SEC Announces It Will Not Enforce Amended Rules Governing Proxy Advisors
On June 1, 2021, SEC Chair Gary Gensler and the SEC Division of Corporation Finance issued statements making it clear that the SEC would not be enforcing the 2020 amendments to certain rules governing proxy advisory firms or the SEC guidance on the new rules.
In particular, in July 2020 the SEC adopted amendments to change the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provide additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amended Rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules. On the same day, the SEC issued updated guidance on the new rules. See HERE for a discussion on the new rules and related guidance.
Like all rules and guidance related to the proxy process, the amendments were controversial with views generally falling along partisan lines. On June 1, 2021, Chair Gary Gensler issued an extremely brief public statement, as follows:
I am now directing the staff to consider whether to recommend further regulatory action regarding proxy voting advice. In particular, the staff should consider whether to recommend that the Commission revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments, among other matters.
On the same day, the SEC Division of Corporation Finance issued a public statement that CorpFin is following Chair Gensler’s direction and revisiting the rules and guidance. CorpFin stated that, in light of the new direction, it will not recommend enforcement action based on the 2019 Interpretation and Guidance or the 2020 Rule Amendments during the period in which the SEC is considering further regulatory action in this area. Moreover, even if the new rules are left in place, CorpFin will not recommend enforcement for a reasonable period of time thereafter, including until current litigation related to the rule changes have been addressed.
Refresher on Amended Rules and Guidance
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. The rules apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures. Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.
The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.”
The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.
On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request. For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts. The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).
The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.
The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9). A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions. In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters). The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.
New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021. Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while, at the same time, working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.
The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship. The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.
Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects. The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended. Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended. Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible. This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms, such as ISS and Glass Lewis, voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice. The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.
The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses. The time for review was set as a number of days based on the date of filing of the definitive proxy statement. However, commenters pushed back and the SEC listened.
The final rules allow proxy advisory businesses to take matters into their own hands. In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).
As adopted, the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible. Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.
New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule. In particular:
(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.
(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).
The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company. Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice. Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.
It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule. The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does, in fact, meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Supplemental Guidance for Investment Advisors
On the same day as enacting the amended rules, the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE. The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.
The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline. The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.
« OTC Markets; Rule 144; The SPCC A Resolution For SPAC Warrant Accounting »
OTC Markets; Rule 144; The SPCC
Small public companies are in trouble and they need help now! Once in a while there is a perfect storm forming that can only result in widespread damage and that time is now for small public companies, especially those that trade on the OTC Markets. The trains on track to collide include a combination of (i) the impending amended Rule 15c2-11 compliance deadline (which alone would be and is a clear positive); (ii) the proposed Rule 144 rule changes to eliminate tacking upon the conversion of market adjustable securities; (iii) the SEC onslaught of litigation against micro-cap convertible note investors claiming unlicensed dealer activity; (iv) the OTC Markets new across the board unwillingness to allow companies to move from the Pink to the QB if they have outstanding convertible debt; and (v) the SEC’s unwillingness to recognize the OTC Pink as a trading market and its implications on re-sale registration statements.
Any one of these factors alone would not be catastrophic, and in the case of the 211 overhaul, is extremely beneficial. However, putting together all of these elements will inevitably result in the complete failure of many small public companies and unfortunately, a disproportionate number of those companies will be operated by woman and minorities.
Of course, I am not the only one that realizes this. In late 2020 a group of market participants including small public companies, investors, law firms, and advocates formed the Small Public Company Coalition (SPCC) as a first-in-kind, high-level properly organized advocate and lobbying group to bring the issues in front of those that can make a difference including the SEC and Congress.
The SPCC is a member-driven, federal advocacy coalition consisting of participants in the micro-cap space. The SPCC is the real deal with active involvement from the brightest at Gibson Dunn & Crutcher, an international law firm with over 1,400 lawyers, and organized lobbying efforts led by Polaris Consulting, a top 10 lobbying firm in D.C. The team at Gibson, Dunn wrote an excellent comment letter response to the SEC proposed changes to Rule 144 that was signed by over 60 market participants and includes a complete economic impact analysis prepared by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the CFTC. The SPCC has also been actively meeting with groups at the SEC and in Congress in support of the cause. For more information on the SPCC see www.thespcc.com or reach out to info@thespcc.com.
15c2-11 Compliance
On September 26, 2020, the SEC adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11. From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealers to rely on that confirmation. The new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer. For a detailed summary of the new rules, see HERE.
Compliance with the majority of the rule’s requirements, including that all quoted companies have current information in order to remain 211 eligible, is slated for September 28, 2021. For companies that are Alternatively Reporting or intend to be Alternatively Reporting to OTC Markets, the ability to upload information requires access to the OTC Markets OTCIQ system. A company must apply to OTC Markets in order to gain access to the OTCIQ system (and thus publish current information on OTC Markets). If a company has been inactive for a period of time, or if a company goes through a change of control, a new OTCIQ application must be submitted.
Access to the OTCIQ system is the first barrier to entry for companies that wish to publish current information in compliance with the 211 rules, using the Alternative Reporting Standard. OTC Markets is inundated with such applications and has publicly announced that if an application is not submitted before June 30, 2021, it will not be processed in time to allow a company to access the system to upload current information prior to the September 28th deadline. Upon submitting an application, the current processing time is approximately 12 weeks.
Unlike obtaining EDGAR filing codes from the SEC, access to the OTCIQ system involves a merit review. The application itself requires the disclosure of all officers, directors and 5% or greater shareholders and the submittal of a background check authorization form for each. If there is negative history, either actual or reputational, related to any of the people listed on the form, OTC Markets has the authority to, and will likely, deny the application. In addition, if a company’s stock has been the subject of volatility in recent months (as so many have – see my blog on Gary Gensler’s recent speech on the subject including social media influencing stock prices – HERE), OTC Markets can, and has routinely been, denying the OTCIQ application.
I applaud the efforts to clean up the micro-cap markets but have issue with the discretionary and arbitrary nature of the review and decision-making process. The SEC has clearly defined bad actor rules, which include a shareholder ownership threshold of 20% and does not include a person’s “reputation.” For a detail of the bad actor rules, see HERE. Small and micro-cap companies often go through changes of control including both organic changes and reverse acquisitions. In fact, the new 211 rules give shell companies an 18-month runway to complete an acquisition. As I discuss below, I understand that OTC Markets is in a unique position to witness micro-cap fraud and the dealings of those that give penny stocks a bad name. I also understand that they are trying to find a balance between allowing access and protection of investors and the reputation of the marketplace itself. However, I would advocate for a more prescriptive test that mirrors the SEC bad actor rules with discretionary power only in extreme circumstances.
I am reminded of FINRA’s similar arbitrary use of Rule 6490 back in 2013-2015. Rule 6490 allows FINRA to deny a corporate action (such as name change, reverse split, etc.) if, among other reasons, “FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors.”
For a period of time, FINRA was relying on “may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors” to deny corporate actions to companies that had any relationship, no matter how far removed, with a person that FINRA deemed a threat, regardless of any actual legal proceedings. See HERE for more information. Several issuers litigated FINRA’s seemingly expansive and arbitrary use of the rule to deny corporate actions. Although the SEC sided with FINRA and upheld their authority, FINRA adjusted their policy moving forward.
FINRA will still deny a corporate action if there is an actual bad actor involved in the company, and even if there is a significant shareholder or investor, whether debt or equity, that is the subject of a pending SEC or other regulatory proceeding but now the results of a review can be anticipated. FINRA considers actual filed legal proceedings and will even provide a company with an opportunity to explain the circumstances and provide exculpatory information. FINRA no longer considers unsubstantiated anonymous internet trolls in its review process. I hope OTC Markets goes the same route.
I also hope that OTC Markets changes its policy of penalizing a company’s ability to provide current public information, because of recent stock volatility and/or internet chat activity. In January 2021 the equity markets saw unprecedented volatility fueled in part by the use of trading apps such as Robinhood and TD Ameritrade and chat rooms such as on Reddit. Many exchange traded middle market companies, such as GameStop and AMC Theaters, were affected as were multiple OTC Markets entities, many of which lacked current public information. In February 2021 the SEC suspended the trading of several OTC Markets companies as result of social media triggered trading volatility without corresponding public information. Of course, this was a valid response.
However, I do not understand OTC Markets denying the ability to provide current information as a result of third-party social media activity or trading volatility (especially when the whole market was experiencing trading volatility). As OTC Markets pointed out in its comment letter response to the proposed 15c2-11 rules and in its application to the SEC for the formation of an expert market, there are companies that trade without current public information that are legitimate businesses. There are also many companies that are now motivated to provide current information as a result of the impending 211 compliance date. They should be allowed to do so, regardless of trading activity.
I note that if any of these companies have engaged in improper stock promotion, pump and dump activity, providing fraudulent or inaccurate public information or misinformation, there are numerous remedies available. The OTC Markets can tag the company with a caveat emptor designation and the SEC can initiate a trading suspension and subsequent enforcement action.
Even once an application for filing code access is granted, all information must be reviewed by OTC Markets prior to receiving current information status or confirmation of 15c2-11 eligibility. Absent actual identifiable bad actors, this seems the best gateway for OTC Markets to exercise its gatekeeper role. Also, in that gatekeeper role, OTC Markets should follow its stated position in its comment letter to the SEC in response to the 211 rule changes and make the review process more objective and efficient. OTC Markets should not review the merits of the information itself. The goal should be to ensure the markets have the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.
Proposed Rule 144 Rule Changes
On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. Market adjustable securities usually take the form of convertible notes which have become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so but have been under attack in recent years. The reasoning for the attacks range from the dilutive effect of the financing (yes, it’s dilutive); to labeling all market adjustable security investors and lenders as predatory sharks swimming in a sea of innocent guppies; to the SEC’s claim that serial lenders are acting as unlicensed dealers; to no articulated reason at all.
When the rule was first proposed and I blogged about it (see HERE), I saw the rule as adding some clarity to an opaque attack by market participants against a category of investors. In other words, I saw it as adding boundaries to what was otherwise just discrimination. Now I think it is a reactive, under-educated, excessive regulatory response to a perceived issue, fraught with unintended consequences. The hardest hit group from the fallout of this rule will be woman- and minority-majority-owned businesses.
In a standard convertible note structure, an investor lends money in the form of a convertible promissory note. Generally, the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer. Since Rule 144 allows for tacking of the holding period as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion. The notes generally convert at a discount to market price so if the converted securities are sold quickly, it appears that a profit is built in. The selling pressure from the converted shares has a tendency to push down the stock price of the issuer. On the flip side, because of the market adjustable feature, the lender can usually offer a lower interest rate and better terms.
The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16, see HERE). As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock in order to satisfy the debt. Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a large increase in the number of outstanding shares and a decrease in the share price. Over the years, this type of financing has often been referred to as “toxic.”
Extreme dilution is only possible in companies that do not trade on a national securities exchange. Both the NYSE and Nasdaq have provisions that prohibit the issuance of more than 20% of total outstanding shares, at a discount to a minimum price, without prior shareholder approval. For more on the 20% Rule, see HERE. In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed Ruel 144 change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange.
Although on first look it sounds like these transactions are risk-free for the investor and that the proposed legislation makes perfect sense – they are not and it does not. Putting aside the fact that not even the SEC could enunciate the problem they are trying to fix (the SEC does not even mention extreme dilution), and only provided a few sentences on the economic impact of the rule (i.e., the impact is “unclear”), a further review makes it obvious the rule doesn’t make sense.
It isn’t all profits and using dollars to light cigars for adjustable security investors. First, Rule 144 itself creates some hurdles. In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations. Also, if the company was formerly a shell company, it must always remain current in its reporting obligations to rely on Rule 144. If a company becomes delinquent, the investor can no longer convert its debt and oftentimes the company does not have the cash to pay back the obligation. Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers. Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.
There are market risks as well. If a company has very low volume and/or an extremely low price, market adjustment will not save the day for the investor. Also, conversion is generally based on a formula over the days prior to the conversion. There is no guarantee that the price will not drop in the time it takes to convert and deposit securities. Of course, there is the time value of money. No matter what, an investor is in for 6 months and would have foregone options on how to put the money to better use.
The problems with the proposed rule go deeper. I urge everyone to read the Comments of the SPCC in response to the rule, the response letter by Michael A. Adelstein, Partner at Kelley, Drye & Warren, LLP and the numerous, almost across the board, comments in opposition to the proposed rule. Whereas the SEC proposed rule contains almost no economic analysis whatsoever, the SPCC’s 187-page response contains an in-depth economic analysis by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the . The results are grim, especially for development stage companies with limited capital and revenue.
It is quite possible that the rule’s implementation will bankrupt hundreds of small public companies. As the SEC notes, unlisted small public companies often have one source, and only one source, of quick affordable capital and that is market adjustable convertible securities. Eliminating this source of financing will likely drive these companies out of business (eliminating jobs and investment funds at the same time). As it is undeniably harder for woman and minorities to raise money, especially from traditional sources, they will be the hardest hit. (See my summary of the Annual Report of Office of Advocate for Small Business Capital Formation – HERE.)
The SEC comment letter focuses on the grievous consequences to small businesses as well as the legal legislative issues with the proposed rule (arbitrary and capricious, etc.). The letter also contains an excellent history of Rule 144 including citing the numerous reasons the SEC amended the rule in 1997 to codify the long-standing practice of allowing tacking to the original issue date of a convertible note upon conversion to securities. Likewise, the comment letter contains a thoughtful dissertation that convertible notes are not overly dilutive but rather provide an affordable valuable form of financing and support the SEC’s mission of promoting access to capital for small companies.
Michael A. Adelstein’s comment response letter takes a more analytic approach with a broader market view discussing the different types of issues and investors and even propounding alternative language to the proposed rule. The fact is that the issuers targeted by the proposed rule change are generally not S-3 eligible, cannot rely on the National Securities Market Improvements Act for registrations (i.e., they must comply with state blue sky laws which are arduous) and generally have smaller floats limiting the amount that could be sold in a re-sale registration statement (because it would be considered an indirect primary offering). For these companies’ private placements of public equity or debt (i.e., a PIPE) is the only potential source of meaningful capital. If the company properly uses the capital obtained in PIPE transactions, they will grow out of the need for market-adjustable securities and will move on to registered and underwritten offerings.
Moreover, the SEC does not even consider the impact on small exchange traded companies. If an exchange traded company is struggling financially, under the new rules, it is unlikely that an investor will provide market adjustable convertible sources of capital for fear the company will be delisted and they will lose the ability to tack onto the holding period. As Mr. Adelstein notes, “[A] market-adjustable security can save entire businesses and thousands of jobs, as well as some or all of the value of investments already made into such businesses.”
Likewise, the SEC focuses only on convertible notes, disregarding the multiple types of market adjustable convertible securities which will also be impacted such as floaters, amorts, resets, forced convertibles and default convertibles. Mr. Adelstein’s comment letter contains an excellent discussion of these different types of instruments and provisions, but the most important point is it is not a one-size-fits-all investment. The SEC must at least consider the use of these different instruments and what impact a broad swipe of the pen can have.
Similarly, not all investors are the same. The SEC lumps together all market-adjustable security investors as pump-and-dump offenders out to take advantage of the marketplace. This simply isn’t true. There are some bad actors, but in my experience the majority are sophisticated investors looking to establish a long-term funding relationship with a client. The dumpers earn a reputation as such very quickly and are not sought after for further investments. I don’t mean to say the good ones are purely altruistic, but it just makes good business sense to establish long-term relationships and trade wisely to support growth. Fundamentals count. It is costly from an administrative perspective (accounting, deposit fees, opinion letters, brokerage fees, etc.) to manage multiple small investments. Also, the profit ratio for small investments is significantly lower than for larger ones. A company that utilizes capital properly and continues to grow will have a higher sustained stock price, more volume and more access to a diverse portfolio of capital only rounding out with market adjustable securities. A sophisticated investor will not just dump but will wait for good news and market changes, trading strategically. In this case, all investors make a larger return on investment dollars and are invited back to participate in future opportunities with even higher potential ROI’s and growth opportunities (every company is a small company in the beginning).
Considering the dramatic negative impact, the proposed rule will have on small and micro-cap companies, it seems obvious that there are many, less intrusive ways in which to approach the perceived problem. The SEC could require shareholder approval for any market adjustable convertible security issuance that could result in 20% or greater dilution, mirroring the current Exchange rules for all public companies. The SEC could also allow for tacking where, in fact, the securities were not issued at a discount to market regardless of market adjustable provisions in the security.
SEC Unlicensed Dealer Litigation
Prior to proposing the amendment to Rule 144, the SEC launched a different attack on investors/lenders of market adjustable securities. In November 2017 the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act. Since that time, the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer. I am aware of several other entities that are under investigation for the same activity, which will likely result in enforcement actions.
The SEC certainly knew of the proliferation of convertible note and other market adjustable securities financings over the years. Rule 415 governs the registration requirements for the sale of securities to be offered on a delayed or continuous basis, such as in the case of the take down or conversion of convertible debt and warrants. In 2006 the SEC issued guidance on Rule 415 that the rule would not be available for re-sale registration statements where in excess of 30% of the company’s float was being registered for re-sale. The SEC indicated it would view such registrations as indirect primary offerings, that could not be priced at the market. The SEC action was in direct response to the proliferation of market adjustable equity line of credit financings during that time. Although there were a few large investors that did the majority of the financings, the SEC did not raise the dealer issue.
As mentioned before the Rule 144, 1997 amendment which specifically allowed tacking of the conversion holding period, spoke in depth as to this kind of financing. Likewise, the 2008 amendments that reduced the holding periods to six months and one year also addressed convertible financing and added a provision to clarify that tacking is also allowed upon the exercise of options and warrants where there is a cashless exercise feature. Again, the SEC did not raise an issue that the most prolific investors could be acting as an unlicensed dealer. To the contrary, the SEC recognized the importance of this type of financing.
On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the announcement of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and to determine 8-K filing deficiencies. See HERE for my blog at the time. The SEC did not mention any potential violations by the investors themselves.
Nothing in the prior SEC rule making, interpretive guidance, or enforcement actions foresaw the current dealer litigation issue. The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question. So far, the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes in penny stock issuers. Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded or the size of the issuer.
Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt. Likewise, there is nothing in the broker dealer regime that suggests that if you invest in penny stock issuers vs. middle market or exchange traded entities you need to be licensed as a dealer. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly. Although the SEC has had some wins in the litigations, the issue is far from settled.
Importantly, the dealer litigation, together with the proposed Rule 144 rule changes, makes it that much harder for small and developing public companies to obtain financing to execute on their business plans, support job growth and support the U.S. economy.
OTC Markets QB Standards
I mentioned above that most of the comment letter responses to the proposed Rule 144 amendments were in opposition to the rule change. One that was not, is OTC Markets itself. In supporting the proposed rule change, OTC Markets merely suggested that it not discriminate against OTC Markets securities, but rather that the new rule should apply across the board to both OTC Markets and Exchange traded issuers.
OTC Markets is in a unique position to witness the red flags of micro-cap fraud and has valiantly been engaged in an uphill battle to combat that fraud, and earn the respect of the SEC, FINRA and other regulators. To its credit, it has done an amazing job. Nothing is more illustrative of that than the complete dichotomy between the December 16, 2016 SEC White Paper on penny stocks which disregarded OTC Markets as a viable marketplace and showed a complete disinterest in it or its efforts to create a venture market (see HERE) and the new 15c2-11 rule release which hands over the power to determine compliance with the rule to OTC Markets itself.
Moreover, in the years prior to the 2016 White Paper and certainly since, the OTC Markets has consistently implemented new rule and policy changes, all in an effort to deter micro-cap fraud and create a respected market. They have and are succeeding.
But I don’t agree with everything. In recent years, OTC Markets has taken a stance against convertible note lenders and the issuers that rely on their financing. Effective October 1, 2020, OTC Markets formally updated its QB rules to add that it may “[R]efuse the application for any reason, including but not limited to stock promotion, dilution risk, and use of ‘toxic’ financiers if it determines, in its sole and absolute discretion, that the admission of the Company’s securities for trading on OTCQB, would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.”
This would be fair enough if, like FINRA, it only denied an application if one of the investors or participants was a bad actor under the SEC rules, or had actual proceedings filed against it. Rather, though, OTC Markets has taken it one step further and has been denying the majority of QB applications where the applicant has convertible securities on the books.
In the past few months, this has become a big topic of conversation among market participants. In addition to clients and potential clients, other attorneys, broker-dealers and transfer agents have reached out to me to discuss insight or guidance. Is one convertible instrument enough to deny a QB application? Is three too many? Why are applications being denied even when the convertible instruments are not market adjustable? Will shareholder approval of the financings solve the problem? What if the total amount of potential dilution is less than 20%? 10% or even 5%?
Yesterday, on June 7, 2021, OTC Markets published some guidance on dilution risk associated with an OTCQB or OTCQX application. OTC Markets is focusing on:
- Whether an issuer has recent or currently outstanding convertible notes with conversion features that provide significant discounts to the current market price and whether such notes are held by company officers, directors and control persons;
- Whether an issuer has other classes of outstanding securities that are convertible into common stock at largely discounted rates and are not held by officers or directors;
- A capital table and/or “toxic financing” structure that will substantially reorganize the share ownership of the company;
- Whether an issuer has had a history of substantial increases in the amount of its outstanding shares;
- Whether an issuer has had a history of multiple or large reverse stock splits; and
- Whether an issuer has engaged lenders that have been the subjects of regulatory actions regarding “toxic financing” and related concerns.
The OTC Markets guidance indicates that an application can be renewed if a company takes corrective measures including enhancing corporate governance, providing additional disclosure, changing capital structure or adding protections for minority investors.
Although we appreciate all guidance, it is still opaque. It comes down to effectively identifying and solving a problem. The guidance indicates “substantial discount to market” but in my experience, even convertible notes at a fixed conversion price have been problematic. I know OTC Markets wants to allow listings on the QB and QX and is also trying to be a good steward and fiduciary to the marketplace. It is clear that we are in a period of transition.
In addition to the existence of convertible debt, like the OTCIQ application, OTC Markets has been doing a deep-dive merit review on all companies that apply to the QB and has been quick to deny an application, often without articulating the reasons or in perfunctory emails with a high-level reason that has been the source of some frustration for applicants.
Trading on the QB is not merely for optics. It has a definitive regulatory and capital raising impact.
The OTC Pink is not a Recognized Marketplace
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, 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.
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. 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 market for purposes of filing and pricing a re-sale registration statement.
However, OTC Pink is still not a recognized market. 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 too.
In light of the SEC dealer litigation and proposed Rule 144 amendments, many companies are engaging with investors for registered offerings. Even though the SEC is a proponent of exempt offerings (thus the redo of the entire exempt offering structure in November 2020), it seems that encouraging companies to register offerings will reduce micro-cap fraud and should be supported by OTC Markets. However, in order to properly utilize registration statements for capital market financing transactions, a company must trade on the OTCQB or better. A company’s added difficulty in being accepted to trade on the QB is just another notch on the tightening noose of OTC Markets companies.
« SEC Re-Opens Comments On The Use Of Universal Proxy Cards SEC Announces It Will Not Enforce Amended Rules Governing Proxy Advisors »
SEC Re-Opens Comments On The Use Of Universal Proxy Cards
On April 16, 2021, the SEC voted to reopen the comment period on the proposed rules for the use of Universal proxy cards in all non-exempt solicitations for contested director elections. The original rules were proposed on October 16, 2016 (see HERE) with no activity since. However, it is not surprising that the comment period re-opened, and it is not as a result of the new administration. The SEC’s Spring and Fall 2020 semi-annual regulatory agendas and plans for rulemaking both included universal proxies as action items in the final rule stage. Prior to that, the topic had sat in the long-term action category for years.
In light of the several years since the original proposing release, change in corporate governance environment, proliferation of virtual shareholder meetings, and rule amendments related to proxy advisory firms (see HERE) and shareholder proposals in the proxy process (see HERE), the SEC believed it prudent to re-open a public comment period. In addition, the SEC including additional questions for public input in its re-opening release.
Background
Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Companies subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies.
Currently where there is a contested election of directors, shareholders are likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e., all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned, the second would cancel out and replace the first under state corporate law.
Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally, in a contested election the opposing candidates will not agree, presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.
Shareholders can always appear in person, or in today’s world – virtually in person, and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. Besides other impediments, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years, some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition. To provide the same voting rights to shareholders utilizing a proxy card as they would have in person, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.
In 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First, it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e., those prepared by the company) to get those names.
In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card, and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. As a response, the SEC issued the rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.
SEC Proposed Rule
On October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. In particular, the proposed rule would:
- Create new Rule 14a-19 to require the use of universal proxy cards in all non-exempt solicitations in connection with contested director elections. The universal proxy card would not be required where the election of directors is uncontested. There may be cases where shareholder proposals are contested by a company, in which case a shareholder would still receive two proxy cards; however, in such case, all director nominees must be included in each groups proxy cards;
- Revise the consent required of a bona fide director nominee such that a consent for nomination will include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
- Eliminate the short slate rule;
- Prescribe certain filing, notice, and solicitation requirements of companies and dissidents when using universal proxy cards;
- Require dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
- Require dissidents in a contested election subject to new Rule 14a-19 to solicit holders of at least a majority of the voting power of shares entitled to vote on the election of directors;
- Provide for a filing deadline for the dissidents’ definitive proxy statement; and
- Prescribe formatting and other requirements for the universal proxy cards.
The Proposed Rules also include other improvements to the proxy voting process, such as mandating that proxy cards include an “against” voting option when permitted under state laws and requiring disclosure about the effect of a “withhold” vote in an election.
The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:
| Due Date | Action Required |
| No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [proposed Rule 14a-19(b)(1)] | Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees. |
| No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [proposed Rule 14a- 19(d)] | Registrant must notify the dissident of the names of the registrant’s nominees. |
| No later than 20 business days before the record date for the meeting. [current Rule 14a-13] | Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners. |
| By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [proposed Rule 14a-19(a)(2)] | Dissident must file its definitive proxy statement with the Commission. |
The proposed new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.
In its rule release, the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”
Companies have a concern that dissident board representation can be counterproductive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve. The SEC rule release solicits comments on this point.
Moreover, there is a concern that shareholders could be confused as to which candidates are endorsed by whom, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.
« SEC Chair Gary Gensler Testifies To Congress OTC Markets; Rule 144; The SPCC »
SEC Chair Gary Gensler Testifies To Congress
On May 6, 2021, new SEC Chair Gary Gensler made his debut, giving testimony to the House Financial Services Committee. Although Mr. Gensler is not new to regulatory leadership – he was head of the Commodity Futures Trading Commission (CFTC) – and as such, his style is certainly not new to capital markets participants, the testimony was nonetheless very enlightening of the mindset of the new SEC regime. The purpose of the testimony was particularly related to the market volatility in January, including GameStop and AMC, and reactions to that trading frenzy including Robinhood’s temporary trading restrictions, but over four hours, touched on much more.
From thirty thousand feet, Gensler attributes the January volatility to an intersection of finance and technology. On a more granular level, he highlights: (i) gamification and user experience; (ii) payment for order flow; (iii) equity market structure; (iv) short selling and market transparency; (v) social media; (vi) market plumbing – i.e., clearance and settlement; and (vii) system-wide risks, giving us a first look at potential areas of regulatory change and focus in the coming year.
This is a first look into Gensler’s points of interest and regulatory focus. Interestingly, Gensler’s SEC will obviously be much different than the agency under Clayton. Jay Clayton’s first speech focused on the SEC’s mission to protect Main Street Investors (see HERE), a mantra he continued throughout his regime. Although, I was (and am) a fan of Jay Clayton, I also believe that his policies had the unintended consequences of suppressing the under $300 million market cap class (see for example HERE and HERE regulator, his deep understanding of technology and focus on the bigger system could be a benefit to small and middle market enterprises.
Gamification and User Experience
As with all industries, mobile apps have expanded access to capital markets, making it easy and cost-effective to open accounts, trade, get wealth management advice and learn about investing. Gensler considers gamification as the use of game-like features, such as points, rewards, leaderboards and competitions, to increase customer engagement. Similarly, many apps enhance user experience with push notifications and social media features. Technology allows the designers and engineers to collect data that is used for predictive analytics and which then makes suggestions to users.
Although that technology exists across many platforms from shopping to fitness to entertainment suggestions, in the world of capital markets, the consequences can be more severe. As Gensler puts it, “[A] big loss could have immediate implications for the app user’s ability to afford their rent or pay other important bills. A small loss now could compound into a significant loss at retirement.” Moreover, the apps encourage users to trade more, which in and of itself increases risks and could lower long-term gains.
The SEC staff is in the process of preparing a request for public comment on the issues and the interface with current SEC regulations, including Regulation Best Interest. Moreover, the SEC will be considering new or updated rules that take into account recent technologies and communication practices.
As an aside, Mr. Gensler is not incapable of constructing and implementing an entire new rule set where one did not exist previously. While running the CFTC, Gensler directed the agency to create and then implement regulations for swaps. His tough stance earned him a divisive following with both strong opponents and proponents. I’m an advocate for clear rules and guidance as opposed to regulation through enforcement but as the saying goes, be careful what you wish for. As much as I like guidance, I would hate to see rules that squelched liquidity and opportunity for any investor class, especially the younger, technologically-savvy generation.
Payment for Order Flow
In the past few years, most broker-dealers have stopped charging fees for processing trades. To make up for this lost income, they make money by charging market makers for funneling order flow through them. The process is called payment for order flow. Robinhood reported $331 million of revenue for Q1 this year in payment for order flow – it is a big business.
Gensler breaks down payment for order flow into two categories: payment from wholesalers to brokers, and payment from exchanges to market makers and brokers. In a payment from wholesalers to brokers process, retail broker-dealers enter into agreements with wholesalers to purchase their order flow. Unlike public exchanges that must offer fair access to their publicly displayed quotes, these wholesalers can decide whether to execute these orders directly or to pass them along to be executed by the exchanges or other trading venues. Putting aside other aspects of this process, the data alone that the wholesaler garners is extremely valuable and provides a market advantage.
Gensler raises several other concerns, including a conflict of interest by brokers and an incentive to churn accounts or encourage more frequent trading. He points out that other countries, such as the UK and Canada, prohibit brokers from routing order to off-exchange market makers in return for payment. However, I do not believe that payment for order flow would create any additional conflict, and probably less so, than when a brokerage firm charges a straight-up commission on each trade. Rather, the issue becomes disclosure and ensuring best execution.
Case in point, in the recent settled SEC enforcement action against Robinhood, certain principal trading firms seeking to attract Robinhood’s order flow told them that there was a tradeoff between payment for order flow and price improvement for customers. Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself.
Although Gensler points to this flaw in the system, I believe that requiring a firm to choose best execution over higher payments for order flow can at least partially resolve the issue. In my mind, the issue becomes, if a brokerage firm cannot charge for trades because of competition and cannot charge for order flow, they will be forced to find other income sources (such as selling data, advertising, increased proprietary trading, higher fees on managed accounts, etc.). Hopefully, the SEC will have a clear picture of what those other sources may be, and the potential negative consequences, when considering future policies and rulemaking.
Equity Market Structure
Gensler breaks the equity markets down to three segments: the national exchanges; alternative trading systems (ATSs), also called dark pools); and off-exchange wholesalers. In January, the national exchanges accounted for 53% of volume; ATS trading was 9% and wholesalers accounted for 38%. Of that 38%, only seven wholesalers accounted for the vast majority of volume. Citadel Securities alone represented 47% of all retail volume.
Gensler raises several concerns including potential fragility, lack of healthy competition, and limits on innovation. He has asked the SEC staff to look closely at the matter to make policy recommendations.
Gensler is not the first SEC Chair to be concerned with the state of the equity market structure. In March 2019, then Chair Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform (see HERE). As noted in the speech, in 2018, the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.
Clayton and Redfearn also talked about a need for an overhaul of Regulation NMS. Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
In December 2020, the SEC adopted some amendments to Regulation NMS, including the Market Data Rules (subject of a future blog). Also, related to equity market structure, in September 2020 the SEC adopted new rules completely overhauling Rule 15c2-11 and its related processes (see HERE. Those rules have a September 28, 2021 compliance date which is keeping firms like mine, and audit firms extremely busy in between the regular 10-Q and 10-K seasons.
Short Selling and Market Transparency
Although the Dodd-Frank Act directed the SEC to publish rules on monthly aggregate short sale disclosures and to increase transparency in the stock loan market, those rules are two of the 11 remaining rules required by Dodd-Frank that have not yet been completed. Gensler has directed the SEC staff to prepare recommendations for these rules.
In addition, turning to a topic he knows well, Gensler has asked the SEC staff to consider recommendations about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so, how. He believes that the March 2021 failure of giant family office Archegos Capital Management was fueled, at least in part, by the use of total return swaps based on underlying stocks and the significant exposure that the prime brokers had to the family office as a result. Archegos Capital Management imploded, losing its entire $20 billion in just 10 days.
Social Media
As we all know, social media has officially intersected with the capital markets. On Reddit, individuals gather in online communities to discuss a variety of topics anonymously, including investing; the subreddit r/wallstreetbets has about 10 million members. Outside of Reddit, social media aspects of trading apps, and all social media sites, now have various capital market centered communities.
Of course, the obvious concern is the use of social media to engage in pump-and-dump activities and other market manipulation schemes. Allaying “big brother” feedback, Gensler specifically states, “[T]o be clear, I’m not concerned about regular investors exercising their free speech online. I am more concerned about bad actors potentially taking advantage of influential platforms.”
He also points out that institutional investors and their algorithms also follow these online conversations. Developments in machine learning, data analytics, and natural language processing have allowed sophisticated investors to monitor various forms of public communication to see relationships between words and prices – known as sentiment analysis. At this point, the SEC is monitoring and learning more about these practices.
Market Plumbing – Clearance and Settlement
The clearing process is what makes the markets operate. For more on the U.S. Capital Markets Clearance and Settlement Process, see HERE. Currently the settlement process takes two days – i.e., T+2 – a trade entered on Monday, settles on Wednesday. For more on the settlement cycle and T+2 rule, see HERE.
Clearinghouses have rules to cover the credit, market, and liquidity risk that is present during those two days. All members transacting with the clearinghouses need to post collateral, called margin, to cover potential losses. If the broker went bankrupt before the trade is settled, the clearinghouse would use such margin to back the deliveries and payments with the goal of not disrupting the broader financial system. In January, the rapidly changing prices, high volatility, and significant trading volume of the meme stocks prompted larger-than-usual central clearing margin calls on broker-dealers. Some of those broker-dealers, such as Robinhood, scrambled to secure new funding to post the required margin. A number of brokers, including Robinhood, chose to restrict additional buying activity by their customers in a variety of the meme stocks.
Using this as a backdrop, Gensler questions whether broker-dealers are adequately disclosing their policies and procedures around potential trading restrictions, whether margin and payment requirements are sufficient, and whether the broker can manage its liquidity risk.
Gensler has asked the SEC staff to look into these disclosure requirements and practices. He has also asked for recommendations regarding shortening the settlement cycle further. As an aside, it is thought with current technology the settlement cycle could now be shortened to T+1 and that with further adoption of blockchain-based technologies, settlement could occur simultaneously with the trade. Gensler is a proponent and he understands technology. Time is risk, and he supports a move towards T-0.
System Wide Risks
In general, Gensler points out that the January liquidity explosion highlighted areas of concern. Robinhood, for instance, didn’t have sufficient liquidity to meet margin calls and had to fundraise within hours to meet $1 billion-plus obligations, and several brokers chose to shut down customer access to trading. Several hedge funds also lost significant money during these events. He also points to the Archegos implosion and the losses incurred by its banking partners. Finally, the concentration of trading activity with Citadel and a few other major players increases system-wide risks.
« SEC Fall 2020 Regulatory Agenda SEC Re-Opens Comments On The Use Of Universal Proxy Cards »
SEC Fall 2020 Regulatory Agenda
The SEC’s latest version of its semiannual regulatory agenda and plans for rulemaking has been published in the federal register. The Fall 2020 Agenda (“Agenda”) is current through October 2020. 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.
Like the prior Agendas, the Fall 2020 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 is down to 32 items. The Spring 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. Portfolio margining harmonization was the only item listed in the pre-rule stage in the Fall 2019 and Spring 2020 Agendas. It remained in that category, but the newest Agenda added prohibition against fraud, manipulation, and deception in connection with security-based swaps to the pre-rule stage moving it down in priority from the previous proposed rule category.
Sixteen items are included in the proposed rule stage, down from 19 in Spring 2020 and 31 on the Fall 2019 list. Amendments 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) remain on the proposed rule list. In May 2018, SEC has 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.
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).
Other items that are still on the proposed rule list include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to Guide 5 on real estate offerings and Form S-11; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; amendment to the registration of alternative trading systems (ATS) for government securities; investment company summary shareholder report and modernization of certain investment company disclosures; amendments to the family office rule; and broker-dealer reporting, audit and notifications requirements. Also still in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC.
Items moved up from long-term to proposed-rule stage include execution quality disclosure; and records to be preserved by certain exchange members, brokers and dealers.
New to the list and appearing in the proposed 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.
Another controversial new item 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.
Fourteen items are included in the final rule stage, down from 21 on the Spring Agenda, including a few of which are new to the Agenda. Proposed rules to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation were added to the list appearing in the final rule stage. Although an amendment to the definition for covered clearing agency was adopted in April 2020, a further amendment to the definition related to security-based swaps dealers now appear in the final rule stage. Moved from proposed to final are amendments to the rules regarding the consolidated audit trail.
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); use of derivatives by registered investment companies and business development companies; and market data infrastructure, including market data distribution and market access (proposed rules published in February 2020); and amendments to the SEC’s Rules of Practice. Administration of the EDGAR system moved up from long-term to the final rule stage.
Still listed on the final rule stage is the harmonization of exempt offerings. The SEC adopted final amendments updating the exempt offering rules and processes on November 2, 2020. I published a five-part blog on the series, including related to integration (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 ). Likewise is the disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE). However, final rules were adopted in December 2020.
Keeping with that trend, modernization and simplification of disclosures regarding MD&A, selected financial data and supplementary financial information remain on the final rule list. Those amendments were adopted in November 2020 (HERE). Further valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company remain on the final rule list although changes were enacted in December 2020. Amendments to certain provisions of the auditor independence rules which were adopted in October 2020 still appear on the list (see HERE). As noted at the beginning, the Agenda is current through October 2020.
Several items have dropped off the Agenda as they have now been implemented and completed, including some major overhauls such as: the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were adopted in August 2020 (see HERE); financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses which was finalized in May 2020 (see HERE); amendments to the rules governing proxy advisory firms (see HERE); amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); amendments to the definition of accredited investor (HERE ); and the revamping of the 15c2-11 rules and process (see HERE).
Other items that dropped off the list as rulemaking was completed include procedures for investment company act applications; NMS Plan amendments; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; fund of fund arrangements; customer margin requirements for securities futures; and amendments to the whistleblower program.
Thirty-two items are listed as long-term actions (up from 30 in Spring 2020), including many that have been sitting on the list for years, including implementation of Dodd-Frank’s pay for performance (see HERE) which has sat on the long-term list for several years now.
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. The topic has now been dropped down again to the long-term list. 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. Clawbacks of incentive compensation at financial institutions which had previously been dropped are back on as a long-term plan.
Amendments to the custody rules for investment advisors moved from the proposed rule stage to long-term actions, as did 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.
Also bouncing back to long-term 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.
Still on the long-term action list is custody rules for investment companies; asset-backed securities disclosures (last amended in 2014); conflict minerals amendments; corporate board diversity (although nothing has been proposed, it is a hot topic); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; the modernization of investment company disclosures, including fee disclosures; and prohibitions of conflicts of interest relating to certain securitizations.
Executive compensation clawback (see HERE) which had been on the proposed rule list in Spring 2020 is back as a long-term action. 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.
Also still on the long-term action list are removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; requests for comments on fund names; 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); amendments to improve fund proxy systems; short sale disclosure reforms; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.
Several swap-based rules remain on the long-term list including end user exception to mandatory clearing of security-based swaps; registration and regulation of security-based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
New to the list are money market fund reforms; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.
Sadly, completely dropped from 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.
« Annual Report of Office of Advocate for Small Business Capital Formation SEC Chair Gary Gensler Testifies To Congress »
Annual Report of Office of Advocate for Small Business Capital Formation
The Office of the Advocate for Small Business Capital Formation (“Office”) issued its 2020 Annual Report and it breaks down one of the strangest years in any of our lives, into facts and figures that continue to illustrate the resilience of the U.S. capital markets. Although the report is for fiscal year end September 30, 2020, prior to much of the impact of Covid-19, the Office supplemented the Report with initial Covid-19 impact information.
Background on Office of the Advocate for Small Business Capital Formation
The SEC’s Office of the Advocate for Small Business Capital Formation launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat.
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
Despite the shift to virtual, the Office managed to attend or speak at numerous conferences, sit on panels, host roundtables and otherwise engage in a surprising number of events in 2020.
State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in secondary registered offerings ($1.5 trillion), followed by Rule 506(b) of Regulation D ($1.4 trillion), Rule 506(c) ($69 billion), initial public offerings ($60 billion), Regulation A ($1.3 billion), Rule 504 ($171 million), and Regulation CF Crowdfunding ($88 million). Another $1.2 trillion was raised in a variety of other exempt offerings such as Rule 144A, Regulation S and Section 4(a)(2) directly.
I note this represents a change since last year when the numbers were: Rule 506(b) of Regulation D ($1.4 trillion) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion). Interestingly, the amount of registered offerings increased substantially (including Regulation A which is technically an exempt public offering) and the amount of once popular Rule 506(c) offerings dropped by more than half.
Both years fail to take into account the new exempt offering rules and structure which went into effect on March 14, 2021. My 5-part blog on the new rules can be found here broken down by topic – Integration (HERE), offering communications (HERE), Rule 504, 506(b) and 506(c) (HERE), Regulation A (HERE), and Regulation CF (HERE). My belief is that we will continue to see a big uptick in Regulation A. Regulation CF will also garner more interest due to the increased offering limits and ability to use special purpose vehicles (SPVs) to complete the transaction.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited and angel investor financing has remained strong. The SEC amended the definition of accredited investor in August 2020 (see HERE) to add a few more categories of individuals and entities that qualify. I would like to see further expansion to the list including based on education level and professional expertise.
As the typical seed round is approximately $1.1 million, by the time a company reaches seed financing stage, it is generally a little further along in its life cycle. Following a seed round there is typically a Series A ($2-$15 million), Series B ($10 million ++), possibly a Series C (also $10 million ++) and finally IPO. Venture Capital funds often participate in the Series A and B rounds. However, 70% of VC funds are in the San Francisco, New York or Boston areas and many of those funds prefer to say local. Moreover, venture capital funds generally take a control position, or assert management control, and set a timeline for exit. That can cause a lot of pressure on a growing company. As a result, many groups such as family offices and other institutions that historically invested in venture capital funds are now investing directly in these growing companies. Covid-19 increased that impact with a drop of over 40% in the first quarter alone.
The industries raising the most capital include banking, technology, energy, manufacturing, real estate, and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Colorado, Florida and Texas are responsible for higher amounts of capital raised in aggregate. Regulation A is particularly popular in Florida, California and New York.
Although the Office’s fiscal year end only accounted for the first quarter of the Covid-19 crisis, the Report does discuss its impact. The economic impact was felt most acutely by founders and investors in historically underrepresented groups, in emerging ecosystems, and among smaller fund managers. Reduction in spending has been particularly harsh at businesses that require in-person interaction, such as retail, entertainment, transportation, personal services, food services and hospitality.
From January 2020 through September 2020, the number of small businesses decreased by 27% across the U.S. That number represents an average. The percentage decrease in certain states such as California, Texas, Alaska and states in the northeast was higher. Not surprisingly, the hardest hit industry was leisure and hospitality with a decrease of 37% in small businesses. Even those businesses that managed to stay open saw a dramatic decrease in revenue during the same period.
Those businesses that were able to adopt new technology and virtual processes have the best chances of surviving. As such, businesses in the fintech, ed tech, telemedicine and cloud computing and collaboration software have accelerated. In fact, in the midst of the pandemic, Americans started new businesses at the fastest rate in more than a decade. As with any crisis, entrepreneurs have spotted opportunity. Many of those businesses relied on Regulation CF for capital raising. During July and August of 2020, more money was raised through Reg CF online fundraising then in the full prior year.
IPOs have continued strong, flourishing despite, or maybe because of, a shift to virtual roadshows (see HERE for more information about virtual roadshows and roadshows in general). The Report notes many benefits of the virtual roadshow, including (i) shorter roadshows; (ii) decreased market risk due to the reduction in launch time; (iii) cost savings associated with travel, printing and employee time on the road; (iv) longer test the waters meetings; (v) greater visibility in pricing with prospective investors indicating interest earlier in the process; (v) increased accessibility with video conferencing allowing for access to a wider pool of investors; and (vi) more sophisticated and detailed disclosures. The Report does not opine on whether these systemic changes to the process will continue post pandemic, but I firmly believe they will.
While last year’s annual report glumly talked about the decrease in IPO activity and jumped on the news headlines of the time, this year, IPOs are way up. The number of IPOs increased by 51% and the amount of proceeds raised went up by 81%. Of course, a huge percentage of the increase is a result of the unprecedented increase in SPACs (for more on SPACs see HERE). However, business services, manufacturing, and banking and financial services all saw increased IPO activity. Only technology, health care and hospitality/retail saw a decline.
The new surge doesn’t make up for the prior years’ downturn. The number of public companies has decreased from a high of 7,414 in 1997 to 3,559 in 2020; however, during the same time period, aggregate market cap has almost doubled. The logical reason for that is the dramatic growth of public company giants over the same time period coupled with the trend towards waiting for an IPO until further in the company life cycle.
Women continue to found more start-ups than ever before, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. There has also been an uptick of minority-owned women start-ups. Interestingly, although revenue is up for all woman-owned businesses, the increase in revenues for Asian American woman owned businesses far outpaces that of other groups. Companies with women on their founding teams on average exited 1 year faster than all-men founding teams, returning capital back to investors faster.
Besides minority women, all minorities are increasing business ownership. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. With that said, while all-white founding teams raise the majority of funding rounds, when diverse founding teams do raise capital from VCs, they tend to raise more.
Covid-19 is not the only disaster creating challenges. Natural disasters (hurricanes, fires, tornadoes, etc.) have a significant impact on capital raising and business failures. Ninety-six percent of companies that are in geographical areas that are hit with a natural disaster see a decline in revenues, and 90% of business will fail within a year if they do not resume operations within 5 days.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue. Covid had a crippling effect. Employment in nonmetropolitan communities, including rural communities, is heavily concentrated in the services sector, which includes health care, food, administration, professional, arts, education, and management.
Policy Recommendations
Education to Ease Challenges of Offering Complexity and Friction
Last year the Office recommended rule changes to modernize and clarify the exempt offering framework in line with what was then just a concept release on the subject. This year, following the adoption of those final rule changes, the Office is recommending education. Although the new laws are a simplification of the old system, securities laws, of any kind, are complex and difficult to navigate. It is unlikely that even the most well-intentioned business owner could do so properly without securities counsel, which is expensive. However, a well-educated client can use counsel more efficiently and certainly with less stress.
The Office recommends targeted educational programs that (i) provide information to help promote compliance with the federal securities laws; (ii) provide tools (forms possibly) and other information to understand the offering choices; and (iii) target different groups including minorities and those in rural communities.
Clear Finders Framework
Although the SEC proposed a conditional finder’s exemption (see HERE), the exemption remains a proposal and even if passed, leaves the arena needing more guidance and a much deeper bench of regulation. I have advocated in the past and continue to advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. Although the SEC proposal does have bad actor prohibitions, it is limited to private companies, does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black-market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders. The Office continues to encourage the SEC, as it has in the past, to provide certainty and to finalize a framework that delineates the legal obligations of persons who match small businesses with investors.
Pooled Funding
Small businesses also look for capital from private funds, such as venture capital funds and private equity funds that operate under various exemptions from registration. The increasing concentration of capital into larger, private funds has resulted in a growing unmet need among entrepreneurs looking for seed and early-stage capital, with larger funds finding it inefficient or lacking bandwidth to make multiple small investments.
The Office advocates for increased diversity among fund managers, the location of funds, and the size of funds. To achieve the goal, the Office encourages Congress and the SEC to explore initiatives to increase diversity among investment decision makers to help shift the pattern matching that historically has negatively impacted women and minority entrepreneurs.
Attractiveness of Public Markets
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally, when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on changes to the management’s discussion and analysis section of SEC reports, see HERE and on business descriptions, risk factors and legal proceedings see HERE. The Office encourages further initiatives to incentivize public offerings, including through more liberal direct listing rules and continued use of SPACs.
« The MEMX SEC Fall 2020 Regulatory Agenda »
The MEMX
Although overshadowed by all things ESG and SPAC related, a new Wall Street backed national exchange, the Members Exchange (MEMX), launched in Q4 2020 with ambitions to rival the NYSE and Nasdaq. In the same month, the long-anticipated launch of the Silicon Valley backed Long-Term Stock Exchange (LTSE) came to fruition. The MEMX, founded as a lower cost alternative to Nasdaq and the NYSE, started small, initially only trading the securities of 7 large cap companies including Alphabet and Exxon Mobil, but has since opened to all exchange traded securities.
The MEMX was backed by Blackrock, Charles Schwab, Citadel, Goldman Sachs, Bank of America, JP Morgan, E-Trade and Virtu, among others. These financial giants invested over $135 million into the platform and as such, have a vested interest in its success. They also have the power to direct significant trading activity onto the MEMX, where others will likely follow. In the 6 months since it went live, the MEMX has already locked in over 1% of the U.S. market share.
Just as retail trading activity has been forced to reduce its fees with the likes of Robinhood and E-Trade offering low-cost electronic alternatives, Wall Street expects the exchanges to reduce fees for market data and other services and is apparently forcing the issue with competition. The MEMX plans to undercut the big exchanges on price, initially giving away its data. Going further, the MEMX will pay out rebates that exceed its transaction fees, forgoing early profits in hopes of building a liquid marketplace.
Founded in 2012 by Silicon Valley heavyweights, the LTSE launched for all companies in Q3 2020. The LTSE is designed to support a longer-term vision for listed companies. All listed companies are required to maintain a series of policies that are designed to provide shareholders and other stakeholders with insight into their long-term strategies, practices, plans and measures. Although the Exchange Act still requires quarterly reporting, the LTSE concentrates on yearly and multi-year performance.
The MEMX and LTSE are not the only new exchanges. Also in Q4 2020, the new Miami based options exchange, the MIAX Pearl Equities, kicked off. The MIAX is a low-cost platform marketing itself as a tech savvy competitor to the NYSE and Nasdaq.
Even though new exchanges are a rarity, those that have developed in the past often fail because it is simply very difficult to move volume and participation from the NYSE or Nasdaq. Simply put, traders want to trade where they have the most counter-party choices. Even the Cboe Global Markets, which owns and operates the former BATS markets and is the third largest U.S. exchange, concentrates on ETF’s and ETP’s, thereby creating a niche for itself. Although the BATS does route approximately 15% of the NYSE/Nasdaq equities trading, it is not an equities IPO competitor. Keep in mind that regardless of what exchange an equity is listed on, Regulation NMS requires best execution and a single market structure for all US securities (see HERE).
The timing could be right for new exchanges as we see huge market shifts and expectations moving away from traditional Wall Street. Investors are frustrated with the existing system and feel it is time for competition, technological innovation and more efficiency. The rise of FinTech-based trading platforms such as Robinhood, social media driven stock picks (Reddit and GameStop), the current focus on all things ESG and the enormous shift into digital currency (Bitcoin) investing, together with the fact that the new exchanges are backed by big players, signals that the street is open to more options.
« ESG – Board of Directors and Auditor Matters Annual Report of Office of Advocate for Small Business Capital Formation »
ESG – Board of Directors and Auditor Matters
In a series of blogs, that is likely to be an ongoing topic for the foreseeable future, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE). The last blog on the topic focused on current and prospective ESG disclosure requirements and initiatives, including the Nasdaq ESG Reporting Guide (see HERE).
ESG is not just a topic impacting social position disclosures but can go directly to the financial condition of a reporting company, and as such its financial statements. Accordingly, ESG reporting requires auditor and audit committee engagement.
Board of Directors, Audit Committees and ESG Disclosures
The “G” in ESG generally refers to the governing structure, policies, and practices employed by a company related to responsibilities and decision-making rights that provide the foundation for overall accountability and credibility. In other words, the “G” goes directly to corporate governance and internal controls, the oversight of which rests with the board of directors and its audit committee. Although not a completely new topic, ESG has gained momentum following the Covid-19 pandemic and social justice movement, prompting many companies to take a proactive instead of reactive approach to the matter.
A company that is either merely reacting to the ESG disclosure pressure or that simply has not developed an ESG thought process as of yet, generally does not have a system in place that integrates ESG considerations into its management decision ecosystem, nor does it have active board oversight on the topic. These companies are now developing controls and procedures that include reporting to and updating board members, creating accountability, often hiring a Chief Sustainability Officer and creating a reporting regime within the company that abides by specific standards. Although I am still skeptical on ESG-driven management decisions as a whole (my thoughts align more with Jay Clayton and Hester Peirce), the train has left the station and I wouldn’t be surprised if, in the near future, it goes so far as to include executive compensation tied to ESG performance.
Board oversight of an entity’s ESG reporting is critical for establishing and maintaining good governance, policies, and controls over the ESG reporting process. The board of directors’ responsibilities extend beyond simply reviewing past disclosures or current systems, but also include being proactive and ready for future implementation of new processes. Where ESG matters impact financial statements, oversight clearly lies with the audit committee of the board of directors, but the nominating and governance committee clearly has a role, and many boards are forming a separate ESG/Sustainability committee.
Where a board of directors is considering hiring a third party, such as its audit firm, to provide ESG attestation (and thus give assurances), it should be informed about (i) the purpose and objectives of the ESG information (SEC reports; separate sustainability reporting; future planning; investigation of potential deficiencies, etc..); (ii) the intended users of the ESG information (internal; public filings; investors; ratings organizations); (iii) why the intended users want or need the information; (iv) the potential risks associated with misstatements or omissions; (iv) the type of ESG information intended users are expecting; and (v) the level of ESG attestation service that will achieve the goals (full audit, review, etc.).
Regardless, all boards of directors should be considering (i) what are the company’s policies and processes with respect to the gathering and reporting of ESG information; (ii) how old or dated is the current available information; (iii) who in the company has responsibility for the oversight of ESG information; (iv) is ESG information material to or included in financial statement reporting; (v) what are the company’s internal controls vis-a-vis ESG information gathering and reporting; (vi) have ESG-related internal controls been tested; and (vii) what disclosure controls and procedures and related documentation are available for ESG information.
Auditor Role in ESG Disclosures
Generally, an auditor is only responsible for information contained in an SEC registration statement or report. However, under PCAOB auditing standards, an auditor must at least read the balance of a filing, including ESG information to ensure that such information is consistent with, and at least not materially inconsistent with, the financial statements and notes thereto. Where sustainability reports are presented by a company, either on its website or as an exhibit to a SEC filing, an auditor would have no responsibility for the information contained in those reports.
However, in today’s ESG-centric environment, some companies are seeking third-party assurance on its ESG information. Third-party assurance can (i) assist the board of directors in assessing the quality of ESG disclosures and in overall company oversight; (ii) enhance the reliability of ESG information for investor analysis; (iii) enhance management’s confidence in the integrity of the company’s disclosed ESG information; (iv) assist stakeholders such as customers, suppliers and prospective employees in making ESG based relationship decisions; and (v) impact a company’s ESG rankings and rating on sustainability indices (such as the Dow Jones Sustainability Index).
Public company auditors have stepped up to fill this role and are now regularly being engaged by their public company clients to provide ESG-related assurances. Other third parties, such as engineering or consulting firms, are also competing for this business. Where a public company audit firm is retained, they are guided by the American Institute of CPAs (AICPA) Statements on Standards for Attestation Engagements. That is, where an auditor is engaged to provide ESG attestations, they must comply with standards involving data and systems testing and evaluating evidence and procedures. Accordingly, there is a belief that auditor ESG assurances are reliable.
As when engaged to perform an audit, the auditor engaged for ESG matters must: (i) be independent of the company; (ii) be skilled in understanding the company including its business and processes; (iii) have the resources, such as specific expertise, to provide the requested services (think expert on greenhouse gas emissions); (iv) are required to plan and perform attestations with professional skepticism; (v) are experienced in reporting on compliance matters (not just standard audits); (vi) are required to maintain a system of quality controls; and (vii) are required to maintain continuing professional education and other licensing requirements. A company will often retain the same firm that is performing its regular audit work as that auditor will have a depth of knowledge about the company making the ESG attestation more economical and efficient.
Generally, an auditor’s ESG attestation is made more reliable because of their requirement to test against specific standards. Those standards must be recognized as reliable, such as those published by the Sustainability Accounting Standards Board or the Global Reporting Initiative. Where a company makes a broad statement related to ESG matters not supported by evidence or capable of being measured against a specific metric, the auditor would not be able to provide assurance.
Moreover, just like the difference between an annual audit and quarterly review of financial statements, an auditor can be retained to provide a full independent report and opinion on ESG information or a more limited review such as for material deficiencies with no separate report. An auditor may also provide consulting services helping a company determine its ESG reporting systems, internal controls and best metrics and standards.
« Section 12(g) Registration The MEMX »
Section 12(g) Registration
Unlike a Securities Act of 1933 (“Securities Act”) registration statement, a Securities Exchange Act of 1934 (“Exchange Act”) Section 12(g) registration statement does not register securities for sale or result in any particular securities becoming freely tradeable. Rather, an Exchange Act registration has the general effect of making a company subject to the Exchange Act reporting requirements under Section 13 of that Act. Registration also subjects the company to the tender offer and proxy rules under Section 14 of the Act, its officers, directors and 10%-or-greater shareholders to the reporting requirements and short-term profit prohibitions under Section 16 of the Act and its 5%-or-greater shareholders to the reporting requirements under Sections 13(d) and 13(g) of the Act.
A company may voluntarily register under Section 12(g) at any time and, under certain circumstances, may also terminate such registration (see HERE).
In addition, unless an exemption is otherwise available, a company must register under Section 12(g), if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more as shown on the company’s balance sheet; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year.
A company that is registering on a national securities exchange accomplishes its registration under Section 12(b) of the Exchange Act. Other than the referenced section, the process and registration statements used are the same as for a Section 12(g) registration.
Benefits of Registration
There are numerous business and legal benefits to registration under Section 12(g). Below are a few of the most compelling benefits.
Rule 144
Rule 144 is the most often used exemption to remove the restrictive legend and sell unregistered securities into the public marketplace. For more on Rule 144, see HERE and HERE. In order to utilize Rule 144, the security holder must satisfy certain requirements including a holding period. The holding period varies based on whether the company is subject to the SEC reporting requirements or not.
The holding period for a company subject to the SEC reporting requirements is six months whereas it is one year for a company that is not. An Exchange Act registration statement under Section 12(g) results in the company becoming subject to the SEC reporting requirements. Although a Securities Act registration statement, such as on Form S-1, will also make a company subject to the Exchange Act reporting requirements, that requirement may only be temporary. That is, a company only reporting as a result of a Securities Act registration statement may slip into voluntary reporting status whose security holders would be subject to the longer one-year Rule 144 holding period. For more on voluntary reporting status, see HERE.
Furthermore, w is not available for a company that is or was ever a shell company unless the company: (i) is no longer a shell company; (ii) is subject to the Exchange Act reporting requirements (such as through the filing of a 12(g) registration statement); (iii) has filed all reports under the Exchange Act during the preceding 12 months; (iv) has filed current Form 10 information with the SEC reflecting its status as no longer a shell company; and (v) one year has elapsed since the filing of the Form 10 information.
Regulation S
Similarly, registration under the Exchange Act has implications on the applicable distribution compliance period in a Regulation S offering. For more on Regulation S, see HERE. A distribution compliance period is defined in Rule 903 of Regulation S and provides for a holding period in which securities issued in a Regulation S transaction cannot be re-sold to a U.S. person or for the account or benefit of a U.S. person. There are three categories of distribution compliance periods. Rule 903 imposes duties on a company, a distributor and any affiliates of the company or a distributor to ensure that the distribution compliance periods are abided by to prevent the sale of securities to a U.S. person during the distribution compliance period.
Category 1 can only be relied on by a Foreign Private Issuer (“FPI”) with no substantial U.S. market interest and where the offering is directed into a single country other than the U.S. Category 1 does not impose any additional time restrictions on re-sales. Category 2 applies to equity securities of an Exchange Act reporting FPI and can be relied upon even if there is a substantial U.S. market interest in the securities. The category 2 distribution compliance period is 40 days. Category 3 applies to domestic reporting and non-reporting companies and non-reporting FPI’s where there is a substantial U.S. market interest in the securities. The distribution compliance period for category 3 companies tracks Rule 144 and, as such, is one year for non-reporting U.S. and FPI’s and six months for reporting U.S. companies. Accordingly, both U.S. companies and FPI’s may benefit from becoming subject to the SEC reporting requirements through the filing of an Exchange Act registration statement.
S-3 Eligibility
A basic requirement for any company to be able to use an S-3 registration statement is that it have a class of securities registered under Section 12(g) (or 12(b)) and has otherwise be required to file SEC reports for a period of 12 months. For more on S-3 eligibility, see HERE.
Exemptions; Section 12g3-2
A company that would otherwise be required to register under Section 12(g) may instead register under Section 12(b) by registering with and listing on a national securities exchange. Other than the referenced statutory section, the process and registration statements used are the same as for a Section 12(g) registration.
An FPI has two exemptions from the Section 12(g) registration requirement. First, Exchange Act Rule 12g3-2(a) exempts FPI’s who have fewer than 300 U.S. record holders from the registration requirement. In determining record holders for purposes of this exemption, the calculation is the same as described below except that where the record holder is a broker, dealer, bank or other nominee, the company must look through and count each of the accounts of customers held by such broker, dealer, bank or nominee.
Second, Exchange Act Rule 12g3-2(b) provides an automatic exemption from registration for an FPI if the following three conditions are met: (i) the FPI is not required to file reports under Exchange Act Sections 13(a) or 15(d) (such obligations arising generally as a result of a public offering of securities, a listing on a national securities exchange, or voluntary registration under the Exchange Act); (ii) the FPI maintains a listing of the subject class of securities on one or two exchanges in a non-U.S. jurisdiction(s) that comprise more than 55% of its worldwide trading volume (its “Primary Trading Market”) as of its most recently completed fiscal year; and (iii) the FPI publishes in English on its website or through another electronic delivery platform generally available to the public in its primary trading market certain material items of information.
Calculation of Holders of Record
As mentioned, a company is required to register under Section 12(g) if as of the last day of its fiscal year the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. The determination of record holders and the determination of accredited status are both made as of the last day of the fiscal year.
Accredited investor is defined in Securities Act Rule 501(a) (see HERE) and specifically provides that an accredited investor can be one that the company “reasonably believes” comes within the specific enumerated accreditation categories. In making the determination as to whether a company has over 500 non-accredited investors as of the last day of its fiscal year-end, a company must consider all facts and circumstances, including whether prior information obtained at the time of a sale of securities can reasonably be relied upon to still be correct.
It is important that all private companies with more than 500 shareholders consider the accredited status of its shareholders as of the last day of each fiscal year to be sure it is not inadvertently violating the federal securities laws requiring registration. During times of financial uncertainty and the dramatic impact upon some people’s net worth that has followed the Covid crisis, it is even more important to keep an eye on this ball. All such, companies should consult with competent securities counsel.
At the time of adopting the last amendment to Section 12(g) in 2016, the SEC was asked by many commenters to provide guidance or establish safe harbors related to the requirement to determine shareholder accreditation as of the last day of each fiscal year-end. At that time, the SEC declined to do so and as of today has still not done so, even using C&DI.
The calculation of held of record starts with the actual record holders on the company’s shareholder list, assuming that list has been properly maintained. If it was not properly maintained, any corrections should be made to get to a starting point. Securities held in similar names with the same address can be counted as one holder.
Securities held in the name of a corporation or other entity are counted as a single holder, regardless of the number of beneficial holders of that entity. This is one of the reasons that special purpose acquisition vehicles or SPV’s are very popular for use in investing in private placements.
Securities jointly owned, such as by a husband and wife, are counted as one record holder. Although bearer certificates (i.e., certificates that are owned by the person who is the physical bearer of such document) are rare in today’s world, where such certificates exist, each one is deemed to be held by a separate owner unless there is direct evidence otherwise.
Securities held by a trustee, executor, guardian or other fiduciary are deemed held by one record holder. Securities held of record by a broker, dealer, bank or nominee may be counted as a single shareholder. However, institutional custodians, such as Cede & Co. and other commercial depositories, are not single holders of record for purposes of the Exchange Act’s registration and periodic reporting provisions. Instead, each of the depository’s accounts for which the securities are held is a single record holder.
In addition, persons that received the securities under an employee compensation plan that was exempt from U.S. registration may be excluded (generally shares issued under Rule 701 – see HERE). Securities issued in a Regulation CF offering or a Regulation A, Tier 2 offering may also be excluded.
In order to exclude shares issued in a Regulation CF offering, the company must: (i) be current in its Regulation CF annual reporting (see HERE); (ii) have total assets of less than $25 million as of the end of its most recently completed fiscal year; and (iii) have engaged an SEC registered transfer agent. Moreover, if a company would be required to register solely because it exceeds the asset limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation CF annual reports.
In order to exclude shares issued in a Regulation A, Tier 2 offering, the company must: (i) be required to file SEC reports under Regulation A; (ii) be current in its annual, semi-annual and other Regulation A reports; (iii) have engaged an SEC registered transfer agent; and (iv) have a non-affiliate public float of less than $75 million as of the last day of the second quarter of its most recently completed fiscal year or if no public float, have annual revenues of less than $50 million as of its most recently completed fiscal year. If a company would be required to register solely because it exceeds the market value or revenue limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation A SEC reports.
A few other securities are exempt from the 12(g) calculation, including (i) a security issued under an employee stock option or similar plan which is not transferable except upon death or incapacity; (ii) subject to certain regulations, any interest or participation in a common trust fund by a bank exclusively for collective investment; (iii) any class of equity security which will not be outstanding 60 days after a registration statement would be required to be filed with respect thereto; (iv) standardized options issued by a clearing agency and traded on a national exchange; (v) securities futures traded on a national exchange; and (vi) certain compensatory stock options.
Form of Registration Statement and Time for Effectiveness
Eligibility to use a particular form of registration is determined by a review of the instructions for such form at the time of use. A Form 10 is the general form of registration statement for a U.S. domestic company; however, the short Form 8-A may be used by a company that is already required to filed reports under the Exchange Act, usually as a result of having filed a registration statement under the Securities Act, or that is concurrently qualifying a Tier 2 offering statement relating to that class of securities using the Form S-1 or Form S-11 format.
A Form 20-F is the common basic registration statement for an FPI and a Form 40-F is favored for Canadian companies that qualify for its use. An FPI may voluntarily file a registration statement using a U.S. domestic form, but must meet FPI status within 30 days of filing its first registration statement in order to rely on an “F” form.
Generally, an Exchange Act registration statement automatically goes effective on the 60th day following filing; however, a company may request accelerated effectiveness from the SEC. A Form 8-A goes effective either upon filing, or if a Securities Act registration statement is concurrently being filed, upon effectiveness of that Securities Act registration statement.
« ESG Disclosures – A Continued Discussion ESG – Board of Directors and Auditor Matters »
ESG Disclosures – A Continued Discussion
In a series of blogs, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Former SEC Chair Jay Clayton did not support overarching ESG disclosure requirements. However, new acting SEC Chair Allison Herron Lee has made a dramatic change in SEC policy, appointing a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly forthcoming.
New Corp Fin Director John Coates is fully on-board, making speeches and otherwise being vocal in his support of ESG centered disclosures. On March 22, 2021, the SEC launched a new page on its website bringing together all things ESG including agency actions and the latest information on ESG investing.
Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE) and this third in the series is centered on ESG disclosures other than climate change.
Non-U.S. countries have also been beating the ESG drum with Europe requiring increased disclosures and the International Organization of Securities Commissions or “IOSCO,” without the participation of the SEC, issued a statement “setting out the importance of considering the inclusion of environmental, social, and governance matters when disclosing information material to investors’ decisions.” At the end of January 2021, 61 companies signed on to the World Economic Forum’s “Stakeholder Capitalism Metrics,” which is a set of ESG metrics and disclosures intended to serve as a “set of universal, comparable disclosures focused on people, planet, prosperity and governance that companies can report on, regardless of industry or region.” A summary of the metrics is below.
Current ESG Disclosure Requirements
Although there is not an ESG facing Regulation S-K item, the current disclosure obligations certainly encompass many ESG topics. For a discussion of the existing and proposed climate change disclosure obligations, see HERE. From a thirty-thousand-foot view, any information that is material to a company’s financial position, regardless of whether it can be labeled under an ESG category, is disclosable. Also, the Nasdaq stock market has published an ESG Reporting Guide, which is discussed below and has proposed a rule requiring listed companies to meet certain minimum board membership diversity targets (that rule proposal will be the subject of another blog).
Countless memorandums and publications have been written on ESG matters, including what in particular and how they should be reported (with countless differing opinions). The recent changes to Regulation S-K added the topic of human capital as a disclosure item including any human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy) (see HERE).
Item 407 of Regulation S-K requires disclosure of “whether, and if so how, the nominating committee (or the board) considers diversity in identifying nominees for director” and “if the nominating committee (or board) has a policy with regard to the consideration of diversity in identifying director nominees, describe how the policy is implemented, as well as how the nominating committee (or the board) assess the effectiveness of its policy.”
Audit committees and auditors must also consider ESG. The Center for Audit Quality has published a roadmap for auditors and separate memo directed at audit committees to help them understand the role of auditors in connection with company-prepared ESG information. I’ll cover ESG audit committee and audit-related matters in a separate blog.
Current disclosure rules require a company to make disclosures as needed to prevent other disclosures from being materially misleading. As ESG rises in importance, and impacts financial statements, additional disclosures should naturally be considered by company management today.
Potential ESG Disclosures
On March 11, 2021, Acting Corp Fin Director John Coates issued a statement on ESG Disclosure clearly supporting additional disclosure requirements while at the same time acknowledging the complexity of a standardized system. To invoke more thought on the topic, Director Coates believes the SEC must consider: (i) what disclosures are useful; (ii) what is the right balance between principles and metrics (including mandatory vs. voluntary disclosure); (iii) standardization across industries; (iv) evolving standards; (v) verification of disclosures; (vi) global comparability; and (vi) alignment with current practices.
Of course, the costs of disclosure must be considered, but Coates puts more emphasis on the costs of not requiring ESG disclosure. There is currently a lack of consistent, comparable, and reliable ESG information available for investors. As I noted in the second blog in this series, companies face higher costs in responding to investor demand for ESG information because there is no consensus ESG disclosure system. A unified system would reduce the redundant requests for information from multiple sources.
Coates is a proponent of adding more provisions like certain board audit committee disclosures which allows a company to explain why they make certain decisions (if a company does not have an audit committee financial expert, it can explain why).
Political Spending
Coming in second place behind climate change, political spending disclosures are a favorite topic at the SEC. In her March 15 speech, which was mainly focused on climate change, Chair Allison Herron Lee stated, “[A]nother significant ESG issue that deserves attention is political spending disclosure.” And that “political spending disclosure is inextricably linked to ESG issues.” One example raised is a company that makes carbon neutral pledges or other climate change friendly disclosures but donates heavily to a politician that consistently votes against these initiatives. Commissioner Caroline A. Crenshaw has also been vocal in her support of political spending disclosures.
However, for now, any rule-making is on hold. Although both a recent House and Senate bill have been introduced that would require additional political spending disclosures, the Consolidated Appropriates Act of 2021, which has already been passed into law, currently restricts the SEC from finalizing a rule requiring company political spending disclosures.
Gary Gensler, who will likely take over as SEC Chair in April, expressed support for the SEC to consider company political spending disclosures while testifying at his senate confirmation hearing in early March. As an aside, Mr. Gensler is very knowledgeable about and supportive of cryptocurrencies. Many are hopeful he will implement the regulatory clarity the industry needs and wants, and in any event, should provide lots of blog material on that topic.
General Topics – World Economic Forum’s “Stakeholder Capitalism Metrics”
As mentioned above, the World Economic Forum has put together Stakeholder Capitalism Metrics. Although a complete summary of the publication is beyond the needed scope for this blog, the main topics include:
- Governing Purpose – a statement by companies as to how they propose solutions to economic, environment and social issues;
- Quality of governing body – qualifications, background and diversity information on board members and executives;
- Stakeholder engagement – what topics are engaged on and how were they decided;
- Ethical behavior – (a) anti-corruption – including training against and disclosure of incidences; and (b) ethics – including training and internal reporting mechanisms;
- Risk and opportunity oversight – risk disclosures and a mandate that opportunities and risks should integrate material economic, environmental and social issues, including climate change and data stewardship;
- Climate Change – including greenhouse gas emissions and implementation of the Task Force on Climate-related Financial Disclosures;
- Nature Loss – land use and ecological sensitivity;
- Freshwater availability – water consumption and withdrawal in water-stressed areas;
- Dignity and equality – including diversity and inclusion; pay equality; wage levels and risks for incidents of child, forced or compulsory labor;
- Health and well-being – work related injuries and fatalities;
- Skills for the future – training provided;
- Employment and wealth generations – absolute number and rate of employment; economic contribution; and financial investments;
- Innovation of better products and services – R&D spending; and
- Community and social vitality – total tax paid by category.
Many other articles and memos have been published recently containing similar lists of proposed and expected ESG reporting.
Nasdaq ESG Reporting Guide
Nasdaq has had a corporate sustainability program in place for six years and has a decidedly positive viewpoint on ESG, seeing these factors as beneficial to investors, “but also for public companies trying to increase operational efficiency, decrease resource dependency, and attract a new generation of empowered workers.” Nasdaq states, “[E]ffective management of sustainability issues helps Nasdaq (and our listed companies) better understand operational performance, address resource inefficiencies, and forecast enterprise risk. In addition, there is a growing body of academic and analytic evidence suggesting that ESG excellence correlates with other benefits, such as lower costs of capital, reduced shareholder turnover, and enhanced talent recruitment and retention. With a renewed market emphasis on long-term value creation, we also believe that ESG is an effective and mutually beneficial communication channel between public companies and the investment community.”
With that said, the Nasdaq ESG Reporting Guide is merely a recommendation for the record keeping and reporting of material information on ESG matters. In determining materiality, Nasdaq suggests that companies consider impacts to external stakeholders and ecosystems in addition to those directly affecting the company. Nasdaq does not impose financial or legal reporting requirements beyond those required by Regulations S-K and S-X. Many companies choose to report ESG matters in separate ESG reports made available to investors on their website, rather than in formal reports to the SEC.
The Nasdaq guide focuses on economic principles and specific data, rather than moral or ethical arguments. The ESG topics that Nasdaq address include:
- Environmental – (i) GHG Emissions (i.e., greenhouse gas emissions); (ii) emissions intensity; (iii) energy usage; (iv) energy intensity; (v) energy mix; (vi) water usage; (vii) environmental operations; (viii) climate oversight/board; (ix) climate oversight/management; and (x) climate risk mitigation.
- Social – (i) CEO pay ratio; (ii) gender pay ratio; (iii) employee turnover; (iv) gender diversity; (v) temporary worker ratio; (vi) non-discrimination; (vii) injury rate; (viii) global health and safety; (ix) child and forced labor; and (x) human rights.
- Corporate Governance – (i) board diversity; (ii) board independence; (iii) incentivized pay; (iv) collective bargaining; (v) supplier code of conduct; (vi) ethics and anti-corruption; (vii) data privacy; (viii) ESG reporting; (ix) disclosure practices; and (x) external assurance.
For each topic, Nasdaq provides an explanation as to why such a measurement is important and a formula for completing the measurement or setting a policy addressing the topic.
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