficult to apply.  There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available.  Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure. The SEC has been consistent in its description of materiality for purposes of disclosure in all of its guidance, commentary and rule releases.  Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information.

In its recent request for public comment on climate change disclosure, the SEC sought input on, among other items, what disclosure would be material to an investment or voting decision.  Likewise, the SEC’s 2010 Climate Disclosure Guidance seeks disclosure of material information.  Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if they fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading) (see for more information on the request for comment and 2010 guidance HERE.

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

In May 2021 Commissioner Allison Herren Lee gave a speech on ESG disclosures expressing her well known support for disclosure.  As the concept of materiality has arisen as a gating question in the need for ESG disclosure, Ms. Lee focused on that concept in her speech.  Beginning with the inarguable position that materiality is based on “information that is important to reasonable investors,” she posits that management, lawyers and accountants often get it wrong.  Rather, she believes that a “disclosure system that lacks sufficient specificity and relies too heavily on a broad-based concept of materiality will fall short of eliciting information material to reasonable investors.”

Ms. Lee continues that despite this concept of materiality, she does not believe that the disclosure rules are, or should be, constrained by materiality.  She points to many prescriptive disclosure requirements that are not guided by materiality, such as related party transactions, share repurchases and executive compensation – which leads to ESG disclosures.  Commissioner Lee believes that ESG is material in and of itself and thus disclosure is required.  She continues that “investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”

This is where I put the brakes on.  SEC disclosures are not meant to provide specific factions of, or for that matter any faction of, investors with particular disclosures.  Rather, the standard is well settled that disclosures are meant to provide a “reasonable investor” with information useful in making decisions (investment, voting, etc.).  The test is objective.  The SEC should not be catering to particular factions on investors, especially on a clearly partisan political subject.  That doesn’t mean that I am opposed to climate change disclosures, but rather, that I don’t agree the rulemaking on such disclosures should deviate from the long-standing objective principals of materiality.

More on ESG and Climate Change Disclosures

The SEC request for public comment has been met with an enthusiastic response on both sides of the fence.  However, as many great thinkers are pointing out, although the view that climate change will impact society is fairly accepted, the view that it will impact specific economic sectors, is far less so.  For a financial regulator like the SEC, that discrepancy between societal costs and costs to public companies and markets creates a potential disconnect.

On June 3, 2021, Commissioner Elad L. Roisman gave a poignant speech on ESG disclosure, and its inevitable costs.  Mr. Roisman is vocally against the SEC issuing prescriptive, line-item disclosure requirements on ESG matter and in particular environmental and social issues.  Echoing prior speeches by former Chair Jay Clayton, Mr. Roisman states the obvious that standardization is extremely difficult.  The data is imprecise and fraught with political motivations.

Commissioner Roisman is focused on the costs of disclosure.  The SEC has a mandate to consider the costs of compliance with any new regulations.  Certainly, companies would incur costs in obtaining and presenting the new information and liability for the adequacy of such information. To counter some of these costs, Roisman suggests (i) scaled disclosure for smaller reporting companies; (ii) flexibility in methodologies in fashioning disclosure (for example, a company’s ability to calculate Scope 3 greenhouse emissions depends on it gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities and can be daunting and expensive); (iii) safe harbors similar to forward looking statements disclaimers to reduce litigation risks; (iv) allow disclosures to be furnished not filed; and (v) an extended implementation period.

He also poses basic structural questions such as what standards would the SEC use; if they rely on third parties, how will those standards be monitored and supervised going forward (especially if that party changes political views); and is the SEC the best regulator to require disclosures, especially related to the external impact a company has on society/the environment (as opposed to the potential impact on the company itself).

Staying true to form, Commissioner Hester M. Peirce made a pragmatic and pointed statement on ESG disclosures.  Ms. Peirce points out that “[T]he task before us is to find a way to bring about lasting, positive change to our countries on a range of issues without sacrificing in the process the very means by which so many lives have been enriched and bettered.”  Ms. Peirce also takes aim at the push to follow European disclosure requirements and to create a comprehensive international disclosure regime.  However, ESG factors are complex, evolving and not readily comparable across issuers and industries.  Peirce notes that “[T]he European concept of ‘double materiality’ has no analogue in our regulatory scheme and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of ‘stakeholders,’ would mark a departure from these fundamental aspects of our disclosure framework.”  Clearly, the U.S. capital markets are number one for a reason and an international homogenous disclosure system is likely to impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance.

Turning back to the SEC request for comments, one such comment letter response submitted by UVA law professors Paul and Julia Mahoney, argues that the movement to require disclosure is being led by institutions whose purpose is in part “to pursue public policy goals outside the normal political process,” and whose statements asserting the supposed financial value of ESG are “cheap talk that conveys no information other than that the institution wants the SEC to require the disclosures.”  The article suggests that by requirement disclosure the SEC “risks eroding public trust in its capacity and willingness to serve as an apolitical, technocratic regulator of the capital markets.”

Realizing that climate change disclosures are likely forthcoming, the Securities Industry and Financial Markets Association (SIFMA) advocates for the SEC to start slowly with climate change disclosures and hold off on other ESG matters.  SIFMA suggests requiring disclosures of metrics related to greenhouse gas emissions and so-called carbon footprints based on a materiality standard and principles approach.

Illustrating that the issue follows party lines, supporting disclosure is the New York Department of Financial Services; California Attorney General Rob Bonta and the Attorney Generals for Connecticut, Illinois, Maryland, Massachusetts, Michigan, Minnesota, New York, Oregon, Vermont and Wisconsin.

Congress is getting in on the act as well.  On June 16, 2021, the U.S. Democratic run house narrowly passed H.R. 1187, the Corporate Governance Improvement and Investor Protection Act, which would require the SEC to issue rules within two years requiring every public company to disclose climate specific metrics in financial statements.  The Act would modify Section 14 of the Exchange Act which governs the solicitations of proxies, information statements following shareholder consents, and tender offers and require specified disclosures in proxy solicitations and information statements for annual meetings.  The Act also requires the SEC to create a Sustainable Finance Advisory Committee.  Next the Act goes to the Senate and if passed, to the President to be signed into law or vetoed.  Many Acts are passed by either the House or Senate but never go the distance.  Since this Act is so narrow compared to the SEC’s much broader request for comment on climate disclosure, even if passed, I suspect the SEC rulemaking will be broader than this requires.

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A Resolution For SPAC Warrant Accounting
Posted by Securities Attorney Laura Anthony | June 25, 2021 Tags: , ,

On April 12, 2021, the SEC effectively chilled SPAC activity by announcing that it had examined warrant accounting in several SPACs and found that the warrants were being erroneously classified as an asset.  The SEC identified two accounting issues, one related to the private placement warrants and the other related to both the private placement and public warrants.  These companies were required to restate previously issued financial statements to reclassify warrants as liabilities, and the ripple effect began.  Overnight SPAC management teams, accountants and auditors were scrambling to determine if a restatement was required (in most cases it was) and in-process SPACs were put on hold or at least delayed while market participants tried to figure out the meaning of the SEC guidance and how to address it.

The timing of the statement was interesting as well; most calendar year end SPACs had just filed their Form 10-K for FYE 2020 requiring a slew of 8-Ks to disclose non-reliance on previously issued financial statements.  Those that had filed a Form 12b-25 to obtain a 15-day extension scrambled to re-do the financial statements before filing and as such most were late in filing.  Likewise, many companies that had recently completed business combinations with SPACs had to restate previously issued financial statements and/or delay reports.

The SEC statement specifically indicated that where warrants had been improperly characterized as assets instead of liabilities, a company should consider its obligation to maintain internal controls over financial reporting and disclosure controls and procedures to determine whether those controls are adequate.  Further, a company needed to assess whether prior disclosure on the evaluation of internal controls over financial reporting and disclosure controls and procedures needs to be revised in the amended filings.  As a result, most restated Exchange Act reports contained a disclosure that previously disclosed internal controls were not, in fact, effective due to a material weakness and added risk factors related to inadequate internal controls including litigation risks.

However, the industry was extremely motivated (with just under $90 billion raised in 2021 so far alone) and it appears that accounting firms and the SEC have agreed on a form of warrant that can classified as equity and not as a liability for financial reporting purposes.  Despite the resolutions discussed below, the SEC has not issued any formal guidance or statements updating the April 12, 2021 statement.  Many market participants do not feel they can confidently rely on these changes to be sure that the SEC will not find further issues and have called for lawmakers to add clarity.

Indexation

The Accounting Standards Codification (“ASC”) provides rules and guidelines for when warrants can be classified as equity (and thus an asset) or treated as a liability.  Under the rules, a warrant can only be classified as equity if the warrant is indexed to the company’s common stock.  One of the features of indexing is that a warrant has a fixed strike price.  In its review of SPAC warrants, the SEC found that some warrants included variables that would impact the exercise price and in particular, a variable exercise price depending on whether the warrant was held by the sponsor or a non-permitted transferee.

In a typical SPAC structure (see HERE) the private placement (sponsor) warrants have different features than the public warrants.  For example, the private placement warrants are generally not redeemable and always have cashless exercise provisions.  The public warrants, on the other hand, are almost always redeemable by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days and only have a cashless exercise feature if there is no effective registration statement as to the underlying shares.  Furthermore, both the private warrants and public warrants usually have provisions adjusting the exercise price in certain circumstances associated with the business combination transaction, with the private warrants being entitled to a greater adjustment than the public.  The warrant agreement provides that once the private placement warrants are transferred to persons other than certain permitted transferees, they become public warrants and thus are treated differently depending on the holder of the warrant.  The SEC took issue with potential variations in exercise price depending on holder of the warrant as not being consistent with the rules allowing indexing, and thus treatment as equity and not a liability.

The SEC staff and market participants have come up with two alternatives to address this issue.  The first is to keep private placement warrants separate and distinct from public warrants with no possibility of changes to their terms regardless of transfer.  That is, the concept of “permitted transferee” could be removed and all transfers would then be permitted.  The issue is that the public warrants generally trade on a national exchange (or OTC Markets) and since the features of the private warrant are different, there would be no opportunity to sell such private warrants on the open market.  Liquidity would only be had in a private transaction or upon exercise (which may or may not be in-the-money).

The second alternative is to remove the distinctions between the private and public warrants.  Of course, this would change the economics significantly for the sponsor.

Another alternative, which is not a fix to the warrants but a different structure altogether, is to utilize rights instead of warrants.  Many SPACs include rights as part of their offering structure, though generally in addition to, and not instead of, a warrant.  A right entitles the holder to purchase a share of common stock for xx number of rights (such as one share of common stock for 10 rights).  A right generally has a fixed exercise price and is a short-term instrument.  Care would have to be given such that a Rights Agreement did not contain the same provisions that the SEC found problematic in the Warrant Agreement.

Forced Cashless Exercise

Some SPAC warrant agreements contain a provision that allows the company to force a cashless conversion (i.e., payment in net shares) if the stock price of the company equals or exceeds $10.00 for a period of time.  The exercise price for these warrants is based on a warrant table that varies based on the current stock price and period of time remaining prior to expiration of the warrants.  The formula is based on Black-Scholes and is meant to compensation warrant holders for lost value based on the forced exercise.  As this provision causes the warrant exercise price to be variable, the SEC found that it precluded the warrants from being treated as equity and instead had to be treated as a liability.

SEC staff, together with accounting professionals, have reached the conclusion that if the warrant table is removed or modified, the warrants could be treated as equity.  Removal of the table is straightforward.  Modification would need to be in such a manner that the SEC no longer views the exercise price as variable.

I note that if the table is removed, a post business combination company could still proceed with a tender or exchange offer to entice warrant holders to exchange their warrants for cash and/or stock, but the company would no longer have an absolute right to force conversion.

Tender Offer Provisions

In addition to being properly indexed to common stock, in order to qualify for equity treatment, the warrant must allow the company to settle the warrant with shares.  That is, GAAP accounting includes a general principle that if an event that is not within the entity’s control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity.  There is an exception to this rule if net cash settlement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, such as in a complete change of control.

In its statement the SEC pointed out a fact pattern in which, if a company made a tender or exchange offer that was accepted by the holders of more than 50% of the Class A common stock, all holders of the warrants would be entitled to receive cash for their warrants.  Since in the typical SPAC structure the sponsor’s Class B common stock represents 20% of the total issued and outstanding equity, there would not necessarily be a change of control of the company as a result of the tender offer, and thus the exception would not apply.  In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash.  The SEC staff concluded that, in this fact pattern, the tender offer provision would require the warrants to be classified as a liability measured at fair value, with changes in fair value reported each period in earnings.

SEC Staff, together with accounting professionals, have reached the conclusion that if the language in the tender offer provisions is modified such that the tender offer triggering cash settlement of the SPAC warrants results in the maker of the tender offer holding more than 50% of the voting power of the company’s securities, the company would not be precluded from classifying the warrants as equity.

 

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