SEC Adopts Amendments To Tighten Shareholder Proposals
Posted by Securities Attorney Laura Anthony | November 13, 2020 Tags:

Following a tense period of debate and comments, on September 23, 2020, the SEC adopted amendments to Rule 14a-8 governing shareholder proposals in the proxy process.  The proposed rule was published almost a year before in November 2019 (see HERE).  The amendment increases the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement.  The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954.  The new rules represent significant changes to a shareholder’s rights to include matters on a company’s proxy statement.

Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years.  The rules have not been amended in decades and during that time, shareholder activism has shifted.  Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.

In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets.  The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”  Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements.  A study completed in 2018 found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.

The amendment alters the current ownership requirements for the submission of shareholder proposals to: (i) incorporate a tiered approach that provides for three options involving a combination of amount of securities owned and length of time held; (ii) specify documentation that must be provided when submitting a proposal; (iii) require shareholder proponents to specify dates and times they can meet with company management either in person or on the phone to discuss the submission; and (iv) provide that a person may only submit one proposal, either directly or indirectly, for the same shareholders meeting.  The amendment also raise the current thresholds for the resubmission of proposals from 3, 6 and 10 percent to 5, 15 and 25 percent.

The final amendments go into effect 60 days after being published in the federal register and will apply to any proposal submitted for an annual or special meeting to be held on or after January 1, 2022.

Background – Current Rule 14a-8

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

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

Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors.  Rule 14a-8 has been the source of considerable contention.  Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that subject to substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.

State laws in general allow a shareholder to attend a meeting in person and at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process.  By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost to themselves.  It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.

The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so.  Under the current Rule 14a-8 to qualify to submit a proposal, a shareholder must:

  • Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
  • If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
  • If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
  • Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
  • Clearly state the proposal and course of action that the shareholder desires the company to follow;
  • Submit no more than one proposal for a particular annual meeting;
  • Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
  • Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
  • If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
  • The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.

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

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

As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder.  The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion.  Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.

Substantive grounds for exclusion include:

  • The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
  • The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
  • The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
  • The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
  • The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
  • The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
  • The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
  • The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
  • The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
  • The proposal seeks to remove an existing director whose term is not completed;
  • The proposal questions the competence, business judgment or character of one or more director nominees;
  • The company has already substantially implemented the requested action;
  • The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
  • The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
  • The proposal seeks to require the payment of a dividend; or
  • The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.

Final Amended Rule

The need for a change in the rules has become increasingly apparent in recent years.  As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and, as such, is susceptible to abuse.  In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules.  Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals.  The SEC also conducted a Proxy Process Roundtable and invited public comments and input.  The SEC continued its research, including reviewing a plethora of comment letters, after the rule proposals.

Submission Eligibility and Process

The final rule changes amend eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal.  The amendments:

(i) Update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;

(ii) Investors who currently are eligible to submit proposals under the current $2,000 threshold/one-year minimum holding period, but currently do not satisfy the new requirements, will continue to be eligible to submit proposals through the expiration of the transition period that extends for all annual or special meetings held prior to January 1, 2023, provided they continue to hold at least $2,000 of a company’s securities;

(iii) Eliminate the 1% test as it historically is never used;

(iv) Eliminate the ability to aggregate ownership with other shareholders to meet the threshold for submittal.  Shareholders can still co-file or co-sponsor proposals, but each one must meet the eligibility threshold;

(v) Require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal including a signed statement by the shareholder;

(vi) Require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal (regardless of prior communications on the subject), and provide contact information (of the shareholder, not its representative) as well as business days and specific times (i.e., more than one date and time) that the shareholder is available to discuss the proposal with the company.

One Proposal Requirement

The final amendments change the “one proposal” requirements in Rule 14a-8(c) to:

(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.

Resubmission Thresholds

The final amendments also increase the resubmission thresholds.  Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.”

The final amendments amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to increase the current resubmission thresholds of 3%, 6% and 10% of shareholder support related to matters voted on once, twice or three or more times in the last five years, respectively, to 5%, 15% and 25%.

The final amendments did not adopt an amendment from the proposed rule release that would have: (i) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote.  Commenters strongly objected to this proposals and the SEC agreed with their reasoning.

SEC Process

As discussed above, a company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder.  In its proposing release, the SEC asked for comments on this process and how it might be improved upon, or whether the SEC should remove itself from the process altogether deferring to state law.  After reviewing comments, the SEC declined to implement any changes to the process.

« »
SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings
Posted by Securities Attorney Laura Anthony | November 6, 2020 Tags:

Just eight months following the rule proposal (see HERE), on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.  The amendments make a more principles-based approach to business descriptions and risk factors, recognizing the significant changes in business models since the rule was adopted 30 years ago.  The amendments to disclosures related to legal proceedings continue the current prescriptive approach.  In addition, the rule changes are intended to improve the readability of disclosure documents, as well as discourage repetition and disclosure of information that is not material.

The Item 101 and Item 103 amendments only apply to domestic companies and foreign private issuer that elect to file using domestic company forms.  The forms generally used by foreign private issuers (F-1, F-3, 20-F, etc.) do not have references to Items 101 and 103 of Regulation S-K but rather refer to specific disclosure provisions in Form 20-F.  However, the Item 105 (Risk Factor) amendments will apply across the board to both domestic and foreign issuers as the foreign issuer forms specifically refer to that section of Regulation S-K.

The effective date of the new rules is November 9, 2020 and as such, compliance with the new rules will need to be included in any filings made after 5:30 EST on Friday, November 6.

Item 101 – Description of Business

Item 101(a) of Regulation S-K requires a description of the general development of the business of the company during the past five years (or three years for smaller reporting companies) and lists five specific categories of information to include in the disclosure, including, for example, the year the company was formed and a description of any acquisitions or dispositions of businesses.

The SEC has amended Item 101(a) related to a company’s description of its business, to:

(i) Make it largely principles-based by providing a non-exclusive list of the types of information that could be disclosed and only requiring that disclosure to the extent it is material to an understanding of the general development of the business.  The non-exclusive list includes: (a) material bankruptcy, receivership or similar proceeding; (b) nature and effects of any material reclassifications, merger or consolidation; (c) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (d) material changes to a company’s previously disclosed business strategy (note the proposed rule was more expansive on this topic but was determined to be repetitive to MD&A disclosures);

(ii) Eliminate a prescribed time frame for the disclosure.  The SEC would rather require companies to focus on the information material to an understanding of the development of their business, irrespective of a specific time frame; and

(iii) Permit a company, in filings made after a its initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period.  A company must incorporate the previous discussion by reference and can only incorporate from a single previously filed document.

Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by the company, focusing on the segments that are reported in the company’s financial statements. Item 101(c) currently includes a list of 12 topics to cover.  Like Item 101(a), the amendments make the rule largely principles-based and encourage a company to exercise judgment in evaluating what disclosure to provide.  Only material information need be provided.  The rule also provides a list of topics for a company to consider, and maintains the focus on providing company segment information.

The new list of topics include: (i) revenue generating activities, products or services, and any dependence on key products, services, product families, or customers, including governmental customers; (ii) status of development efforts for new or enhanced products, trends in market demand and competitive conditions; (iii) resources material to a company’s business, including raw materials; (iv) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held; (v) a description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (vi) the extent to which the business is or may be seasonal; (vii) compliance with material government regulations, including environmental regulations (the prior list only included environmental regulations) to the extent they impact capital expenditures, earnings and competitive position; and (viii) human capital disclosure.

The human capital category is completely new and would include any material 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).  The final rule includes non-exclusive examples of subjects that may be material, depending on the nature of the registrant’s business and workforce.  The SEC declined to define “human capital” allowing a company to tailor the concept to its circumstances and objectives.

The human capital category is a win for advocates of environmental, social and governance (ESG) disclosures which have advocated for increased rule requirements related to these disclosure topics.  For more on ESG, see HERE). It is unlikely we will see more than minor incremental increases in ESG disclosures beyond human capital under the current SEC regime.  The SEC continues to review and study the issue, but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics.

Item 103 – Legal Proceedings

Item 103 of Regulation S-K requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or of which any of their property is the subject.  Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, and a description of the factual basis alleged to underlie the proceeding and the relief sought.

The SEC has amended Item 103 to: (i) expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage companies to avoid duplicative disclosure; and (ii) revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.

Item 105 – Risk Factors

Item 105 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky and specifies that the discussion should be concise and organized logically.  The disclosure of risk factors has always been principles-based with the SEC consistently discouraging the use of boilerplate items.  However, despite this guidance, most companies include a lengthy laundry list of boilerplate risks.

The SEC has amended Item 105 to: (i) require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.

A company rarely requires more than 15 pages of risk factors, and as such, the new rule should be a good lesson in brevity and pointedness.

Further Background on SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative.  The following is a recap of such initiative and proposed and actual changes.  I have scaled down this recap from prior versions to focus on the most material items.

As discussed in this blog, on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.

In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses.   See my blog HERE on the proposed amendments.  My blog on the final amendments will be published after this blog.

In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls.  See HERE.

On January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K.  In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information.  See HERE.

On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE.  Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.

In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.

In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016.  In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE .

On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K.  See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC.  The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list.  In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format.  The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers.  See my blog here on the Item 601 rule changes HERE and HERE related to SEC guidance on same.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments).  See my blog on the proposed rule change HERE.  Final amendments were approved on August 17, 2018 – see HERE.

The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016.  See my two-part blog on the S-K Concept Release HERE and HERE.

In September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates.  See my blog HERE.  In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities.  See my blog HERE

In early December 2015, the FAST Act was passed into law.  The FAST Act required the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K.  See my blog HERE.

« »
SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses
Posted by Securities Attorney Laura Anthony | October 29, 2020 Tags: ,

One year after proposing amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses, in May 2020 the SEC adopted final amendments (see here for my blog on the proposed amendments HERE).  The amendments involved a long process; years earlier, in September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates which was the first step culminating in the final rules (see HERE).

The amendments make changes to Rules 3-05 and 3-14, 8-04, 8-05, and 8-06 of Regulation S-x, as well as Article 11.  The SEC also amended the significance tests in the “significant subsidiary” definition in Rule 1-02(w), Securities Act Rule 405, and Exchange Act Rule 12b-2.  Like all recent disclosure changes, the proposed rules are designed to improve the information for investors while reducing complexity and compliance costs for reporting companies.  The amendments also make several related conforming rule and form changes.  The new amendments go into effect on January 1, 2021 but voluntary compliance is permitted immediately.

Introduction

When a company acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires the company to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. Similarly, Rule 3-14 requires a company to file financial statements with respect to a significant real estate acquisition.  The number of years of financial information that must be provided depends on the relative significance of the acquisition to the company.

Article 11 requires a company to file unaudited pro forma financial information, including a balance sheet and income statements, relating to the acquisition or disposition of businesses.  Pro forma financial information is intended to show how the acquisition or disposition might have affected those financial statements.

Form 8-K generally requires that the audited financial statements and pro forma financial information be filed in an amendment to the original transaction closing form 8-K within 71 days of that closing 8-K (i.e., 75 days from the closing).  Where an acquisition or disposition is not significant, no separate audits or pro forma’s are required.

The final amendments will:

  • update the significance tests under these rules by revising the investment test to compare the company’s investments in and advances to the acquired or disposed of business to the company’s worldwide market value;
  • update the significance tests under these rules by revising the income test by adding a revenue component;
  • expanding the use of pro forma financial information in measuring significance;
  • conforming the significance threshold and tests for a disposed business;
  • modify and enhance the required disclosure for the aggregate effects of acquisitions for which financial statements are not required by increasing the pro forma information related to the aggregated businesses and eliminating historical financial information for insignificant businesses;
  • reduce the period of the financial statements of the acquired business from three years to the two most recent fiscal years;
  • permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
  • permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB);
  • no longer require separate acquired business financial statements once the business has been included in the company’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;
  • align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
  • clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
  • amend the pro forma financial information requirements to include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; “Autonomous Entity Adjustments,” reflecting the operations and financial position of a company as autonomous where it was previously part of another entity; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects;
  • make corresponding changes to the smaller reporting company and Regulation A requirements in Article 8 of Regulation S-X;
  • add a definition of significant subsidiary that is tailored for investment companies; and
  • add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.

The rules related to disclosures for the acquisitions and dispositions of businesses are complex and involve a significant accounting analysis.  I like to leave the accounting to the accountants, but legal advisors need to be able to understand the requirements and assist client companies in making fully informed business decisions regarding the acquisition or disposition of a business.  This blog will focus on explaining the rules without diving into the overly labyrinthine accounting technicalities.

Rules 3-05 and 8-04 of Regulation S-X – Financial Statements of Businesses Acquired or to Be Acquired

               Summary of Current Rule

Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue-producing assets will likely be treated as the purchase of a business.

In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X.  The “investment test” considers the value of investments in and advances to the acquired business relative to the value of the total assets of the company prior to the purchase. The “asset test” considers the total value of the assets of the company pre- and post-acquisition. The “income test” considers the change in income of the company as a result of the acquisition.

Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal years and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.

Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.

Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.

An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.

The Rule 3-05 or Rule 8-04 financial statements are also required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.

In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.

Final Rule Change

The SEC has substantively revised the investment and income tests for non-investment companies and made non-substantive changes to the asset test.  All three significance tests have been revised for investment companies.  The final amendments also provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the company’s and its subsidiaries’ consolidated total assets when computing the Asset Test.

Investment Test

The investment test compares the company’s and its other subsidiaries’ investments in (i.e., the purchase consideration paid) and advances to the tested subsidiary to the total assets of the company and its subsidiaries consolidated reflected at the end of the most recently completed fiscal year, or in the case of an acquired business, in the company’s most recent annual financial statements required to be filed at or prior to the acquisition date.

The SEC has amended the investment test such that the company’s investments in and advances to the acquired business will be compared to the aggregate worldwide market value of the company’s voting and non-voting common equity when available.   If the company does not have a worldwide market value, the existing test would still be used.  The SEC believes that market value is a better parameter for determining the economic significance of an acquisition.  I agree.  Assets generally remain on the books at purchase price valuation, or are reduced for depreciation or amortization.  For non-investment companies, assets are never marked up to fair value and, as such, can quickly become a stale indication of a company’s current value.

The amendments specifically address when aggregate market value should be determined, provide instructions for determining investments and advances, including contingent consideration, and clarify the use of the test for related party transactions.

Income Test

The income test compares the company’s equity in the tested subsidiary’s income from continuing operations before income taxes, including only income amounts contributed to the company’s particular equity in the subsidiary (such as when the subsidiary is not wholly owned) to such income of the company for the most recently completed fiscal year.

The SEC has revised the income test by adding a revenue component and by using income or loss from continuing operations after income taxes (as opposed to before income taxes).  This change will help account for factors that could distort income in a given year such as non-recurring expense items.  In addition, the change will reduce the anomalous result of making an otherwise insignificant acquisition seem significant, where a company has marginal or break-even net income or loss in a year.

Under the amendment, where a company and the target have recurring revenue, both revenue and income should be tested.  By revising the income test to require that the company exceed both the revenue and net income components when the revenue component applies, the SEC believes the test will more accurately determine whether a tested subsidiary is significant.  If the company or the target does not have recurring revenue, only the net income test would be used.

In addition, the SEC has eliminated the requirement that three years of financial statements be provided for certain significant acquisitions and instead has capped the period at two years.  The SEC has also revised Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period.

The final amendments also clarify that where a Form 10-K is filed after an acquisition closes but prior to the filing of the target financial statements, significance can be determined using either the last Form 10-K filed prior to the acquisition closing, or the newest Form 10-K filed after the closing.  The final amendments also make various definition and word changes thought to more clearly and accurately reflect the implementation of the rules.

Asset Purchase

Where assets are purchased that constitute a business, but are not all of the assets or products of the seller, it can be difficult to create historical financial statements that only cover the sold assets.  Accordingly, the SEC has amended the rules to permit companies to provide abbreviated audited financial statements including a balance sheet consisting of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if: (i) the business constitutes less than 20% all of the assets and revenues of the seller, after eliminating intercompany transactions, as of the most recent fiscal year-end; (ii) the acquired business was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required; (iii) separate financial statements for the business have not previously been prepared; (iv) the seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements; (iv) interest expense may only be excluded if the corresponding debt will not be assumed; (v) the financial statements do not omit selling, distribution, marketing, general and administrative, research and development, or other expenses other than corporate overhead, interest in some cases, and income taxes, incurred by or on behalf of the acquired business during the periods to be presented; and (vi) the notes to financial statements include certain additional disclosures.

Foreign Business Acquisition

The SEC is modified Rule 3-05 to permit financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to permit foreign private issuers that prepare their financial statements using IFRS-IASB to provide Rule 3-05 financial statements prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP.

Smaller Reporting Companies and Regulation A Issuers

As mentioned above, Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the company is a smaller reporting company.  Regulation A issuers are permitted to follow Rule 8-04.

The SEC has revised Rule 8-04 such that smaller reporting companies would be directed to Rule 3-05 for the requirement relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Article 8.

Additionally, under the amendments, a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days prior to the date of the relevant final prospectus or prospectus supplement, rather than 74 days prior to the effective date of the registration statement as under the current rules.

Financial Statements in Registration Statements and Proxy Statements

Prior to the amendments, the rules could result in separate historical financial statements of the acquired business required to be included in registration statements and/or proxy statements after the closing of the acquisition and after SEC reports have been filed including the consolidated financial statements of the then combined entities.  The amendment rule no longer requires Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition company consolidated financial statements in certain circumstances.

Specifically, where an acquisition exceeds 20% but is less than 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least nine months, separate financial statements will no longer need to be included in proxy or registration statements.  Where an acquisition exceeds 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least a complete fiscal year, separate financial statements will no longer need to be included in proxy or registration statements.

Individually Insignificant Acquisitions

If the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.  The rule amendments require disclosure if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the company, exceeds 50%.  Pro forma financial information is only required for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.

Use of Pro Forma Financial Information to Measure Significance

A company is generally permitted to use pro forma, rather than historical, financial information to test significance of a subsequently acquired business if the company made a significant acquisition after the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K as required.   The amended rules continue to permit a company to use these pro forma financial statements and expands that ability to include pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end as long as such pro forma information has been filed in an 8-K or amended 8-K.

Rule 3-14 of Regulation S-X – Financial Statements of Real Estate Acquired or to Be Acquired

The SEC has historically believed that the real estate industry has distinct considerations.  For example, audited financial statements for a real estate operation are rarely available from the seller without additional effort and expense because most real estate managers do not maintain their books on a U.S. GAAP basis or obtain audits.  However, in reality the SEC had found that the differences between the financial statement materiality throughout the industries is much less significant than thought.   As such, the SEC has amended the rules to more closely align the financial statement requirement of Rule 3-14 with Rule 3-05.

Article 11 – Pro Forma Financial Information

Article 11 of Regulation S-X details the pro forma financial statement requirements that must accompany both Rule 3-05 and 3-14 financial statements.  Typically, pro forma financial information includes the most recent balance sheet and most recent annual and interim period income statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05 and Rule 3-14, respectively. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all companies.

The SEC has revised the accounting adjustments made in preparation of the pro forma financial statements with the intent of simplifying the requirements and better reflecting the synergies of the transaction.  The SEC amended Article 11, by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.

The SEC also raised the pro forma financial statement requirement for a disposition from 10% to 20% based on significance testing.  Rule 8-05 for smaller reporting companies and Regulation A issuers have been amended to align with the pro forma financial statement requirements in Article 11.

« »
Covid-19 Disclosures – Not Just Speculation Anymore
Posted by Securities Attorney Laura Anthony | October 21, 2020 Tags:

Now that the market can review and dissect two quarters of Covid-related disclosures and reporting companies are gearing up for third-quarter reporting, Covid disclosures are no longer pure speculation.  Following the two official guidelines released by the SEC (Disclosure Guidance Topic No. 9A which supplemented the previously issued Topic No. 9), a new CD&I issued on Covid-19 executive employment benefits, and numerous unofficial statements and speeches on the topic, the investment community and reporting companies are navigating the areas that require the most attention and thoughtful disclosure.  Not surprisingly, the areas requiring the greatest consideration are management, discussion and analysis (including human capital disclosures and forecasting), risk factors, and internal controls over financial reporting.

Covid-19 “Benefits” – SEC Issues New C&DI

On September 21, 2020, the SEC issued a new compliance and disclosure interpretation (C&DI) related to the reporting of compensation perks or benefits.  In particular, the SEC stated that:

In reporting compensation for periods affected by Covid-19, questions may arise as to whether benefits provided to executive officers because of the Covid-19 pandemic constitute perquisites or personal benefits for purposes of the disclosure required by Item 402(c)(2)(ix)(A) and determining which executive officers are “named executive officers” under Item 402(a)(3)(iii) and (iv). The two-step analysis articulated by the Commission in Release 33-8732A continues to apply when determining whether an item provided because of the Covid-19 pandemic constitutes a perquisite or personal benefit.

  • An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.
  • Otherwise, an item that confers a direct or indirect benefit and that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, is a perquisite or personal benefit unless it is generally available on a non-discriminatory basis to all employees.

Whether an item is “integrally and directly related to the performance of the executive’s duties” depends on the particular facts. In some cases, an item considered a perquisite or personal benefit when provided in the past may not be considered as such when provided as a result of Covid-19. For example, enhanced technology needed to make the CEO’s home his or her primary workplace upon imposition of local stay-at-home orders would generally not be a perquisite or personal benefit because of the integral and direct relationship to the performance of the executive’s duties. On the other hand, items such as new health-related or personal transportation benefits provided to address new risks arising because of Covid-19, if they are not integrally and directly related to the performance of the executive’s duties, may be perquisites or personal benefits even if the company would not have provided the benefit but for the Covid-19 pandemic, unless they are generally available to all employees.

Although not tied into Covid, a week after issuing the new C&DI, the SEC filed settled enforcement charges against Hilton Worldwide Holdings for failing to fully disclose perquisites and personal benefits provided to executive officers.  This is clearly a topic the SEC is paying attention to.

Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A)

Item 303 of Regulation S-K (MD&A) requires discussions on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations including any material changes.  For example, Item 303 requires disclosure of “known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”  It also requires disclosure of unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations as well as known trends or uncertainties that have had or that the the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.

In January 2020, the SEC issued interpretative guidance on MD&A (see Here) reminding companies to include   information not specifically referenced in the item that the company believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations.  Covid-19 has made MD&A a source of heartburn for most companies.

A part of MD&A necessarily involves a level of forecasting, especially related to liquidity and cash flows and uses (in addition to the obvious forecasting included in earnings releases and published guidance – see Here).  The Covid pandemic has affected different companies and sectors of the economy dramatically differently, with some struggling to get back to pre-outbreak operations (airlines) and others benefiting (Amazon).  Either way, management has to use all of its available resources to provide meaningful MD&A disclosure on the results of operations for current periods and potential future impacts and changes.  Moreover, it is likely that the world will not simply return to pre-Covid growth and operations, but rather, there could be a permanent shift in business models as a result of the pandemic.

Some steps management can take to assist in forecasting include (i) focusing on factors that the management can control and that are known; (ii) automating operational data to the greatest extent possible to maintain real-time updated information; and (iii) modeling different scenarios and weighing which ones seem most likely in light of current information.

In addition to operational changes, whether positive or negative, management has been carefully considering and disclosing the impact Covid has had on various expenses such as work-from-home changes or the restructuring of severance, impairments or stock incentive plans.  Some expenses and write-downs have evolved into ordinary as opposed to unusual or non-recurring.  On the flip side, a company must disclose the receipt of government assistance and the impact that is having on liquidity and the likely impact when such assistance is used up and no longer available.

Although there is an outstanding proposed rule amendment which would alter this structure, the substantive information that must be disclosed by management, including related to Covid-19 and its impact on a business, would remain unchanged.

Risk Factors

Covid-19 risk factors are now included in close to 100% of periodic reports that require risk factor disclosures and likewise in close to 100% of Securities Act and Exchange Act registration statements.  As a reminder, smaller reporting companies are not required to include risk factors in their Exchange Act reports though they are required in all registration statements and Regulation A offering circulars.

Almost all companies, whether truly directly impacted or not, now include general risk factors related to uncertainty regarding the duration of the Covid-19 pandemic, the impact of the economic downturn, and changes in consumer behaviors both during and after the pandemic.  In addition, almost all companies in which such disclosures could be applicable, include general risk factors regarding travel and energy, work-from-home practices and governmental stay-at-home orders.

Internal Controls over Financial Reporting (ICFR)

One of the most difficult aspects of managing the Covid-19 crisis has been the impact on internal controls over financial reporting (ICFR).  In particular, managing remote workforces, the sometimes drastic impacts on income and expenses, government-mandated shutdowns, cluster breakouts in some businesses, and controlling the expenditures of government PPP loans have all had a direct impact on ICFR.

In addition to the high level necessity of ensuring that ICFR procedures make certain that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS), ICFR procedures include ensuring that access to assets, including cash and inventory, is only had in accordance with management’s instructions or authorization.  Recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences.  Covid-19 necessarily has an impact on these responsibilities.

It is vitally important that a company carefully review its ICFR, including with the advice of professionals, and make adjustments to be sure that proper controls are and remain in place.  Potential and actual disruptions to a company’s supply chain, customer base, operations, processes and workforce should be weighed when evaluating the operating effectiveness of legacy controls.  In situations in which the responsibilities for controls have been reassigned because of changes in personnel, companies should specifically evaluate whether appropriate segregation of duties continues to exist.  Technology and cyber-security must also be reviewed to be sure that remote workers can continue to perform effectively.

Some companies are adapting quickly implementing video technology for inventory and asset review and improved technology, including blockchain, for real-time assessments.

It is also important that management’s assessment over internal controls in the body of Forms 10-Q and 10-K be carefully reviewed to ensure that any deficiencies created by Covid-19 are disclosed together with remedial measures.

Non-GAAP – EBITDAC Reporting

Since Covid began, some companies have created a new metric of for reporting financial results – earnings before interest, taxes, depreciation, amortization, and Covid – or EBITDAC.  The form of EBITDAC varies with some companies adjusting EBITDA for Covid-19-related expenses or presenting gross margin without Covid-19 impacts.

Despite the natural inclination to want to disclose to the marketplace that, but for Covid, results of operations would be better than they actually are, the SEC is scrutinizing any such creative financial metric.  Also, Topic 9 specified that the SEC does not think it is appropriate to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.  Any metric must include an explanation as to why management finds the measure useful and how it helps investors assess the impact of Covid on the company’s financial position and results of operations.

Also, it is important that companies remember that whenever presenting a figure or metric that is non-GAAP, it must comply with Regulation G or Item 10 of Regulation S-K, including providing a reconciliation to GAAP numbers, the reasons for presenting the non-GAAP numbers and particulars on the presentation and formatting of the information – see Here.

« »
New CDI On Mining Company Disclosures
Posted by Securities Attorney Laura Anthony | October 16, 2020 Tags:

In the 4th quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).  See HERE.   In addition to providing better information to investors about a company’s mining properties, the amendments were intended to more closely align the SEC rules with industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO).  The amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K.

The final amendments require companies with mining operations to disclose information concerning their mineral resources and mineral reserves.  Disclosures on mineral resource estimates were previously only allowed in limited circumstances.  The rule amendments provided for a two-year transition period with compliance beginning in the first fiscal year on or after January 1, 2021.

In April 2020 the SEC issued three new compliance and disclosure interpretations (C&DI) providing guidance on the new rules.

The C&DI focus on when a company must comply with the new rules.  The SEC clarifies that a company engaged in mining operations must comply with Subpart 1300’s disclosure rules beginning with its Exchange Act annual report for the first fiscal year beginning on or after January 1, 2021. Until then, staff will not object if the company relies on the guidance provided in Guide 7 and by the Division of Corporation Finance staff for the purpose of filing an Exchange Act annual report.  To be clear, a company with a fiscal year end of December 31st would not have to comply with the new rules until its annual report for the year ended December 31, 2021.

The second C&DI clarifies requirements for Securities Act registration statements for mining companies.  In particular, where a company qualifies to utilize incorporation by reference (see HERE), it may do so when filing a Securities Act registration statement, even if the Exchange Act report being incorporated does not satisfy the requirements of the new Subpart 1300 disclosure requirements.

Until annual financial statements for the first fiscal year beginning on or after January 1, 2021 are required to be included in the registration statement, the SEC will not object if a Securities Act registration statement incorporates by reference disclosure prepared in accordance with Guide 7 from an Exchange Act annual report for the appropriate period filed by a company engaged in mining operations if otherwise permitted to do so.  The SEC also reminds companies to consider all SEC rules related to incorporation by reference when doing so, including that information must not be incorporated by reference in any case where such incorporation would render the disclosure incomplete, unclear, or confusing.

Likewise, the third C&DI drills down on the “when” for compliance with the new Subpart 1300 rules.  An Exchange Act or Securities Act registration statement that does not incorporate by reference mining property disclosure from an Exchange Act annual report filed by a registrant engaged in mining operations must comply with the new mining property disclosure rules set forth in Subpart 1300 of Regulation S-K on or after the first day of the first fiscal year beginning on or after January 1, 2021.

For example, a calendar year-end company would be required to comply with the new mining property disclosure rules when filing an Exchange Act registration statement or a Securities Act registration statement that does not incorporate by reference from its Exchange Act annual report on or after January 1, 2021, while a company with a June 30th fiscal year-end would be required to comply with the new mining property disclosure rules when filing an Exchange Act or Securities Act registration statement that does not incorporate by reference disclosure from its Exchange Act annual report on or after July 1, 2021.

Refresher on Subpart 1300

In amending the disclosure rules for mining companies, the SEC considered that many companies are already subject to one or more of the rules and that by aligning the SEC reporting requirements to these rules, the compliance burden and costs for these companies could be reduced while still providing the necessary investor protections.

Under the final rules, a company with material mining operations must disclose specific information related to its mineral resources and mineral reserves on one or more of its properties. The rules define “mineral reserve” to include diluting materials and allowances for losses that may occur when the material is mined or extracted. The rules also amend the definition of “mineral resource” to exclude geothermal energy.  Consistent with CRIRSCO standards, a company must disclose exploration results, mineral resources, or mineral reserves in SEC filings based on information and supporting documentation prepared by a mining expert referred to as a “qualified person.”

A company must obtain a dated and signed technical report summary from the qualified person related to mineral resources and reserves determined to be on each material property. The report must be signed either directly by the qualified person or the firm that employs them. Moreover, multiple qualified persons may take part in preparing the final technical report summary. The qualified person may conduct either a pre-feasibility or final feasibility study to support a determination of mineral reserves even in high-risk situations. The report must be filed as an exhibit to the company’s SEC report when first disclosed and subsequent changes or amendments to the report must also be filed as exhibits. A technical report on exploration results may also be voluntarily filed as an exhibit.

The final rules require the qualified person to use a price for each commodity that provides a reasonable basis for establishing estimates of mineral resources or reserves. The price may be either historical or forward-looking, but the report must disclose and explain the reasons for using the selected price, including any material underlying assumptions. Similarly, instead of requiring a specific point of reference, the qualified person may choose any point of reference subject to disclosure and explanations. The technical report summary may disclose mineral resources as mineral reserves as long as it also discloses mineral resources excluding mineral reserves.

A qualified person is not subject to expert liability under Section 11 of the Securities Act of 1933 (“Securities Act”) for information and factors that are outside that person’s expertise, even if discussed in the technical report.

Although the proposed rule amendment provided for quantitative presumptions as to when mineral resources or reserves will be deemed material, the final rule did not include this provision, instead allowing management to rely on a principles-based approach in determining materiality. Likewise, management can determine when a change in previously reported estimates of mineral resources or reserves is material. Also, the proposed rule would have required a table with certain information on a company’s top 20 properties, but the final rule instead also uses a principles-based approach, again leaving it to the company to determine material disclosures of its properties and mining operations.

Materiality relating to mineral resources and reserves has been modified to consistently rely on a principles-based approach. A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required. The SEC has shown a trend towards this principles-based approach for determining materiality for purposes of disclosure in its recent reviews and amendments to Regulation S-K and Regulation S-X (see, for example, HERE  and HERE).  Practitioners, including the American Bar Association (“ABA”), have advocated for principles-based disclosure over quantitative or bright line tests (see HERE) believing that a quantitative guideline results in lengthy, and often immaterial, information.

The number of summaries and tables that are currently required has been reduced from seven to two and the company may now choose to make its disclosures using either tables or a narrative format. A company is permitted to voluntarily disclose exploration targets in its SEC reports as long as they are accompanied by certain specified cautionary and explanatory statements. Disclosure of exploration activity and results is mandatory once the company determines the information is material to investors. Also, the qualified person may include inferred resources in their economic analysis as long as certain conditions are met.

A company may now use historical estimates of mineral resources or reserves in SEC filings pertaining to mergers, acquisitions, or business combinations if they are unable to update the estimate prior to the completion of the relevant transaction, provided that the company discloses the source and date of the estimate, and does not treat the estimate as a current estimate.

Finally, the amended rules allow a company holding a royalty or similar interest to omit any information required under the summary and individual property disclosure provisions to which it lacks access and which it cannot obtain without incurring an unreasonable burden or expense.

« »
SEC Proposed To Modernize Auditor Independence Rules
Posted by Securities Attorney Laura Anthony | October 9, 2020 Tags:

As is usual, there are times where I find there are fewer current events to write about in the world of capital markets and I go back to the basics of this regulatory regime I find so fascinating, and others where I have 30 current topics in my writing queue and then a global pandemic occurs adding daily new topics to my list and poof! – six months goes by.  Although they were bumped down the list, many of the proposed and completed regulatory changes, and other events, that were on the list remain worthy of attention.

In December 2019, the SEC proposed amendments to codify and modernize certain aspects of the auditor independence framework.  The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time.  The new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time consuming audit committee review of non-substantive matters.

The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company.  The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets.  Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.”

In 2000, the SEC adopted a comprehensive framework of rules governing auditor independence, laying out governing principles and describing certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent.  Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances.  Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties.  Rule 2-01(c) provides a non-exclusive list of circumstances in which the SEC would consider inconsistent with independence.

However, over the years, based on company and SEC staff review and feedback, it has become apparent that the current rules should be updated to address changing market conditions and eliminate unnecessary burdens and expenses associated with the client-auditor relationship.

Proposed Amendments

                Definition of Audit Client

The SEC is proposing to amend the definition of an “audit client” with a focus of decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited.  Currently an audit client includes not only the entity being audited but also affiliates of the audit client.  Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities.  Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also includes any investment company advised by a sister investment adviser or has a sister sponsor.

The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies.  In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.

Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality.  In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.

The SEC is proposing to amend the definition of affiliate and ICC as relates to an “audit client” to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor.  The amendment to the definition would not alter the general requirement that an auditor review all facts and circumstances to confirm independence.  The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.

Audit and Professional Engagement Period

Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies.  For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC.  For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC.  That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.

The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI.  The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO.

The SEC is proposing to amend the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.

Loans and Debtor-Creditor Relationships

Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client.  The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.

The SEC is now proposing to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions.  In addition, the SEC is proposing to add language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.

The SEC is also proposing to revise the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.

Business Relationship Rule

The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders.  The SEC is proposing to replace the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”

As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.

Inadvertent Violations for Mergers and Acquisitions

An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction.  The SEC is proposing a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner.  Under the proposed rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances.  Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.

« »
A Covid IPO: The Virtual Roadshow
Posted by Securities Attorney Laura Anthony | October 2, 2020 Tags:

Although many aspects of an IPO are unaffected by a pandemic, assuming the capital markets continue to have an appetite for public offerings, the grueling road show has gone virtual, and it may be here to stay.  An old-fashioned road show involved an intense travel schedule and expensive setup.  The new virtual road show can be completed in half the time and a fraction of the price, and interestingly, the IPO’s that have been completed since March 2020, have all priced their deals at the midpoint or higher of their ranges.  The lack of face-to-face presentations is not hurting the deals.

I tend to believe the world has changed forever.  However, fluidity of memory and a capacity to adapt are fundamental human traits and we have and will adapt our business style to adjust to a world where germs are a real enemy and getting sick doesn’t just mean a day or two out of the office.   There has been a perfect storm of advanced technology that allows us to see and hear each other in real time, coupled with a need to avoid crowds and close person-to-person contact with people you don’t live with.  We are all comfortable with Zoom, and very quickly 3D holographic images, avatars and other AR/VR technologies could become business commonplace.

In addition to the dramatic change of the road show, IPO’s in the Covid world require a more complex carefully crafted registration statement and prospectus.  As I’ve discussed in a series of blogs on Covid-related disclosures (see here for the most recent which contains links to prior blogs on the topic HERE), regulators and the marketplace expect in-depth discussions on the current and anticipated effects of the virus on businesses, with updates as those effects and projections evolve.  Risk factors are generally much more robust with drill-downs on an array of potential issues from debt management to human resource uncertainties.

The good news is that the markets are booming.  Tech and pharma IPO’s continue unabated and even increased compared to other mid-summer years, especially election years.  The country is mired in the worst pandemic in a century and suffered its steepest-ever quarterly plunge in economic activity in the second quarter. Yet the equity markets are rallying, and tech and pharma stocks are trading at historical premiums.  Some are predicting there will be at least 15 venture-backed tech IPO’s before the end of the year.  Also, although analysts and venture firms focus on the big-board IPO’s, the small and lower middle market deals are busier than ever with IPO’s, a record-setting number of SPAC deals, and a non-stop string of follow on offerings.

We are resilient and the success of the virtual road show is just an example of that resilience.  In addition, to the decreased time and expense, as explained below, a virtual road show will almost never involve a written offering or free writing prospectus, allowing for widespread use by all levels of companies.

The Road Show

We often hear the words “road show” associated with a securities offering. A road show is simply a series of presentations made by company management to key members of buy-side market participants such as broker-dealers that may participate in the syndication of an offering, and institutional investor groups and money managers that may invest into an offering. A road show is designed to provide these market participants with more information about the issuer and the offering and a chance to meet and assess management, including their presentation skills and competence in a Q&A setting. Investors often place a high level of importance on road show presentations and as such, a well-run road show can make the difference as to the level of success of an offering.  In a virtual road show it is extremely important that the best technology be utilized so the audience can clearly see and hear the presenter to be able to make the same type of assessment as they would in person.

A road show historically involved an intensive period of multiple meetings and presentations in a number of different cities over a one-to-two-week period. Although road shows were generally live, even before Covid they were sometimes by teleconference, or electronic using prepared written presentation materials.  Road shows are often recorded from a live presentation and made available publicly for a period of time. The meetings and presentations can vary in length and depth depending on the size and importance of the particular audience. During the road show, the underwriters are building a book of interest which will help determine the pricing for the offering.

A company can also conduct a “non-deal road show” for the purpose of driving interest in the company and its stock, where no particular offering is planned.

Unless it is a non-deal road show, the road show involves an offer of securities. “Offers” of securities are very broadly defined.  Section 2(a)(3) of the Securities Act defines “offer to sell,” “offer for sale,” or “offer” to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”

The timing and manner of all offers of securities are regulated, and especially so in registered offerings. All issuers that have filed a registration statement are permitted to make oral offers of their securities, but only certain types of written offers are allowed. Written offers must comply with Section 10 of the Securities Act, including a requirement that a prospectus meeting the information requirements in Section 10(a) be delivered at the time of or prior to the offer.   Delivery can be accomplished through the filing of a preliminary prospectus with the SEC, which is publicly available on the EDGAR system.

In addition, certain eligible issuers may provide supplemental written information and graphic communications not otherwise included in the prospectus that is filed with the SEC (i.e., a free writing prospectus) as part of an offer of securities. All of these oral and written communication rules are implicated in the road show process and must be considered when planning and completing the road show whether it is live or virtual.

A road show is generally timed to be completed in the last few weeks before a registration statement goes effective or a Regulation A offering circular becomes qualified.  In a registered offering, Section 5(c) prohibits offers prior to the filing of the registration statement and as such, the road show would never commence pre-filing. Regulation A is not a registered offering for purposes of Section 5(c), but for practical purposes, a Regulation A road show also commences right before SEC qualification.

Securities Act Rule 163 provides an exception to the pre-filing offer rules only available to well-known seasoned issuers.  A well-known seasoned issuer is generally one with a non-affiliate public float of more than $700 million or has issued at least $1 billion in non-convertible securities in primary offerings for cash in the last 3 years, is S-3 eligible (see HERE), is not an ineligible issuer (described below), is not an asset-backed issuer and is not an investment company.

For a private offering, the road show occurs once the offering documents are completed.  A company that has filed its registration statement on a confidential basis must make the initial filing and all confidentially submitted amendments public a minimum of 15 days prior to starting the road show.  For more information on confidential filings, and when a company is eligible to do so, see HERE.

A road show is subject to the test-the-waters and pre-effective communication rules.  For a review of testing the waters in a registered offering, see HERE and HERE  and for Regulation A offerings, see HERE.

A road show is specifically regulated under Rule 433 of the Securities Act and the free writing prospectus rules.  Securities Act Rule 433(h)(4) defines a road show as an offer, other than a statutory prospectus, that “contains a presentation regarding an offering by one or more of the members of the issuer’s management ….. and includes discussion of one or more of the issuer, such management, and the securities being offered.”

The SEC definition of road show includes the language “other than a statutory prospectus.” The statutory prospectus is one that meets the requirements of Section 10(a) of the Securities Act and is generally the filed prospectus that contains the disclosures outlined in the particular offering form being used (for example, Form S-1 or 1-A) and including disclosures delineated in Regulations S-K and S-X.  To meet the requirements of Section 10(a), the prospectus must include a price range and estimate of volume of shares to be registered.

In general, if the information being presented in a road show is nothing more than what is already included in the prospectus filed with the SEC, there are no particular SEC filing requirements.   On the other hand, if the information is written and goes beyond the statutory prospectus, it may be considered a “free writing prospectus” and be subject to specific eligibility requirements for use, form and content and SEC filing requirements all as set forth in Rule 433 and discussed herein.

Securities Act Rule 405 of the Securities Act defines a free writing prospectus (“FWP”) as “any written communication as defined in this section that constitutes an offer to sell or a solicitation of an offer to buy the securities relating to a registered offering that is used after the registration statement in respect of the offering is filed… and is made by means other than (i) a prospectus satisfying the requirements of Section 10(a) of the Act…; (2) a written communication used in reliance on Rule 167 and Rule 426 (note that both rules relate to offerings by asset backed issuers); or (3) a written communication that constitutes an offer to sell or solicitation of an offer to buy such securities that falls within the exception from the definition of prospectus in clause (a) of Section 2(a)(10) of the Act.”  Section 2(a)(10)(a), in turn, exempts written communications that are provided after a registration statement goes effective with the SEC as long as the effective registration statement is provided to the recipient prior to or at the same time.

Types of Road Shows; Oral/Live vs. Written; Free Writing Prospectus (FWP) Requirements

The rules distinguish between a “live” vs. a “written” road show communication, with one being an “oral offer” and more freely allowed and the other being a “written offer” and more strictly regulated. In addition, the rules differentiate requirements based on whether a road show is for a registered or private offering and, if a registered offering, whether such offering is an initial public offering (IPO) involving common or convertible equity.

Where a road show communication is purely oral, even if virtual, it is not an FWP and thus there are no specific SEC filing requirements (though see the discussion on Regulation FD below). Where an oral communication implicates Regulation FD, a Form 8-K would need to be filed regardless of whether the communication is during a road show or in any other forum.

Although road shows are generally live and specifically designed to constitute oral offers, they can also be electronic using prepared written presentation materials.  Both live and electronic road shows may be made available for replay electronically over the Internet.  The live virtual road show has made the recording and replay process even easier.

Live road shows include: (i) a live, in-person presentation to a live, in-person audience; (ii) a live, real-time presentation to a live audience or simultaneous multiple audiences transmitted electronically; (iii) a concurrent live presentation and real-time electronic transmittal of such presentation; (iv) a webcast or video conference that originates live and is transmitted in real time; (v) a live telephone conversation, even if it is recorded; and (vi) the slide deck or other presentation materials used during the road show unless investors are allowed to print or take copies of the information.

The explanatory note to Rule 433(d)(8) states: “A communication that is provided or transmitted simultaneously with a road show and is provided or transmitted in a manner designed to make the communication available only as part of the road show and not separately is deemed to be part of the road show. Therefore, if the road show is not a written communication, such a simultaneous communication (even if it would otherwise be a graphic communication or other written communication) is also deemed not to be written.”

Accordingly, road show slides and video clips are not considered to be written offers as long as copies are not left behind.  Even handouts are not written offers so long as they are collected at the end of the presentation.  If they are left behind, however, they become a free writing prospectus (FWP) and are subject to Securities Act Rules 164 and 433, including a requirement that the materials be filed with the SEC.  Accordingly, if a company is not FWP eligible, it is important to make sure that there are no downloadable materials when completing a virtual road show.

A video recording of the road show meeting will not need to be filed as an FWP so long as it is available on the Internet to everyone and covers the same ground as the live road show. Such video road shows are considered a “bona fide electronic road show.” Rule 433(h)(5) defines a “bona fide electronic road show” as a road show “that is a written communication transmitted by graphic means that contains a presentation by one or more officers of an issuer or other persons in an issuer’s management….”  It is permissible to have multiple versions of a bona fide electronic road show as long as all versions are available to an unrestricted audience. For example, different members of management may record different presentations and, although access must be unrestricted, management may record versions that are more retail investor facing or institutional investor facing.

On the other hand, a FWP would include any written communication that could constitute an offer to sell or a solicitation of an offer to buy securities subject to a registration statement that is used after the filing of a registration statement and before its effectiveness. A FWP is a supplemental writing that is not part of the filed registration statement. If the writing is simply a repetition of information contained in the filed registration statement, it may be used without regard to the separate FWP rule.

Rule 405 of the Securities Act defines a written communication as any communication that is “written, printed, a radio or television broadcast or a graphic communication.” A graphic communication includes “all forms of electronic media, including but not limited to, audiotapes, videotapes, facsimiles, CD Rom, electronic mail, internet websites, substantially similar messages widely distributed (rather than individually distributed) on telephone answering or voice mail systems, computers, computer networks and other forms of computer data compilation.” Basically, for purposes of rules related to FWP’s, all communications that can be reduced to writing are considered a written communication.  Accordingly, radio and TV interviews, other than those published by unaffiliated and uncompensated media, would be considered a FWP and subject to the SEC use and filing rules.

Electronic road shows that do not originate live and in real time are considered written communications and FWP’s. Once it is determined that a road show includes a FWP, unless an exemption applies, an SEC filing is required.  As mentioned, bona fide electronic road shows are not required to be filed with the SEC.  In addition, Rule 433 only requires the filing of a FWP for an IPO of common or convertible equity.

A non-exempted FWP must be filed with the SEC, using Form 8-K, no later than the date of first use. An after-hours filing will satisfy this requirement as long as it is on the same calendar day. Moreover, all FWP’s must be filed with the SEC, whether distributed by the registrant or another offering participant and whether such distribution was intentional or unintentional.

The use of a FWP has specific eligibility requirements. A FWP may not be used by any issuer that is “ineligible” for such use. The following entities are ineligible to use a free writing prospectus: (i) companies that are or were in the past three years a blank-check company; (ii) companies that are or were in the past three years a shell company; (iii) penny-stock issuers; (iv) companies that conducted a penny-stock offering within the past three years; (v) business development companies; (vi) companies that are delinquent in their Exchange Act reporting requirements; (vii) limited partnerships that are engaged in an offering that is not a firm commitment offering; and (viii) companies that have filed or have been forced into bankruptcy in the last three years.

Small- and micro-cap issuers will rarely be eligible to use a free writing prospectus. Accordingly, small and micro-cap companies generally are limited to live road shows involving oral offers not constituting a FWP.

Moreover, underwriters generally require specific representations and warranties and indemnification related to FWP’s regardless of whether they are required to be filed with the SEC.

Content

The road show presentation usually covers key aspects of the offering itself, including the reasons for the offering and use of proceeds. In addition, management will also cover important aspects of their business and growth plans, industry trends, competition and the market for their products or services. An important aspect of the road show is the question-and-answer period or Q&A, though obviously this is only included in live or virtual real-time interactive road shows. It is common for materials to include drilled-down information that is provided on a higher level in the prospectus as well as theory and thoughts behind business plans and management goals.

The preparation of the road show content is usually a collaborative effort between the company, underwriters and legal counsel. Although the road show begins much later in the process, since its content is derived from the registration statement, ideally the planning begins at the same time as the registration statement drafting. Also, slides, PowerPoint presentations and other presentation materials should be carefully prepared to get the most out of their effectiveness.

The lawyer generally reviews all materials for compliance with the rules related to offering communications as well as potential liability for the representations themselves. Part of the compliance review is ensuring that no statements conflict with or provide a material change to the information in the filed offering prospectus that could be deemed materially misleading by content or omission, and compliance with Regulation FD if applicable.

Also from a technical legal perspective, all road show materials should contain a disclaimer for forward-looking statements, and that disclaimer should be read in live, virtual or prerecorded road show presentations. Where the road show content includes a FWP, it is required to contain a legend indicating that a prospectus has been filed, where it can be read (a hyperlink can satisfy this requirement), and advising prospectus investors to read the prospectus.

Pursuant to Rule 433(b)(2), the FWP for a non-reporting or unseasoned company must be accompanied with or preceded by the prospectus filed with the SEC. The delivery requirement can be satisfied by providing a hyperlink to the filed prospectus on the EDGAR database.

Road show materials, even those that are also a FWP, generally are not subject to liability under Section 11 of the Securities Act. Section 11 provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement.  Road-show materials, including FWPs, are not a part of the registration statement, but rather are supplemental materials.  Section 12 liability, however, does apply to road-show materials.  Section 12 provides liability against the seller of securities for material misstatements or omissions in connection with that sale, whether oral or in writing.

Follow-on Offerings and Regulation FD

Regulation FD requires that companies subject to the SEC reporting requirements take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Consequently, Regulation FD would be implicated in connection with communications in a road show for a follow-on offering by a company already subject to the Exchange Act reporting requirements.  Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence, such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence; and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings).

Where a road show is being conducted by a company subject to the Exchange Act reporting requirements, counsel should ensure that that the presentation either does not include material non-public information or that the information is simultaneously disclosed to the public in a Form 8-K.  As a backstop where Regulation FD applies, the company should also consider having all road-show attendees sign a confidentiality agreement.

« »
The SEC Has Adopted Final Amendments To Rule 15C2-11; Major Change For OTC Markets Companies
Posted by Securities Attorney Laura Anthony | September 25, 2020 Tags: Despite an unusual abundance of comments and push-back, on September 16, 2020, one year after issuing proposed rules (see HERE), the SEC has adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11.   The primary purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities.  The SEC believes the final amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors. 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-dealer to rely on that confirmation.  Importantly 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. The final rule release contains an in-depth discussion of the numerous comments received (I was one of the many comment writers), especially related to the piggyback exception.  As part of the comment process, the OTC Markets, and many of its supporters, suggested the creation of a new “expert market” which would allow the trading of securities with no or limited information, by institutions and other qualified individual traders.  In rejecting the proposal, the SEC  indicated that there was not enough detail and information around how such a market would operate, but that it was open to considering such a segregated expert qualified marketplace in the future following the appropriate groundwork. The final rules entail a complete overhaul of the current rule structure and as such will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system.  I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks. The final rule release contains a section on guidance related to the rules implementation and use. The guidance includes information on determining the reliability of information sources, conducting information reviews, and red flags that may heighten a review requirement. The effective date of the rule is 60 days following publication in the federal register.  The rule will be published any day now.  Compliance with the majority of the rule is required nine months after the effective date.  However, compliance with the provision requiring a catch-all category of company to have current information for the preceding two years in order to qualify for the piggyback exception is not until two years from the effective date.  As discussed more fully below, a catch-all company is generally an alternatively reporting company on OTC Markets. Background Rule 15c2-11 was enacted in 1971 to ensure that proper information was available to a broker and its clients prior to quoting a security in an effort to prevent micro-cap fraud.  The last substantive amendment was in 1991.  At the time of enactment of the rule, the Internet was not available for access to information.  In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years.  Since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures.  The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. I’ve written about 15c2-11 many times, including HERE and HERE.  In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11.  FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security.  Generally, a non-exchange-traded security is quoted on the OTC Markets.  Compliance with the rule is demonstrated by filing a Form 211 with FINRA. The specific information required to be maintained by the broker-dealer when it initiates a quotation is delineated in Exchange Act Rule 15c2-11.  The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace.  The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or Regulation A under wand quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv). In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.   This reasonable basis requirement has altered the initial quotation process dramatically over the last ten years.  In particular, FINRA uses this requirement to conduct a deep dive into the due diligence and background of a company when processing a 211 Application. As discussed below, although the amended rule continues to require that a broker-dealer have a reasonable basis to believe information is accurate and from a reliable source, the revamped structure itself may help shift the burden back to the broker-dealer, where it belongs, and reduce FINRA’s overlapping merit review. Importantly as discussed, OTC Markets will not be required to submit a Form 211 but rather its determination of compliance with the rules will be self-effectuating, and a broker-dealer relying on OTC Markets review, will also not be required to submit a Form 211 to FINRA.  This alone will make a tremendous difference in the process. The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information.  In other words, once an initial Form 211 has been filed by a market maker and approved by FINRA and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA.  The piggyback exception lasts in perpetuity as long as a stock continues to be quoted.  As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.  The disparity is so extreme that a quotation can take on a life of its own and continue long after a company has ceased to exist or closed operations. The SEC’s rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies.  However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity).  Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company. The final rules: (i) require that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allow OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamline the rule and eliminate obsolete provisions. The final rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security.  The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout.  In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.  However, if new IDQS platforms or national securities associations develop, they would also be covered by the rule. Final Amendments                 OTC Markets Review The new rule allows a qualified IDQS to comply with the information review requirements.  As mentioned, in reality, the qualified IDQS is OTC Markets.  In complying with the information review requirements under Rule 15c2-11, OTC Markets will be subject to the same review, responsibility and record keeping requirements of a broker-dealer and must have reasonably designed written policies and procedures associated with the rule’s compliance.  OTC Markets would then “make known” to the public that it has completed a review and that a broker-dealer can quote or resume quoting the securities, and be in compliance with Rule 15c2-11.  Likewise, OTC Markets can make a determination that a company qualifies for an exception to the 211 rule requirements and a broker-dealer can rely on that determination. A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review.  Keeping the rule’s current 3 business day requirement, a broker-dealer’s quotation must be published or submitted within three business days after the qualified IDQS (OTC Markets) makes a publicly available determination. Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies, to file Forms 211 with FINRA.  I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews. Current Public Information Requirements; Location of Information The final rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed.  In addition, the amendment will restructure and renumber paragraphs and subparagraphs. To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation.  The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation. The catch-all category encompasses companies that alternatively report on OTC Markets (see HERE for more information), as well as companies that are delinquent in their SEC reporting obligations.  Provided however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggy-back exception. For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence.  The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet. Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied.  In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension.  The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggy-back exception, for continued quotations. Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.  In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information.  Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.  I’ve included a brief discussion of red flags in the section titled guidance below. The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available.  Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security.  The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties. Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present.  Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application.  I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements. Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer .  The posted information must not be password-protected or otherwise user-restricted.  A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information. Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation.  A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security. The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category.  A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet.  However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.  A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet. The categories of information required to be reviewed will also expand.  For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors.  In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.  As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10% or greater shareholders unless the company has current publicly available information. The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets.  In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system.  If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security. Exceptions in General The final rule amendments add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception; and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met. Piggyback and Unsolicited Quote Exception Changes The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information.  As discussed, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted.  As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.  Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme. There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception.  The final rule, which contains a 60 page discussion on the piggyback exception,  will amend the exception to: (i) require that information be current and publicly available (see below chart); (ii) require at least a one-way priced quotation (either bid or ask) – which is a modification from the proposal which would have required a two-way quotation; (iii) eliminate the current 30 calendar day window before the exception can be relied upon but retain the requirement that that no more than 4 days in succession can elapse without a quotation; (iv) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (v) allow a period in which the exception can be relied upon for quotations of shell companies (modified from the rule proposal); and (vi) provide a conditional 15 day grace period to continue quotations when current information is no longer available (this provision was not in the rule proposal); and (vi) revise the frequency of quotation requirement. Notably, the SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggy-back exception, rather, the amended rule provides a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations.  In particular, a broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period.  Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter end.  Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility.  Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility. The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:
Category of Company 15c2-11 Current Information
Exchange Act reporting company Filed within 180 days following end of the reporting period
Regulation A reporting company Filed within 120 days of fiscal year end and 90 days of semi-annual period end
Regulation Crowdfunding filer Filed within 120 days of fiscal year end
Foreign Private Issuer Since first day of most recent completed fiscal year, information required to be filed by the laws of home country or principal exchange traded on
Catch-all company Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet. Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e. approximately 2 years and 2 months).  A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date – i.e. 9 months after the effective date.
The amended rule adds a 15 day conditional grace period for a broker-dealer to continue to quote securities which no longer qualify for the piggyback exception as a result of a company no longer having current available public information upon expiration of the time periods in the above chart. In order to use the grace period, three conditions must be met: (i) OTC Markets or FINRA must make a public determination that current public information is no longer available within 4 business days of the information no longer being available (i.e. expiration of the time periods in the chart), this could be by, for example, a tag on the quote page or added letter to the ticker symbol; (ii) all other conditions for reliance on the piggyback exception must be effective (such as a one way quote); and (iii) the grace period ended on the earliest of the company once again making current information publicly available or the 14th calendar day after OTC Markets or FINRA makes the public determination in (i) above. To reduce some of the added burdens of the rule change, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the piggyback exception have been met.  To be able to properly keep track of piggyback exception eligibility, OTC Markets will need to establish, maintain, and enforce reasonably designed written policies and procedures to determine, on an ongoing basis, whether the documents and information are, depending on the type of company, filed within the prescribed time periods.  I think the amendments, especially requiring ongoing current public information, will have a significant impact on micro-cap fraud. The initial rule proposal contained a provision that would have eliminated the piggyback exception altogether for shell companies.  This provision received significant push-back and would have had a huge chilling effect on reverse merger transactions in the OTC Markets.  In its rule proposal the SEC admitted that there are perfectly legal and valid reverse-merger transactions.  My firm has worked on many reverse-merger transactions over the years. In response to the push back and the final rule allows for broker-dealers to rely on the piggyback exception to publish quotations for shell companies for a period of 18 months following the initial priced quotation on OTC Markets. In essence, a shell company is being granted 18 months to complete a reverse merger with an operating business, or in the alternative, to organically begin operations itself.  To be clear, the amended rules only allow the piggyback exception for a period of 18 months following the initial quotation.  Accordingly, if a company falls into shell status after it has been quoted for 18 months, a new 15c2-11 review would need to be completed by either a broker-dealer or OTC Markets under the initial quotation standards.  Upon that new initial review, and assuming compliance with the requirements to initiate a quote, a new 18 month period would begin.  If the company remained a shell at the end of the 18 month period, it would lose piggy back eligibility and a new 211 compliance review would be necessary.  That is, either a broker-dealer would need to file a new Form 211, or OTC Markets would need to conduct the review upon which the broker-dealer could rely. The amended rule adopts a definition of shell company that tracks Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2, but also adds a “reasonable basis” qualifier to help broker-dealers and OTC Markets make determinations.  In particular, a shell company is defined as any issuer, other than a business combination related shell company as defined in Rule 405 or asset backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents.  A company will not be considered a shell simply because it is a start-up or has limited operating history.  In order to have a reasonable basis for its determination, a broker-dealer or OTC Markets can review public filings, financial statements, business descriptions, etc. The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information.  The amended rule eliminated both the 12 and 30 day frequency of quotation requirements but retains the four day requirement. The piggyback exception rule change was the subject of a plethora of comments and push-back from the marketplace, including retail traders that were concerned they would in essence lose their livelihood, presumably this is one of the reasons the SEC devoted a full 60 pages to its discussion on this topic.  In a sort of comprise, the SEC stated that it understands that market participants may have unique facts and circumstances as to how the amended Rule affects their activities, and the SEC will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule. In a request for relief the SEC will consider all facts and circumstances including whether based on information provided, the issuer or securities are less susceptible to fraud or manipulation.   The SEC may consider, among other things, securities that have an established prior history of regular quoting and trading activity; companies that do not have an adverse regulatory history; companies that have complied with any applicable state or local disclosure regulations that require that the company provide its financial information to its shareholders on a regular basis, such as annually; companies that have complied with any tax obligations as of the most recent tax year; companies that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors.  Requests for relief should be submitted as soon as possible to prevent a quotation interruption prior to the rule’s implementation. The requirement limiting the piggyback exception for the first 60 calendar days after a trading suspension will not likely have a market impact.  A trading suspension over 5 days currently results in the loss of the piggyback exception and requirement to file a new Form 211.  In practice, the SEC issues ten-day trading suspensions on OTC Securities, and there is no broker-dealer willing to file a new 15c2-11 within 60 days thereafter in any event.  In fact, in reality, it is a rarity for a company to regain an active 211 after a trading suspension.  Perhaps that will change with implementation of the new rules. The existing rule excepts from the information review requirement the publication or submission of quotations by a broker-dealer where the quotations represent unsolicited customer orders.  Under the final rule, a broker-dealer that is presented with an unsolicited quotation, would need to determine whether there is current publicly available information.  If no current available information exists, the unsolicited quotation exception is not available for company insiders or affiliates including officers, directors and 10%-or-greater shareholders. In the final rule, a broker-dealer may rely on a written representation from a customer’s broker that such customer is not a company insider or an affiliate.  The written representation must be received before and on the day of a quotation.  Also, the broker-dealer must have a reasonable basis for believing the customer’s broker is a reliable source including for example, obtaining information on what due diligence the broker conducted.  Like the piggy-back exception, a broker-dealer will be able to rely on a qualified IDQS (OTC Markets) or a national securities association (FINRA) that there is current publicly available information. Lower Risk Securities; New Exceptions The final rule provides an exception for companies that are well capitalized and whose securities are actively traded.  In order to rely on this exception, the security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”). The ADTV test requires that the security have a worldwide reported ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation.  To satisfy the final ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade). The asset test requires that the company have at least $50 million in total assets and stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end.  This would cover both domestic and foreign issuers.  The proposed rule would have required that the $10 million of stockholder’s equity be from unaffiliated stockholders but that requirement was eliminated in the final rule. The rule also creates an exception for a company who has another security concurrently being quoted on a national securities exchange.  For example, some companies quote their warrants or rights on OTC Markets following a unit IPO offering onto a national exchange. Like the piggyback exception, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the ADTV and asset test or the exchange-traded security exception have been met.  Conversely if OTC Markets or FINRA is publishing the availability of an exception, they will also need to publish when such exception is no longer available. The final rule adds an exception to the rule to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This change may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation. This exception requires that the broker-dealer have the 211 current information in its possession and have a reasonable basis for believing the information is accurate and the sources of information are reliable.  Since FINRA issues a ticker symbol, this new exception will still require a broker-dealer to file a Form 211 (or new form generated by FINRA to facilitate the exception). Miscellaneous Amendments to Streamline The SEC has also made numerous miscellaneous changes to streamline the rule and eliminate obsolete provisions.  The miscellaneous changes include: (i) allowing a broker-dealer to provide an investor that requests company information with instructions on how to obtain the information electronically through publicly available information; (ii) updated definitions; and (iii) the elimination of historical provisions that are no longer applicable or relevant. Guidance As part of its rule release, the SEC eliminated the preliminary note that appeared with the former rule and adopted new guidance. Reliable Source As discussed, a broker-dealer must have a reasonable basis under the circumstances to believe that 211 information is accurate in all material respects and from a reliable source.   In its guidance, the SEC specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely on information provided by a another broker-dealer, company or its agents, including, officers, directors, attorneys or accountants and information that is publicly available.  Where a source of information indicates it was prepared by a company or one of its agents, the broker-dealer should confirm with the company or the particular agent. Information Review Upon reviewing all information in its possession and confirming that all information required by the rule has been received, the information review process can generally be completed.  However, where a red flag presents itself such as a material inconsistency, a further review needs to be conducted.  A reviewer either needs to resolve the red flag, or choose not to publish a quotation.  This portion of the guidance stresses that investigations are not necessary beyond the specific information required in the rule, unless a red flag is present. Red Flags The guidance provides a non-exclusive list of red flags: (i) SEC or foreign trading suspensions; (ii) concentration of ownership of the majority of outstanding freely tradeable stock; (iii) large reverse stock splits; (iv) companies in which assets are large and revenue is minimal without explanation; (v) shell company’s acquisition of private company or other material business development; (vi) a registered or unregistered offering raises proceeds that are used to repay a bridge loan made or arranged by an underwriter where the loan is short term with a high interest rate, the underwriter received securities at below market prior to the offering and the company has no apparent business purpose for the loan; (vii) significant write-up of assets upon a company obtaining a patent or trademark; (viii) significant assets consist of substantial amounts of shares in other OTC companies; (ix) assets acquired for shares of stock when the stock has no market value; (x) unusual auditing issues; (xi) significant write-up of assets in a business combination of entities under common control; (xii) extraordinary items in notes to the financial statements; (xiii) suspicious documents; (xiv) a broker-dealer or qualified IDQS receives substantially similar offering documents from different issuers with certain characteristics; (xv) extraordinary gains in year to year operations; (xvi) reporting company fails to file an annual report; (xvi) disciplinary actions against a company’s officers, directors, general partners, promoters, auditors or control persons; (xvii) significant events involving a company or its predecessor or any majority subsidiaries; (xviii) request to publish both bid and offer quotes on behalf of a customer for the same stock; (xix) issuer or promoter offers to pay a fee; (xx) regulation S transactions of domestic companies; (xxi) Form S-8 stock; (xxii) “hot industry” OTC stocks; (xxiii) unusual activity in brokerage accounts of company affiliates, especially involving related shareholders; and (xxiv) companies that frequently change their names or lines of business. Conclusion In general I am happy with the rule changes.  Allowing OTC Markets to separately review and make a determination as to initial compliance with Rule 15c2-11 or the availability of an exemption should improve the system dramatically.  The existing rule was antiquated, simply did not meet its intended purpose, and provided unnecessary burdens on certain market-participants and none at all on others.  However, I would like to see additional changes.  In particular, the proposing release did not address the prohibition on broker-dealers, or now, OTC Markets, charging a fee for reviewing current information, confirming the existence of an exemption and otherwise meeting the requirements of Rule 15c2-11 (as set out in FINRA Rule 5250 – see here for more information HERE).  The process of reviewing the information is time-consuming and the FINRA review process is arduous.  Although not in the rule, FINRA in effect conducts a merit review of the information that is submitted with the Form 211 application and routinely drills down into due diligence by asking the basis for a reasonable belief that the information is accurate and from a reliable source.   Most brokerage firms are unwilling to go through the internal time and expense to submit a Form 211 application.  I believe the SEC needs to allow broker-dealers and OTC Markets to be reimbursed for the expense associated with the rule’s compliance.
« »
NYSE Continues To Struggle With Direct Listing Rule Changes
Posted by Securities Attorney Laura Anthony | September 18, 2020 Tags: ,

Late last year, around the same time that the SEC approved Nasdaq rule changes related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market (see HERE), the SEC rejected proposed amendments by the NYSE big board which would allow a company to issue new shares and directly raise capital in conjunction with a direct listing process.  Nasdaq had previously updated its direct listing rules for listing on the Market Global Select Market (see HERE).

The NYSE did not give up and in August of this year, after two more proposed amendments, the SEC finally approved new NYSE direct listing rules that allow companies to sell newly issued primary shares on its own behalf into the opening trade in a direct listing process.  However, after receiving a notice of intent to petition to prevent the rule change, the SEC has stayed the approval until further notice.  Still pushing forward, on September 4, the NYSE filed a motion with the SEC requesting that the stay be lifted and allowing the rule change to proceed.  The NYSE argued that the objection to the rule change lacks merit and that the arguments raised were already fully vetted in the lengthy rule approval process.

Shortly after the August rule change approval, software unicorn Palantir Technologies filed an S-1 with the SEC to go public via direct listing on the NYSE.  Although Palantir does not intend to sell securities under the new rule, but rather only filed for re-sale of existing shareholders’ equities, the much anticipated public transaction continues to be delayed.  However, it is likely that the delay is not related to the stalled rule change, but rather normal market conditions.

Not wanting the NYSE to have a competitive edge, Nasdaq has filed a similar proposal with the SEC to allow for companies to sell shares directly in conjunction with direct listings onto the Exchange.  I suspect that a ruling on that request will be delayed until the NYSE issue has been resolved.

Direct Listings in General

Traditionally, in a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors.  Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary.  A company would also not necessarily need a banker in the resale direct listing process.  A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC.  For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.

Most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors.  As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.  Rule 506(c) allows for general solicitation and advertising of the offering.  For more on Rule 506, see HERE.

Early investors take a greater risk because there is no established secondary market or clear exit from the investment.  Even where an investment is made in close proximity to an intended going public transaction, due to the higher risk, the private offering investors generally are able to buy shares at a lower valuation than the intended IPO price.  The pre-IPO discount varies but can be as much as 20% to 30%.

Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round.  Main Street investors will not be able to participate until the company is public and trading.  Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk.  For more on the accredited investor definition including the SEC’s recent amendments, see HERE.

The private offering, or private offerings, can occur over time.  Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round.  Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages.  In a direct listing, a company can register all these shareholdings for resale in the initial public market.

In a direct listing there is a chance for an initial dip in trading price, as without an IPO and accompanying underwriters, there will be no price stabilization agreements.  Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option.  An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position.  A covered short position is one in which a seller sells securities it does not yet own, but does have access to.

A typical overallotment option is 15% of the offering.  In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option.  This helps stabilize an offering price in two ways.  First, if the offering is a big success, more orders can be filled.  Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).

The new NYSE rule (and Nasdaq proposal) will change the direct listing process to allow a company to sell shares directly into the trading market and thus complete a capital raise at the same time as its going public transaction.  In essence, this direct listing hybrid is an IPO without an underwriter.

Direct Listing with Company Share Sales

A company that seeks to list on the NYSE must meet all of the minimum initial listing requirements, including specified financial, liquidity and corporate governance criteria, a minimum of 400 round lot shareholders, 1.1 million publicly held outstanding shares and a $4.00 share price. Direct listings are subject to all initial listing requirements applicable to equity securities and as such, in a direct listing process, the rules must specify how the exchange will calculate compliance with the initial listing standards including related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.

In order to qualify for the NYSE big board in a direct listing process, a company must have a minimum of $100 million aggregate market value of publicly held shares.  In contrast, in an IPO, a company is only required to have a market value of publicly held shares of $40 million.  The reason for the much higher standard in a direct listing process is a concern related to the liquidity and market support in an opening auction process without attached underwriters.

As indicated, the NYSE rule change allows a company to sell shares directly into the market, without an underwriter, as part of a direct listing process.  In order to accomplish this, the NYSE created a new process dubbed an Issuer Direct Offering (IDO).  To get the process across the finish line, the last amendment (i) deleted a provision that would provide additional time for companies completing a direct listing to meet the initial listing distribution standards; (ii) added specific provisions related to the concurrent selling security holder and IDO process; (iii) added provisions related to participation in the direct listing auction when completing an IDO; and (iv) removed references to direct listing auctions in the rule related to Exchange-Facilitated Auctions.

The material aspects of the final NYSE rule change (i) modifies the provisions relating to direct listings to permit a primary offering in connection with a direct listing and to specify how a direct listing qualifies for initial listing if it includes both sales of securities by the company and possible sales by selling shareholders; (ii) modifies the definition of “direct listing”; and (iii) adds a definition of “Issuer Direct Offering (IDO)” and describes how it participates in a direct listing auction.

To clarify the difference between an IDO and selling security holder process, the NYSE has defined a shareholder-resale process as a “Selling Shareholder Direct Floor Listing.”  A pure Selling Shareholder Direct Floor Listing occurs where a company is listing without a related underwritten offering upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements.

The Selling Shareholder Direct Floor Listing process retains the existing standards for direct listing and how the NYSE determines company eligibility including the market value of publicly held shares.  In particular, a company can meet the $100 million market value of publicly held shares requirement using the lesser of (i) an independent third-party valuation; and (ii) the most recent trading price of the company’s common stock in a trading system for unregistered securities that is operated by a national securities exchange or a registered broker-dealer (“Private Placement Market”).  In order to satisfy the $100 million valuation, the NYSE requires that the independent valuation comes in at a market value of at least $250 million.  In addition, the NYSE will only consider the Private Placement Market price if the equity trades on a consistent basis with a sustained history of several months, in excess of the market value requirement.  Shares held by directors, officers or 10% or greater shareholders are excluded from the calculation.

An IDO listing is one in which a company that has not previously had its common equity securities registered under the Exchange Act, lists its common equity securities on the NYSE at the time of effectiveness of a registration statement pursuant to which the company would sell shares itself in the opening auction on the first day of trading on the Exchange in addition to, or instead of, facilitating sales by selling shareholders.  This process is being called a “Primary Direct Floor Listing.”  In a Primary Direct Floor Listing, a company can meet the $100 million market value of publicly held shares listing requirement if it sells at least $100 million in market value of shares in the NYSE’s opening auction on the first day of trading.  Alternatively, where a company will sell less than $100 million of shares in the opening auction, the NYSE will determine that the company has met its market value of publicly held shares requirement if the aggregate market value of the shares the company will sell in the opening auction on the first day of trading and the shares that are publicly held immediately prior to the listing is at least $250 million.  In that case the market value is calculated using a price per share equal to the lowest price of the price range established by the company in its registration statement.

In order to facilitate the direct sales by the company, the NYSE has created a new type of buy-sell order called an “Issuer Direct Offering Order (IDO Order)” which would be a limit order to sell that is to be traded only in a Direct Listing Auction for a Primary Direct Floor Listing.  An IDO Order is subject to the following: (i) only one IDO Order may be entered on behalf of the company and only by one member organization; (ii) the limit price of the IDO Order must be equal to the lowest price of the price range in the effective registration statement; (iii) the IDO Order must be for the quantity of shares offered by the company as disclosed in the effective registration statement prospectus; (iv) an IDO Order may not be cancelled or modified; and (v) an IDO Order must be executed in full in the Direct Listing Auction.

A designated market maker effectuates the Direct Listing Auction manually and is responsible for setting the price (which involves many factors including working with the valuation financial advisor and the price set in the registration statement).  The Direct Listing Auction and thus Primary Direct Floor Listing would not be completed if (i) the price is below the minimum or above the highest price in the range in the effective registration statement or (ii) there is not enough interest to fill both the IDO Order and all better priced sell orders in full.  In other words, a Primary Direct Floor Listing can fail at the finish line.  To provide a little help in this regard, the NYSE has provided that an IDO Order that is equal to the auction price, will receive priority over other buy (sell) orders.

The NYSE has also added provisions regarding the interaction with a company’s valuation or other financial advisors and the designated market maker to ensure compliance with all federal securities laws and regulations, including Regulation M.  To provide an additional level of investor protection, and to satisfy the SEC, the NYSE retained FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of the federal securities laws and NYSE rules. Finally, the NYSE made several changes to align definitions and rule cross-references with the new provisions and direct listing process.

In passing the rule, the SEC noted that after its several modifications, they were satisfied that the final rule helped ensure that the listed companies would have a sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly markets.

« »
SEC Adopts Amendments To Accredited Investor Definition
Posted by Securities Attorney Laura Anthony | September 11, 2020 Tags: ,

The much anticipated amendments to the accredited investor definition and definition of qualified institutional buyer under Rule 144A were adopted by the SEC on August 26, 2020.  The amendments come almost five years after the SEC published a report on the definition of “accredited investors” ( see HERE)  and nine months after it published the proposed amendments (see HERE).  The rule changes also took into account the input and comment letters received in response to the SEC’s concept release and request for public comment on ways to simplify, harmonize and improve the exempt offering framework (see HERE).

As a whole industry insiders, including myself, are pleased with the rule changes and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.  As the SEC pointed out historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets.  The amendments are meant to improve the definition to include institutional and individual investors with knowledge and expertise in the marketplace.

The current test for individual accredited investors is a bright line income or net worth test.  The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications.  The amended definition will also add categories of businesses, entities, and organizations that can qualify with $5 million in assets and a catch-all category for any entity owning in excess of $5 million in investments.  The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.

The SEC has also amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities.  The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).

The amendments become effective 60 days after publication in the Federal Register.

Background

All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.

The definition of an accredited investor has become a central component of exempt offerings, including Rules 506(b) and 506(c) of Regulation D.  Qualifying as an accredited investor allows an investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds.  Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.

Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses.  In 2019 the estimated capital raised in exempt offerings was $2.7 trillion compared to $1.2 trillion in registered offerings.  The amended definition of accredited investor is part of the SEC’s larger effort to simplify, harmonize, and improve the exempt offering framework.  Earlier this year the SEC published broader proposed rule changes to the exempt offering structure, which I broke down into a 5-part blog series.  The first centered on the offering integration concept (see HERE); the second on offering communications, testing the waters and a new demo day exemption (see HERE); the third on Regulation D, Rule 504 and bad actor rules (see HERE); the fourth on Regulation A (see HERE); and the fifth on Regulation Crowdfunding (see HERE).

The Current Definition of “Accredited Investor”

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

  1. Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
  2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
  3. Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
  4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
  5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
  6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
  7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
  8. Any entity in which all of the equity owners are accredited investors.

Summary of Amendments

The amendment to the accredited investor definition adds new categories of natural persons based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order.  In particular, to start the amendment provides that a holder in good standing of a Series 7, 65 or 82 license qualifies as an accredited investor.  The SEC further provides that it may add additional certifications, designations, or credentials in the future.  In addition, a knowledgeable employee of a private fund will now be considered accredited.  The amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test for natural persons.

The amendments also: (i) clarify that limited liability companies with $5 million in assets qualify as accredited and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify; (ii) add a new catch-all category for any entity,  including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (iii) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (iv) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

The amendments to the qualified institutional buyer definition in Rule 144A add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition.  The amendments also add a catch-all category that permits institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.

Professional Certifications, Designations and Credentials

Noting that relying solely on financial thresholds as an indication of financial sophistication is suboptimal, including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth, the final amendment adds new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations.  The final amendments track the proposed amendments in this area except that the final amendments require that any certification, license or designation be in good standing in order to qualify for accreditation.

The final amendment provides that the SEC may designate qualifying professional certifications, designations, and other credentials by order, with such designation to be based upon consideration of all the facts pertaining to a particular certification, designation, or credential.  The final amendment includes a non-exclusive list of attributes the SEC will consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.  The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status will be posted on the SEC’s website.

Concurrent with adopting the final amendments, the SEC issued an order designating good standing holders of a Series 7, 65 or 82 license as qualifying for accredited status.  Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and would leave too much discretion to the marketplace.  Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.

Requiring that a list of individuals that hold the certifications be publicly available will reduce the costs of verifying accredited status for companies relying on Rule 506(c).  Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.

Knowledgeable Employees of Private Funds

With respect to investments in a private fund, the SEC has added a new category based on the person’s status as a “knowledgeable employee” of the fund.  A knowledgeable employee is defined as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund who in connection with his or her regular functions or duties, participates in the investment activities of the fund and has been doing so for at least 12 months.

The private fund category is meant to encompass funds that rely on the investment company registration exemptions found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940.  These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.

Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.”  A qualified purchaser is one that owns $5 million or more in investments.  The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds.  In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser.  However, prior to this amendment, if the knowledgeable employee does not qualify as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded.

Spousal Equivalents

The SEC has added a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent.  A spousal equivalent is defined as a cohabitant in a relationship generally equivalent to a spouse.  The rule does not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.

Additional Entity Categories

The amended rules add the following entities to the accredited investor definition: (i) limited liability companies with total assets in excess of $5 million that were not formed for the specific purpose of making the investment; (ii) SEC and state registered investment advisers and exempt reporting advisors; (iii) rural business investment companies (RBICs); (iv) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (v) “family offices” with at least $5 million in assets under management, that were not formed for the purpose of making the investment, and their “family clients,” as each term is defined under the Investment Advisers Act as long as the prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.

These additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.

Qualified Institutional Buyer – Rule 144A

The SEC has amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities.  Rule 144A(a)(1)(i) specifies the types of institutions that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested threshold.  The amendments expand the definition of qualified institutional buyer by adding RBICs, limited liability companies, and all entities, including Indian tribes that meet the $100 million threshold.

The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).

« »