Nasdaq Rule Amendments 2020
In addition to the temporary rule changes and relief that Nasdaq has provided this year for companies affected by Covid-19 (see HERE and HERE), the exchange has enacted various rule amendments with varying degrees of impact and materiality.
In particular, over the last year Nasdaq has amended its delisting process for low-priced securities, updated its definition of a family member for the purpose of determining director independence and has clarified the term “closing price” for purposes of the 20% rule. This blog discusses each of these amendments.
Delisting Process
In April 2020, the SEC approved Nasdaq rule changes to the delisting process for certain securities that fall below the minimum price for continued listing. The rule change modifies the delisting process for securities with a bid price at or below $0.10 for ten consecutive trading days during any bid-price compliance period and for securities that have had one or more reverse stock splits with a cumulative ratio of 250 shares or more to one over the prior two-year period.
Nasdaq’s rules require that primary equity securities, preferred stocks, and secondary classes of common stock maintain a minimum bid price of at least $1.00 per share for continued listing. Under Rule 5810(c)(3)(A), a security is considered deficient with this bid price requirement if its bid price closes below $1.00 for a period of 30 consecutive business days. Under Nasdaq Rule 5810(c)(3)(A), a company with a bid price deficiency has 180 calendar days from notification of the deficiency to regain compliance. A company generally can regain compliance with the bid-price requirement by maintaining a $1.00 closing bid price for a minimum of ten consecutive business days during the 180-day compliance period.
Also under the current rules, if a company is listed on or moves to the Nasdaq Capital Market, the lowest tier of Nasdaq, it may be eligible for a second 180-day period to regain compliance, provided that in the last half of the first compliance period, the company met the market value of publicly held shares requirement, as well as compliance with other Nasdaq rules. Accordingly, a company trading on the Nasdaq Capital Market could have up to 360 days to regain compliance with a deficient bid price.
However, where a company has a bid price below $.10 or has completed several reverse splits, it likely has more severe issues that will not be able to be corrected regardless of the allowable period to regain compliance.
The rule amendment allows Nasdaq to provide a notice of Staff Delisting Determination to a company that has traded below $1.00 for thirty consecutive business days (the time it would normally receive its deficiency notice) if the security has a closing bid price of $0.10 or less for a period of ten consecutive trading days. Likewise, instead of receiving a notice of deficiency, a company will receive a Staff Delisting Determination if it falls out of compliance with the $1.00 minimum bid price after completing one or more reverse stock splits resulting in a cumulative ratio of 250 shares or more to one over the two-year period immediately prior to such non-compliance.
A company could appeal the Staff Delisting Determination to a Nasdaq hearing panel which could grant a 180-day compliance period if it believes the company will be able to achieve and maintain compliance with the bid-price requirement.
The rule amendment was effective immediately and applied to all companies that received notice of noncompliance with the bid-price requirement after the date of its effectiveness. However, on May 14, 2020, Nasdaq extended the new rule such that it will be effective for companies that first receive notification of non-compliance on or after September 1, 2020. Nasdaq extended the rule effective date to provide relief for companies experiencing wide trading fluctuations as a result of Covid-19. The effective date extension is in addition to Nasdaq’s prior announcement that it would toll the 180-day period for companies that had already received a non-compliance notice, through June 30, 2020 (see HERE).
Although the new rule was extended, Nasdaq notes that it still may rely on its discretion to deny a second 180-day period to regain compliance for a company with a very low stock or that has completed multiple prior reverse splits. For a review of Nasdaq’s current initial listing standards, see HERE.
Definition of Family Member for Purposes of Determining Director Independence
Back in December, I wrote a blog drilling down on the Nasdaq board independence requirements (see HERE) and noted that a few months earlier, the SEC had declined to approve a Nasdaq rule change to the definition of “family member.”
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
For purposes of Rule 5605, “family member” was defined as a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule-change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The proposed language matched the NYSE definition. However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change believing that the rule release made an over-correction.
In February, Nasdaq submitted its third amendment to the proposed rule change, which was approved by the SEC. Although the definition of “family member” as approved by the SEC, is the same as proposed in June 2019, the rule release now states that Nasdaq intends to exclude domestic employees who share the director’s home, and stepchildren who do not share the director’s home, from the types of relationships that always preclude a finding that a director is independent. Rather, a company’s board of directors will need to examine all facts and circumstances to determine if a particular step-child relationship would be likely to interfere with the director’s exercise of independent judgment in carrying out his or her responsibilities
Clarification of “Closing Price” in 20% Rule
In January 2020, Nasdaq filed a rule change to clarify the meaning of the term “Closing Price” as used in Rule 5635(d), known as the 20% Rule. For more information on Rule 5635(d), see HERE. The rule change does not make any substantive changes but rather is meant to clarify the language to avoid any potential confusion.
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The rule amendment changes the term “closing price” to “Nasdaq Official Closing Price” in the definition of Minimum Price. The term Nasdaq Official Closing Price had been used in the September 2018 rule release when Nasdaq adopted the definition of Minimum Price. Aligning the language will add a layer of consistency and avoid any confusion for listed companies.
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A COVID IPO
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
« SEC Spring 2020 Regulatory Agenda Nasdaq Rule Amendments 2020 »
SEC Spring 2020 Regulatory Agenda
In July 2020, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the spring 2020 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame has decreased to 42 items as compared to 47 on the fall 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months. Portfolio margining harmonization was the only item listed in the pre-rule stage in the fall 2019 and remains so on the current list.
Nineteen items are included in the proposed rule stage, down from 31 on the fall list. Still on the proposed rule list is executive compensation clawback (HERE). Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.
Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements), and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list. The SEC has recently amended the rules and issued a concept release (see HERE and HERE) and appears committed to enacting much-needed updates and improvements to the rules.
Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the spring 2019 list and up to proposed in fall 2019 where it remains. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments to the transfer agent rules remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). SEC top brass speeches suggested that it would finally be pushed over the finish line last year but so far it remains stalled (see, for example, HERE).
Other items that are still on the proposed rule list include amendments to Guide 5 on real estate offerings and Form S-11; amendments to the custody rules for investment advisors; investment company summary shareholder report; amendments to Form 13F filer thresholds; amendments to the family office rule; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and broker-dealer reporting, audit and notifications requirements.
Items moved up from long-term to proposed-rule stage include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to the Family Office Rule; amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and amendments to the rules regarding the consolidated audit trail.
New to the list and appearing in the proposed rule stage is a rule regarding the valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company. Also new to the list and in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC. Another new item that made it to the proposed stage is a proposal to amend Regulation ATS to increase operational transparency and foster oversight of ATSs that transact in government securities.
Twenty-one items are included in the final rule stage, increased from 16 on the fall list, including a few of which are new to the agenda. Amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019 – see HERE) moved up from the proposed list to final rule stage.
Still in the final rule stage is the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE). The SEC previously made some changes to risk factor disclosures in an amendment adopted in March 2019 (see HERE) but the newest proposals would go further to: (i) require summary risk factor disclosure 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.
Financial disclosures about acquired businesses are still listed in the final rule stage although final rules were adopted in May 2020, which are still on my list as a catch-up blog. The proposed amendments were published in May 2019 (see HERE). Similarly, amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE) still appear on the final rule list although final rules were adopted in July 2020 (also on my future blog list).
Jumping from a long-term action item to final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.
Moving up from proposed rule to final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE); proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); procedures for investment company act applications; NMS Plan amendments; use of derivatives by registered investment companies and business development companies; market data infrastructure including market data distribution and market access (proposed rules published in February 2020); amendments to the SEC’s Rules of Practice; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; amendments to marketing rules under the Advisors Act; and amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendments to MD&A were adopted in March 2019 (see HERE)
The much-needed amendments to the accredited investor definition moved from the proposed list to the final rule stage. The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE). As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, moved from the proposed rule list to the final agenda. The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change. 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, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject. Comments and responses to the proposed rules have been voluminous and largely negative. The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system.
Other items remaining in the final rule stage include Fund of fund arrangements (proposed rules were issued in December 2018); customer margin requirements for securities futures (proposed rules published in July 2019); and amendments to the whistleblower program.
At least partially, new to the agenda and in the final rule stage is the harmonization of exempt offerings. In March 2020 the SEC proposed sweeping rule changes. For my five-part blog on the proposed rules, see HERE, HERE, HERE, HERE, and HERE. Regulation A and Regulation CF amendments were on the fall 2019 proposed rule list and although dropped off as separate items, are encompassed in the harmonization of exempt offerings proposed amendments.
Several items have dropped off the agenda as they have now been implemented and completed, including financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE) and the final rules adopted in March 2020 (see HERE). Amendments to the definition of an accelerated and large accelerated filer were finalized in March 2020 (see HERE) and thus removed from the list.
Items also completed and removed from the agenda include offering reform for business development companies (adopted in April 2020); amendments to Title VII cross-border rules (final rules adopted in September 2019); recordkeeping and reporting for security-based swap dealers (adopted in September 2019); disclosure for unit investment trusts and offering variable insurance products (adopted in May 2020); a new definition for covered clearing agency (adopted in April 2020); and risk mitigation techniques (adopted on December 2019).
Thirty items are listed as long-term actions (down from 37 in fall 2019 and 52 in spring 2019), including many that have been sitting on the list for a long time now. Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now. Other items still on the long-term list include asset-backed securities disclosures (last amended in 2014); corporate board diversity (although nothing has been proposed, it is a hot topic); conflict minerals amendments (prior proposed rules were challenged in lengthy court proceedings on a constitutional First Amendment basis and yet another proposal was published in December 2019 – HERE); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); and stress testing for large asset managers.
Also still on the long-term action list is the modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; covered broker-dealer provisions under Title II of Dodd-Frank; additional changes to exchange-traded products; short sale disclosure reforms; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.
A few electronic filing matters remain on the long-term list including electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.
Several swap-based rules remain on the long-term list including ownership limitations and governance requirements for security-based swap clearing agencies, security-based swap execution facilities, and national exchanges; end user exception to mandatory clearing of security-based swaps; registration and regulation of security-based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
New to the list are requests for comments on fund names; amendments to improve fund proxy systems; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); records to be preserved by certain exchange members, brokers and dealers; and proposed Rule 15 to Regulation S-T, administration of the EDGAR system.
Items that dropped from the agenda without action include amendments to the registration of alternative trading systems and clawbacks of incentive compensation at financial institutions. Sadly, completely dropped from the agenda is Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See here for more information HERE.
« SEC Final Amendments On Disclosures For Registered Debt Offerings A COVID IPO »
SEC Final Amendments On Disclosures For Registered Debt Offerings
Writing a blog once a week during a time when almost daily events are publish-worthy means that some topics will be delayed, at least temporarily. Back in March, the SEC adopted final amendments to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed rule changes were published in the summer of 2018 (see HERE).
The amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The SEC also created a new Article 13 in Regulation S-X, renumbered Rules 3-10 and 3-16 to Rules 13-01 and 13-02, and made conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.
As stated in the SEC press release on the new rules, the amended rules focus on the provision of material, relevant, and decision-useful information regarding guarantees and other credit enhancements, and eliminate prescriptive requirements that have imposed unnecessary burdens and incentivized issuers of securities with guarantees and other credit enhancements to offer and sell those securities on an unregistered basis. The amendments are intended to improve disclosure and reduce the SEC registration-related compliance burdens for issuers. It is hoped that the rules will encourage registered debt offerings over unregistered offerings and thus improve disclosures and protections for investors.
The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.
Rule 3-10
Under the Securities Act, a guarantee of a debt is a separate security requiring either registration, with audited financial statement, or an exemption from registration upon its offer or sale. Rule 3-10 of Regulation S-X requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements and that the subsidiary be 100% owned. If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.
The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.
The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.
To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.
When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.
The amendments streamline the current structure, which has differing criteria depending on which exemption is being relied upon to unify all criteria. The amendments broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the eligibility requirements to rely on the exception are met and the parent company includes specific financial and non-financial disclosures about those subsidiaries.
The amended rule will:
(i) Allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned;
(ii) Replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis;
(iii) New non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities;
(iv) Permit disclosures to be provided outside the footnotes of the parent’s audited and interim unaudited financial statements in the registration statement covering the offering and in the Exchange Act reports thereafter;
(v) Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, provided however, if the acquisition is significant, summarized financial information must be provided; and
(vi) Reduce the time in which additional Alternative Disclosure must be made to the period for which the issuer and guarantors have Exchange Act reporting obligations instead of the entire period that the guaranteed securities are outstanding.
To be eligible to rely on the exception, the following conditions must be met:
(i) The consolidated financial statements of the parent company have been filed;
(ii) The subsidiary or guarantor is a consolidated subsidiary of the parent;
(iii) The guaranteed security is debt or debt-like; and
(iv) One of the following issuer and guarantor structures is applicable: (a) the parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or (b) a consolidated subsidiary issues the security or co-issues the security with one or more other consolidated subsidiaries of the parent company, and the security is guaranteed fully and unconditionally by the parent company.
Importantly, as noted, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subjects the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
The new rules include conforming amendments to also apply to the Rule 8-01 of Regulation S-X dealing with smaller reporting companies and Forms 1-A, 1-K and 1-SA to apply to Regulation A issuers.
Rule 3-16
Current Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.
The amendments replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security. The amended financial and non-financial disclosures are included in new Rule 13-02.
The level of disclosure is based on materiality and would include certain line items of the balance sheet and income statement of the affiliate. Where more than one affiliate provides collateral, financial information can be included on a consolidated rather than individual basis. However, when information is applicable to one or more, but not all, affiliates, it will need to be separated out. For example, when one or more affiliates separates trades, it would need to be clear which affiliate trading market information is being provided for.
In addition, the amendment changes the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.
Furthermore, the amendments replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered, with a requirement to provide the financial and non-financial disclosures to the extent material, eliminating numerical thresholds. The rule leans towards materiality with the need to determine information is immaterial for it to be omitted.
« Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards SEC Spring 2020 Regulatory Agenda »
Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets (see HERE). Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
Following the public statements, in June 2020, Nasdaq issued new proposed rules which would make it more difficult for a company to list or continue to list based on the quality of its audit, which could have a direct effect on companies based in China.
Nasdaq Proposed Rule Changes
On June 2, 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The rule currently provides that Nasdaq may use its authority to deny listing or continued listing to a company when an individual with a history of regulatory misconduct is associated with that company. The rule sets out a variety of factors that may be considered by the exchange in making a determination. I’ve detailed the current rule below.
The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market.” The proposed rule change is meant to codify Nasdaq’s current interpretation of its discretionary authority to provide clarity to the marketplace on its position related to the importance of quality audits.
Nasdaq’s listing requirements are designed to ensure that a company is prepared for the reporting and administrative requirements of being a public company, to provide for transparency and the protection of investors, and to ensure sufficient investor interest to support a liquid market. Rule 5101 describes Nasdaq’s broad discretionary authority over the initial and continued listing of securities on Nasdaq in order to maintain the quality of and public confidence in the market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest.
Part of both the general federal securities laws and Nasdaq requirements relate to properly completed audits by an independent auditor. Investors need to be able to rely on the audit report to gain confidence that the financial statements are properly completed and free of material misstatements due to mistakes or fraud. For more on the requirements for an audit report, see HERE.
Auditors are subject to oversight by both the SEC and PCAOB. PCAOB inspections are designed to, among other things, identify deficiencies in audits and/or quality control procedures. Investigations can lead to the audited public company having to revise and refile its financial statements or its assessment of the effectiveness of its internal control over financial reporting. In addition, through the quality control remediation portion of the inspection process, inspected firms identify and implement practices and procedures to improve future audit quality. Accordingly, Nasdaq relies on auditors and the PCAOB oversight to maintain audit integrity.
Citing the recent joint public statement by SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III (see HERE), Nasdaq notes that audit work and the practices of auditors in certain countries, cannot be effectively reviewed or subject to the usual oversight. Those countries currently include Belgium, France, China and Hong Kong.
Currently, Nasdaq may rely upon its broad authority provided under Rule 5101 to deny initial or continued listing or to apply additional and more stringent criteria when the auditor of an applicant or a Nasdaq-listed company: (i) has not been subject to an inspection by the PCAOB, (ii) is an auditor that the PCAOB cannot inspect, or (iii) otherwise does not demonstrate sufficient resources, geographic reach or experience as it relates to the company’s audit, including in circumstances where a PCAOB inspection has uncovered significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls. The proposed rule change is meant to codify the existing rights of Nasdaq in that regard.
The proposed rule change would add a new paragraph (b) to IM-5101-1 detailing factors that Nasdaq will consider including:
(i) whether the auditor has been subject to PCAOB inspection including due to the audit firm being located in a jurisdiction that limits the PCAOB’s inspection ability;
(ii) if the auditor has been inspected, whether the results of the inspection indicate the auditor has failed to respond to inquiries or requests by the PCAOB or that the inspection revealed significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls;
(iii) whether the auditor can demonstrate that it has adequate personnel in offices participating in the audit with expertise in applying U.S. GAAP, GAAS or IFRS, in the company’s industry;
(iv) whether the auditor’s training program for personnel participating in the company’s audit is adequate;
(v) for non-U.S. auditors, whether the auditor is part of a global network or other affiliation of auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
(vi) whether the auditor can demonstrate to Nasdaq sufficient resources, geographic reach or experience as it relates to the company’s audit.
An auditor would not necessarily have to satisfy each of the factors but rather Nasdaq will consider all facts and circumstances, and may impose additional or more stringent criteria to mitigate concerns. Additional criteria could include: (i) higher equity, assets, earnings or liquidity measures; (ii) that an offering be completed on a firm commitment basis (as opposed to best efforts); (iii) lock-ups for officers, directors or other insiders; (iv) higher float percentage or market value of unrestricted publicly held shares; or (v) higher average OTC trading volume before an uplisting.
The proposed rule change would also add a new subparagraph (c) to IM-5101-1 to confirm Nasdaq’s ability to impose additional or more stringent criteria in other circumstances, including when a company’s business is principally administered in a jurisdiction that Nasdaq determines to have secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction (a “Restrictive Market”). In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s: (i) principal business segments, operations or assets; (ii) board and shareholders’ meetings; (iii) headquarters or principal executive offices; (iv) senior management and employees; and (v) books and records.
In the event that Nasdaq relies on its discretionary authority and determines to deny the initial or continued listing of a company, it would issue a denial or delisting letter to the company that will inform the company of the factual basis for the Nasdaq’s determination and its right for review of the decision.
Current Rule IM-5101-1
Nasdaq may use its authority under Rule 5101 to deny initial or continued listing to a company when an individual with a history of regulatory misconduct is associated with the company. Such individuals are typically an officer, director, substantial shareholder, or consultant to the company. In making this determination, Nasdaq will consider a variety of factors, including:
(i) the nature and severity of the conduct, taking into consideration the length of time since the conduct occurred;
(ii) whether the conduct involved fraud or dishonesty;
(iii) whether the conduct was securities-related;
(iv) whether the investing public was involved;
(v) how the individual has been employed since the violative conduct;
(vi) whether there are continuing sanctions (either criminal or civil) against the individual;
(vii) whether the individual made restitution;
(viii) whether the company has taken effective remedial action; and
(ix) the totality of the individual’s relationship with the company including their current or proposed position, current or proposed scope of authority, responsibility for financial accounting or reporting and equity interest.
Nasdaq may also exercise its discretionary authority with a company filed for bankruptcy, when its auditor issues a disclaimer opinion or when financial statements do not contain a required certification.
Where concerns are raised, Nasdaq will consider remedial measures by the company including the individual’s resignation, divestiture of stock holdings, termination of contractual arrangements or the creation of a voting trust to vote their shares. Nasdaq will also consider past corporate governance.
Nasdaq may impose restrictions or heightened listing requirements where concerns are raised, but may not allow for exceptions or lower standards to the listing rules. In the event that Nasdaq staff denies initial or continued listing based on such public interest considerations, the company may seek review of that determination through the procedures set forth in the Rule 5800 Series. On consideration of such appeal, a listing qualifications panel comprised of persons independent of Nasdaq may accept, reject or modify the staff’s recommendations by imposing conditions.
« SEC Statements On Capital Markets Amid Covid-19 SEC Final Amendments On Disclosures For Registered Debt Offerings »
SEC Statements On Capital Markets Amid Covid-19
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
« SEC Further Comments On Emerging Markets Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards »
SEC Further Comments On Emerging Markets
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets. On July 9, 2020, the SEC held an Emerging Markets Roundtable where Chair Clayton reiterated his concerns about emerging market investment risks. Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
SEC and PCAOB Joint Statement
On April 21, 2020, SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III issued a joint public statement warning of the significant disclosure, financial and reporting risks of investing in emerging markets, and the limited remedies where such investments turn bad.
Over the past years, emerging markets have increased their access to U.S. capital markets with China becoming the largest emerging market economy and world’s second largest overall economy. The ability for regulators to enforce financial reporting and disclosure requirements for entities either based in, or with significant operations in, emerging markets is limited and dependent on the cooperation and assistance of local authorities. As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies. The joint statement summarizes specific risks and considerations for market participants.
Risk Disclosures
I have written about risk factors and the importance of company-specific risk disclosures in the past (see HERE). Companies that have significant operations in emerging markets often face greater risks and uncertainties, including idiosyncratic risks, than in more established markets. The operational risk disclosures for companies in emerging markets need to be robust including considering industry and jurisdiction-specific factors.
Likewise, the varying standards for financial reporting and oversight in different jurisdictions create unique risks that must be disclosed. Companies should discuss these matters with their independent auditors and where applicable, audit committees, and should disclose the related material risks.
Companies based in emerging markets should consider providing a U.S. domestic investor-oriented comparative discussion of matters such as (i) how the company has met the applicable financial reporting and disclosure obligations, including disclosure control procedures and internal controls over financial reporting and (ii) regulatory enforcement and investor-oriented remedies including, as a practical matter, in the event of a material disclosure violation or fraud or other financial misconduct.
Quality of Financial Information; Varying Requirements and Standards
The foundation of investor confidence in capital markets is high-quality, reliable financial statements. The SEC regulatory regime contains numerous rules and regulations to ensure these high-quality financial statements, including rules related to internal controls over financial statements (ICFR); auditor attestations; CEO and CFO attestations (see HERE); independent audit committees; auditor independence standards, PCAOB review and oversight and SEC review and enforcement.
While the form of disclosure may appear substantially the same as that provided by U.S. issuers and FPIs in many jurisdictions, it can often be quite different in scope and quality. Furthermore, that scope and quality of disclosure can significantly vary from company to company, industry to industry, and jurisdiction to jurisdiction.
In addition, if a foreign entity does not report to the SEC, the information and standards for preparing that information may be completely unreliable. Some jurisdictions have much lower regulatory, accounting, auditing or auditor oversight requirements or none at all.
The bottom line is that investors and financial professionals should carefully consider the nature and quality of financial information, including financial reporting and audit requirements, when making or recommending investments. Companies should ensure that relevant financial reporting matters are discussed with their independent auditors and, where applicable, audit committees.
PCAOB’s Inability to Inspect Audit Work Papers in China
The SEC and PCAOB’s first statement on this matter in December 2018 drilled down on the fact that China will not cooperate with their requests to review, investigate or audit local PCAOB member firms in China, thereby casting doubt and a lack of transparency on the quality and reliability of audits. The newest statement reiterates this situation and specifically notes a lack of improvement despite ongoing efforts. Investors should understand the potential impacts of the PCAOB’s lack of access when investing in companies whose auditor is based in China and public companies with operations in China must disclose these risks in SEC reports.
Limited Rights or Remedies
The SEC, U.S. Department of Justice (“DOJ”) and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China. Likewise, shareholder claims, including class action lawsuits, can be difficult or impossible to pursue in emerging markets. Even if investors successfully sue in the U.S., judgments may be impossible to enforce or collect upon.
Companies should clearly disclose the related material risks in their SEC reports.
Passive Investing
Passive investing strategies, such as through or following an index fund, often fail to consider the increased and specific risks associated with emerging markets.
Investment Advisers, Broker-Dealers and Other Market Participants Should Consider Emerging Market Risks
The SEC reminds investment professionals to consider the risks discussed in their statement when making investment decisions or providing investment advice or recommendations involving emerging markets.
« SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions SEC Statements On Capital Markets Amid Covid-19 »
SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions
In March, 2020 the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer.” The amendments were adopted largely as proposed in May 2019 (see HERE).
A company that is classified as an accelerated or large accelerated filer is subject to, among other things, the requirement that its outside auditor attest to, and report on, management’s assessment of the effectiveness of the issuer’s internal control over financial reporting (ICFR) as required by Section 404(b) of the Sarbanes-Oxley Act (SOX). The JOBS Act exempted emerging growth companies (EGCs) from this requirement. Moreover, historically the definition of a smaller reporting company (SRC) was set such that an SRC could never be an accelerated or large accelerated filer, and as such would never be subject to Section 404(b) of SOX.
In June 2018, the SEC amended the definition of an SRC to include companies with less than a $250 million public float (increased from $75 million) or if a company does not have an ascertainable public float or has a public float of less than $700 million, an SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year (see HERE). At that time the SEC did not amend the definitions of an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRC’s remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of SOX.
Under the new rules, smaller reporting companies with less than $100 million in revenues are not required to obtain an attestation of their internal controls over financial reporting (ICFR) from an independent outside auditor under Section 404(b) of SOX. In particular, the amendments exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and that had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
All Exchange Act reporting companies, whether an SRC or accelerated filer, will continue to be required to comply with SOX Rule 404(a) requiring the company to establish and maintain ICFR and disclosure control and procedures and have their management assess the effectiveness of each. This management assessment is contained in the body of all quarterly and annual reports and amended reports and in separate certifications by the company’s principal executive officer and the principal financial officer.
The new rules also increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new rules will assist with capital formation for smaller companies and reduce compliance burdens while maintaining investor protections. The SEC also hopes that the amendments will catch the attention of companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets.
In the press release announcing the rule change, Chair Jay Clayton stated: “[T]he JOBS Act provided a well-reasoned exemption from the ICFR attestation requirement for emerging growth companies during the first five years after an IPO. These amendments would allow smaller reporting companies that have made it to that five-year point, but have not yet reached $100 million in revenues, to continue to benefit from that exemption as they build their businesses, while still subjecting those companies to important investor protection requirements.”
Background
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been prolific over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
| Filer Category | Form 10-K | Form 10-Q |
| Large Accelerated Filer | 60 days after fiscal year-end | 40 days after quarter-end |
| Accelerated Filer | 75 days after fiscal year-end | 40 days after quarter-end |
| Non-Accelerated Filer | 90 days after fiscal year-end | 45 days after quarter-end |
| Smaller Reporting Company | 90 days after fiscal year-end | 45 days after quarter-end |
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances 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) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues.
Detail on Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million, would be both an SRC and an accelerated filer.
The SEC has now amended the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC and that had annual revenues of less than $100 million during its most recently completed fiscal year for which audited financial statements are available. The effect of this change is that such a company will not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement under SOX Section 404(b).
The rule change does not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the amendments:
| Relationships between SRC’s and Non-Accelerated and Accelerated Filers | ||
| Status | Non-Affiliated Public Float | Annual Revenues |
| SRC and Non-Accelerated Filer | Less than $75 million | N/A |
| $75 million to less than $700 million | Less than $100 million | |
| SRC and Accelerated Filer | $75 million to less than $250 million | $100 million or more |
| Accelerated Filer (not SRC) | $250 million to less than $700 million | $100 million or more |
| Large Accelerated Filer (not SRC) | Over $700 million | N/A |
The amendments also revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million and increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the amendments allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the amendments on transition provisions:
| Amendments to the Non-Affiliate Public Float Thresholds | |||
| Initial Public Float Determination | Resulting Filer Status | Subsequent Public Float Determination | Resulting Filer Status |
| $700 million or more | Large Accelerated Filer | $560 million or more | Large Accelerated Filer |
| Less than $560 million but
$60 million or more |
Accelerated Filer | ||
| Less than $60 million | Non-Accelerated Filer | ||
| Less than $700 million but $75 million or more | Accelerated Filer | Less than $700 million but
$60 million or more |
Accelerated Filer |
| Less than $60 million | Non-Accelerated Filer | ||
Determining Non-Affiliated Public Float
To determine the value of the public float, a company must multiply the aggregate worldwide number of shares of common equity held by non-affiliates by the price at which it was last sold, or the average of the bid and asked prices, in the principal trading market. Derivative securities such as options, warrants and other convertible or non-vested securities are not included in the calculation. An “affiliate” of, or a person “affiliated” with, a company, is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the company. The term “control” (including the terms “controlling,” “controlled by” and “under common control with”) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a company, whether through the ownership of voting securities, by contract, or otherwise.
From a top line, directors, executive officers and their spouses and relatives living with them are always considered affiliates as are trusts and corporations of which that director, executive officer or their spouses control in excess of 10%. There is a rebuttable presumption that 10% or greater stockholders are affiliates. Beyond that, the SEC has consistently refused to provide definitive guidance on the matter, rather requiring companies and their management to make an analysis based on their individual facts and circumstances.
Through various guidance, including comment letters and SEC enforcement actions, important facts to consider in determining control/affiliate status include:
- Distribution of voting shares among all stockholders – Consider whether a stockholder has a large percentage of the company’s voting stock as compared to all other stockholders;
- Impact of possible resale – if a particular larger shareholder threatens to sell their stock into the market unless management takes certain actions, and management believes that such sale would have a material negative impact on the stock price, that person could be considered to have control;
- Influence of a stockholder – a particular stockholder could have influence because of their general position or power over other stockholders – this could be because of a direct or indirect relationship with other stockholders or because of the person’s reputation as a whole. For example, certain activist shareholders such as Carl Icahn can exert control over management of companies in which they invest;
- Voting agreements – if a person has the right to vote on behalf of other people’s shares, they may have control;
- Contractual arrangements – any other contract that gives a person the right to assert control over management decisions.
« Proposed 2021 U.S. Budget SEC Further Comments On Emerging Markets »
Proposed 2021 U.S. Budget
In February, the Office of Management and Budget released the proposed fiscal 2021 United States government budget. The beginning of the Budget contains a message from President Trump delineating a list of key priorities of the administration including better trade deals, preserving peace through strength, overcoming the opioid crisis, regulation relief and American energy independence. The budget has some notable aspects that directly relate to the capital markets and its participants.
SEC
As the federal government has been doing for all agencies, the 2021 Budget seeks to eliminate agency reserve funds. Specifically regarding the SEC, the Budget cuts the SEC reserve by $50 million. The reduction in reserve fund is thought to increase overall accountability as the SEC would need to go to Congress to ask for additional funds if needed, with an explanation, instead of just accessing a reserve account. Reserve fund cuts are sent to the U.S. Treasury for deficit reduction.
However, the Budget also increases the overall SEC financing by 5.6% for a total of $1.9 billion including allowing for a 2.9% increase in workforce. The budget also increases the SEC’s annual funding for cybersecurity from $41.8 million to $46.6 million.
PCAOB
One of the overarching stated principals in the Budget is to reduce overlapping and duplication and in particular, “when multiple agencies or programs have similar goas, engage in similar activities or strategies, or target similar beneficiaries” they should be consolidated or the duplicated functions eliminated. In that regard, the 2021 budget proposed moving the now autonomous PCAOB under the SEC with a mandate that the SEC and PCAOB start to consolidate their duplicative functions. “Consolidating these functions within SEC will reduce regulatory ambiguity and duplicative statutory authorities,” the proposed Budget states.
The PCAOB was originally created by the Sarbanes-Oxley Act of 2002 in response to a series of accounting frauds including involving Enron Corp. However, the SEC is also tasked with investigation, oversight and enforcement against the same accounting firms that must be members of the PCAOB. The PCAOB has faced a series of controversies in recent years.
In December 2017, following a scandal involving the leak of confidential information about future inspections of KPMG LLP to auditors at the accounting firm, the SEC replaced the PCAOB’s entire board. A month later criminal charges were unsealed for three former PCAOB employees and three former KPMG executives.
In May 2018, five key division and office heads departed the regulator. Also in 2018, the number of settled disciplinary proceedings made public by the PCAOB dropped by 63%. In May 2019, a group of current and former PCAOB employees filed a whistleblower complaint alleging infighting, a hostile work environment and retaliatory conduct.
To top off the issues, in September 2019,a nonpartisan government oversight report found that over its full 16-year life, the PCAOB had only brought 18 enforcement actions against the big four accounting firms despite having found 808 instances of defective audits by those same firms. The report found that the PCAOB had only collected a total of $6.5 million in fines despite having the authority to demand as much as $15 million per violation. Finally, the report found an incestuous relationship between the PCAOB and the big four accounting firms with a frequent interchange of employees. In short, the PCAOB has not proved itself worth its expense nor effective in its mission.
Like other savings, the savings from folding in the PCAOB with the SEC would be used to reduce the federal deficit. It is expected that the joining of the two would result in a savings of $57 million in 2022 and a total of $580 million over ten years.
Financial Crimes/Cryptocurrencies
It is widely acknowledged that the increase in digital assets and cryptocurrencies has increased the prevalence of money laundering and funding for criminal activities including cybercriminals and terrorist activities. As an example, in August of last year, the Treasury Department’s Office of Foreign Assets Control (“OFAC”) blacklisted the cryptocurrency addresses of Chinese nationals involved in trafficking and producing the drug fentanyl. It is believed that the perpetrators were laundering funds using cryptocurrency. At the time, FinCEN issued an advisory to financial institutions outlining some of the common schemes used to launder funds.
In a move to increase law enforcement in this sector, after nearly two decades of control under of the U.S. Department of Homeland Security, the 2021 Budget proposes moving the Secret Service to the Department of the Treasury. The Budget cites the need for increased efficiencies in combating threats stemming from financial technology, including cryptocurrencies. The Budget would also provide the Secret Service with $2.4 billion in funding and allow for an additional 119 Secret Service agents.
The budget also proposes funding $127 million to support the Financial Crimes Enforcement Network, which “links law enforcement and intelligence agencies with financial institutions and regulators.” The budget outlines that the funding would help support FinCEN’s actions under the Bank Secrecy Act and would “expand its efforts to combat emerging virtual currency and cybercrime threats.” FinCEN regulates and monitors anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA).
AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC. The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs). For more information, see HERE.
The Budget also allocated $173 million to the Department of Treasury’s Office of Terrorism and Financial Intelligence which combats terrorists, rogue regimes, proliferators of weapons of mass destruction, human rights abusers, and other illicit actors by denying their access to the financial system, disrupting their revenue streams, and degrading their ability to cause harm.
As an aside, in addition to the Secret Service, Budget will also move the Bureau of Alcohol, Tobacco, Firearms and Explosives and the Organized Crime and Drug Enforcement Task Force to the Department of Treasury. The ATF has historically been under the Department of Justice.
Small Business Administration (SBA)
The SBA was established to aid, counsel and assist small businesses. The Budget supports $43 billion in business lending to assist U.S. small business owners in accessing affordable capital to start, build, and grow their businesses though loans will have an up-front administrative fee to offset costs.
Other Points of Interest – Technology and Cybersecurity
The Administration is prioritizing technology and industries of the future across the board with an emphasis on artificial intelligence. The Department of Defense Budget invests over $14 billion in science and technology programs that support key investments in industries of the future, such as artificial intelligence, quantum information science, and biotechnology, as well as core Department of Defense modernization priorities such as hypersonic weapons, directed energy, 5G, space, autonomy, microelectronics, cybersecurity, and fully networked command, control, and communications.
The Department of Commerce provides $718 million for the National Institute of Standards and Technology (NIST) to advance U.S. innovation and technological development, as part of an all-government approach to ensure that the US leads the world in the areas of AI, quantum information science, advanced manufacturing, and next generation communications technologies such as 5G. The Budget doubles NIST’s AI funding in order to accelerate the development and adoption of AI technologies and help ensure AI-enabled systems are interoperable, secure and reliable.
The Department of Energy has a new Artificial Intelligence and Technology Office responsible for providing department wide guidance and oversight on AI technology development and application. The Budget provides $5 million for this new office to enhance AI R&D projects already underway. In addition, the Department of Energy is allocated $5.8 billion for the Office of Science to continue its mission of focusing on early-stage research. Within this amount: $475 million is requested for Exascale computing to help secure the United States as a global leader in supercomputing; $237 million is requested for quantum information science; $125 million is requested for AI and machine learning; and $45 million is requested to enhance materials and chemistry foundational research to support U.S.- based leadership in microelectronics. Moreover, to support broad, interagency cybersecurity efforts, the Budget provides funding in multiple programs, including $185 million for the Office of Cybersecurity, Energy Security, and Emergency Response.
The Department of Education Budget includes $2 billion for Career and Technical Education Grants to ensure that all high schools can offer high-quality technological educations.
« SEC Proposed Rule Changes For Exempt Offerings – Part 5 SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions »
SEC Proposed Rule Changes For Exempt Offerings – Part 5
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this fifth and final blog focusing on amendments to Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see HERE. To review the third blog in this series which focused on Regulation D, Rule 504 and the bad actor rules, see HERE. To review the fourth blog in this series related to changes to Regulation A, see HERE.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c) and Section 4(a)(6) known as Regulation Crowdfunding. For more background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Regulation Crowdfunding
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
Increase in Offering Limit
The proposed amendments would increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding would become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The proposed amendments would increase the investment limit by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits would only apply to non-accredited investors whereas currently they apply to all investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The proposed amendments would allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles would be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding issuer and would not have a separate business purpose. Investors in the crowdfunding vehicle would have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying crowdfunding issuer in an offering made under Regulation Crowdfunding.
The proposed rule would benefit companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders, which can make these companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle would also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle may constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available it is required to register, if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Security Types
The proposed amendments would narrow the types of securities eligible under Regulation Crowdfunding to debt securities, equity securities, and debt securities convertible or exchangeable into equity securities, including guarantees of such securities, to harmonize the provisions of Regulation Crowdfunding regarding eligible security types with those of Regulation A. Other types of securities would be excluded from eligibility under the proposed 260 amendments. For example, Simple Agreements for Future Equity (SAFE) securities would no longer be eligible under Regulation Crowdfunding.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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