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The Treasury Department Report To The President On Capital Markets

Posted by Securities Attorney Laura Anthony | February 27, 2018 Tags: The Treasury Department Report To The President On Capital Markets

In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report was issued in response to an executive order dated February 3, 2017. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports; this one on capital markets discusses and makes specific recommendations related to the federal securities laws.

The Core Principles are:

Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
Prevent taxpayer-funded bailouts;
Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
Enable American companies to be competitive with foreign firms in domestic and foreign markets;
Advance American interests in international financial regulatory negotiations and meetings;
Make regulation efficient, effective, and appropriately tailored; and
Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

This blog will summarize key portions of the 232-page report that directly affect the small and lower middle equity markets. In addition to the areas discussed in this blog, the report covers business development and investment companies, Title III crowdfunding, the bond and treasury markets, securitization, derivatives and multiple other topics. For those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken by category.

Summary of Recommendations and Findings

The U.S. equities market represents $29 trillion in publicly traded U.S. stocks, with an average daily volume of over $270 billion. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), together with state securities regulators, are responsible for regulating U.S. markets. Further self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) oversee parts of the markets and its participants.

Encouraging Going Public Transactions

There are many benefits to a going public transaction. As summarized by the Treasury Report:

Access to the public equity markets means obtaining a source of permanent capital, usually at a cost lower than other alternatives. Proceeds from IPOs can be used to hire employees, develop new products and technologies, and expand operations. Furthermore, IPOs give institutional and other early stage investors an exit, allowing them to reallocate their capital and talent to other ventures. IPOs also have important implications for employees, who may have accepted pre-IPO compensation in the form of options and stock grants. After an IPO, an employee can monetize his or her compensation by selling into the market. This feature can incentivize employee job performance and work commitment.

As I’ve written about several times, the U.S. economy has experienced an extremely slow recovery since the latest financial crisis, though fortunately, that seems to be improving dramatically over the last year. However, over the last 20 years, the number of public companies in the U.S. has declined by nearly 50%. Many factors have been cited for the decrease in IPO’s, including: (i) compliance costs and risk related to regulations, including Sarbanes-Oxley and Dodd-Frank; (ii) changes in equity market structure, such as decimalization, fragmentation of the market and a decline in small and mid-sized investment banks; (iii) nonfinancial disclosure requirements based on social and political issues; (iv) shareholder litigation risk; (v) shareholder pressure to prioritize short-term returns over long-term growth; (vi) inadequate oversight and accountability of proxy advisor firms; and (vii) lack of research coverage for smaller public companies. At the same time, the availability of private equity funds has increased.

The Treasury Department’s recommendations include numerous measures to encourage IPO’s, including eliminating duplicative requirements, liberalizing pre-initial public offering communications (testing the waters), and removing non-material disclosure requirements. he Report makes several recommendations to assist all public companies, including amending the $2000 holding requirement for shareholder proposals and amending resubmission thresholds for repeat shareholder proposals.

Removal of Non-Material Disclosure Requirements

Materiality is an objective standard meant to provide disclosure that would be important to a “reasonable investor” as opposed to a subjective standard meant to serve varied special interest groups. However, Dodd-Frank added special interest disclosure requirements, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Treasury Report notes that the securities laws are not equipped to deal with social issues and that requiring such disclosures for public companies and not private companies not only undermines the overall social aspect of the goals but creates an incentive to remain private.

The Treasury Report recommends eliminating each of these disclosure requirements (conflict minerals, mine safety, resource extraction and pay ratio). I note that the Financial Choice Act eliminates these provisions as well. See HERE.

Eliminate Duplicative Disclosures

The Treasury Report recommends that the SEC proceed to amend Regulation S-K to eliminate duplicative, overlapping, outdated or unnecessary disclosures. The Report mentions that the SEC has been working on this, but doesn’t give real credit to the progress made. I’ve written about the SEC Disclosure Effectiveness Initiative on numerous occasions, including a review of the October 11, 2017 proposed rule amendment to simplify and modernize disclosure requirements (see HERE).

Permit Additional Pre-IPO Communications

Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. Communications made by the company during the IPO process, beginning with the pre-registration filing period, depending on the mode and content, result in violations of Section 5 of the Securities Act. Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.” For a more complete discussion of allowable communications during the IPO process, see HERE.

In April 2012, the JOBS Act was enacted which created emerging growth companies (EGC’s) and provided provisions to allow EGC’s to communicate with qualified institutional buyers (QIB’s) and institutional accredited investors during the pre-filing period. The JOBS Act also allows EGC’s to file confidential registration statements with the SEC. It is thought that testing the waters, together with the ability to file a confidential registration statement, reduces the risk of an IPO by allowing a company to gauge investor interest without having exposed its financial and business information to the public and competitors.

On June 19, 2017, the SEC expanded to the ability to file confidential registration statements to all companies completing an IPO and for some follow-on secondary offerings (see HERE). The Treasury Report recommends that all companies be allowed to test the waters with QIB’s and institutional accredited investors.

Not only do I agree with this recommendation, but I think it should be taken one step further and that testing the waters, to the extent allowed in a Regulation A offering, should be allowed for all companies completing an initial IPO under a certain dollar limit such as $100 million. Regulation A allows for pre-filing and pre-qualification indications of interest as long as no funds are solicited or accepted and proper disclaimers are provided. Regulation A does not limit solicitation recipients and all forms of solicitation and advertising are permitted, subject to the disclaimer requirements and antifraud provisions.

One of the SEC and regulator concerns with gun jumping is that it will create an illusory market interest or prime the market in an unsustainable fashion. One of the reasons why such solicitation is allowed in a Regulation A offering is that it is thought that companies engaging in such offerings, with a high end limit of $50 million, will be smaller and less likely to create overwhelming market interest. In addition, with the offering limitation, it is less likely that the offering marketing will result in an unsustainable initial market price.

Just as all companies can now file confidential registration statements, I think all companies should be allowed to engage in public test-the-waters communications, subject to investor protections through disclaimers, rules against accepting funds, requiring the delivery of a filed prospectus once filed, and subject to offering dollar limitations.

Shareholder Rights and Dual Class Stock

Generally corporate governance and shareholder rights are a matter of state law. Under state law, a corporation may have multiple classes of stock with differing rights, including voting rights. A class of stock may have voting control, regardless of the number of shares or holders of public or common stock.

The Treasury Report recommends that corporate governance, including stock classes, remain under state law. I agree. In fact, I think the Report only addresses this topic because it has been debated recently, especially following the Snapchat IPO, whose public offering only included non-voting stock.

Shareholder Proposals

Exchange Act Rule 14a-8 allows shareholders to include proposals in a company’s proxy materials. The rule requires the company to include the proposal unless it falls within a list of allowable exclusions and provided that the shareholder follow the procedural requirements. To submit a proposal, a shareholder must have held, for at least one year, either (i) company securities with a value of $2,000 or more, or (ii) at least 1% of the outstanding voting securities.

The Treasury Report states that “According to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”

Shareholder proposals are an oft-debated topic as they cost companies tens of millions of dollars and significant time and management resources. The SEC often issues guidance on proposals, including recently in November 2017, about which I will write more in the future. Prior guidance was published in January 2015 (see HERE).

The Treasury Report recommends that the $2,000 holding requirement, which was instituted over 30 years ago, be substantially increased, and adding additional eligibility requirements. The Treasury Report also recommends substantial changes to the resubmission thresholds.

Smaller Public Companies

Smaller public companies face additional challenges, including just by virtue of complying with regulatory requirements with fewer economic and human resources. Furthermore, institutional investors generally favor invest larger companies.

The Treasury has identified opportunities to ease challenges for smaller public companies, including amending the definition of a “smaller reporting company” to increase the public float threshold from $75 million to $250 million and increasing scaled disclosure requirements. Moreover, the Report recommends extending the length of time a company may be considered an emerging growth company (EGC) to up to ten (10) years based on revenue and public float thresholds.

The Treasury Department also recognizes that liquidity remains an issue for smaller public companies. In that regard, the Report recommends increasing “tick size” and making changes to the practices at ATS’s (which would include OTC Markets).

Amend the Definition of a Smaller Reporting Company

Currently a smaller reporting company (SRC) is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. SRC’s have the benefit of scaled disclosure requirements and are not required to comply with Sarbanes-Oxley Section 404(b), requiring independent auditor attestation of management’s assessment on internal controls.

Consistent with SEC proposals, the Treasury Report recommends increasing the threshold for an SRC to $250 million of public float. The Report does not mention the revenue threshold. The SEC has proposed rules to amend the definition of a SRC, which rule change is slated for action this year. For a review of the proposed rule amendment, see HERE.

Increase Time to Qualify for Emerging Growth Company Status

An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).

The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process. The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed. For a discussion of EGCs and the impact of losing EGC status, see HERE.

The Treasury Report recommends increasing the time a company may be considered an EGC to up to 10 years.

Research Analyst Rules

In 2003 and 2004, SEC enforcement settlements with some of the major broker-dealers and investment banks required the firms to separate their research analysts from investment banking. The JOBS Act eased restrictions on research analyst communications during the IPO process. In addition, several changes in legislation have been proposed, with many passing either the House or Senate, but not becoming law. Included in that is the Financial Choice Act, which recommended expanding the exclusion of research reports from the definition of an offer for or to sell securities under the Securities Act.

The Treasury Report recommends a complete overhaul of the rules related to research reports, including harmonizing the 2003 and 2004 enforcement settlements within those new rules.

Regulation A/A+ Amendments

Like research reports, multiple changes in legislation have been proposed, and passed either the House or Senate, including the Financial Choice Act, which would increase the limits for Regulation A to $75 million. Additionally, there have been many proponents, including myself, who advocate for allowing companies that are subject to the Exchange Act reporting requirements to use Regulation A. See HERE for a discussion on efforts in this regard.

Supporting Regulation A, the Treasury Report recommends expanding the eligibility to use Regulation A to include Exchange Act reporting companies and increasing the Tier 2 offering limits to $75 million.

Encouraging Private Funding

Being public is not the right choice for all companies, especially earlier-stage entities, and as such, the Treasury Report discusses the state of private equity and ways to encourage private funding and access to capital for these vital companies as well. In an effort to support private capital-raising efforts, the Report makes recommendations for the modification of the “accredited investor” definition, creating a regulatory structure for finders, and modifying rules for private equity funds, including allowing more investments by unaccredited investors under Rule 506.

Regulation of Finders

The regulation of finders, or lack thereof, has been a topic I have written about many times, and is one of the most deficient areas of guidance in the federal securities laws. I have been vocal about my recommendations, including that I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. For a review of the SEC Advisory Committee on Small and Emerging Companies recommendations related to finders, and a discussion of my own views, see HERE.

The Treasury Report recommends that the SEC, FINRA and states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions. The report generally suggests a “broker-dealer lite” structure; however, it makes no specific recommendations and anything broker-dealer-related will likely not resolve the issues or fix this broken area of the system.

Increase Eligible Investors in Regulation D Offerings

The definition of an accredited investor is another relevant topic to our private (and public) capital markets. On December 18, 2015, the SEC issued a report on the definition of an “accredited investor” and it is expected that new proposed rules amending the definition will be issued this year. For a review of the SEC report and more information on the background of the definition of an accredited investor, see HERE.

The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation. Generally, natural persons can qualify as an accredited investor if they have a net worth of at least $1 million, excluding their primary residence, or have income of at least $200,000 ($300,000 together with a spouse) for each year for the last two years with a reasonable expectation to continue such income in the current year. Certain legal entities with over $5 million in assets are accredited investors, while certain regulated entities such as banks, broker-dealers, registered investment companies, BDC’s, and insurance companies are automatically designated as accredited investors.

The Treasury Report recommends expanding the definition of an accredited investor to include additional sophisticated investors, including, for example, registered representatives working with broker-dealers, investment advisors, financial professionals, and investors that are advised as to the merits and risks by a licensed individual.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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

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« The CFTC And Cryptocurrencies The Senate Banking Committee’s Hearing On Cryptocurrencies »

The CFTC And Cryptocurrencies

Posted by Securities Attorney Laura Anthony | February 20, 2018 Tags: blockchain, CFTC, CFTC Chairman J. Christopher Giancarlo, CFTC Compliance Requirements, DLT/Blockchain and ICO’s, SEC Chairman Jay Clayton, The CFTC And Cryptocurrencies, Virtual Currencies, Virtual Currency

The SEC and U.S. Commodity Futures Trading Commission (CFTC) have been actively policing the crypto or virtual currency space. Both regulators have filed multiple enforcement actions against companies and individuals for improper activities including fraud. On January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo published a joint op-ed piece in the Wall Street Journal on the topic.

Backing up a little, on October 17, 2017, the LabCFTC office of the CFTC published “A CFTC Primer on Virtual Currencies” in which it defines virtual currencies and outlines the uses and risks of virtual currencies and the role of the CFTC. The CFTC first found that Bitcoin and other virtual currencies are properly defined as commodities in 2015. Accordingly, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

The role of the CFTC is substantially similar to the SEC with a mission to “foster open, transparent, competitive and financially sound markets” and to “protect market users and their funds, consumers and the public from fraud, manipulation and abusive practices related to derivatives and other products subject to the Commodity Exchange Act (CEA).” The definition of a commodity under the CEA is as broad as the definition of a security under the Securities Act of 1933, including a physical commodity such as an agricultural product, a currency or interest rate or “all services, rights and interests in which the contracts for future delivery are presently or in the future dealt in” (i.e., futures, options and derivatives contracts).

Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets. At times the jurisdiction of the two regulators overlaps, such as related to swap transactions (see HERE). Furthermore, while there are no SEC licensed securities exchanges which trade virtual currencies or any tokens, there are several commodities exchanges that trade virtual currency products such as swaps and options, including the TeraExchange, North American Derivatives Exchange and LedgerX.

The Commodity Exchange Act would prohibit the trading of a virtual currency future, option or swap on a platform or facility not licensed by the CFTC. Moreover, the National Futures Association (NFA) is now requiring member commodity pool operators (CPO’s) and commodity trading advisors (CTA’s) to immediately notify the NFA if they operate a pool or manage an account that engaged in a transaction involving a virtual currency or virtual currency derivative.

The CFTC refers to the IRS’s definition of a “virtual currency” and in particular:

A virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments it operates like real currency but it does not have legal tender status in the U.S. Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as a convertible virtual currency. Bitcoin is one example of a convertible virtual currency.

I note that neither the CFTC’s definition of Bitcoin as a commodity, nor the IRS’s definition of a virtual currency, conflicts with the SEC’s position that most cryptocurrencies and initial cryptocurrency offerings today are securities requiring compliance with the federal securities laws. The SEC’s position is based on an analysis of the current market for ICO’s and the issuance of “coins” or “tokens” for capital raising transactions and as speculative investment contracts. In fact, a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. For example, an offering of XYZ token for the purpose of raising capital to build a software or blockchain platform or community where XYZ token can be used as a currency would rightfully be considered a securities offering that needs to comply with the federal securities laws. However, when the XYZ token is issued and can be used as a form of currency, it would become a commodity. Furthermore, the bundling of a token securities offering to include options or futures contracts may implicate both SEC and CFTC compliance requirements.

The CFTC primer gives a little background on Bitcoin, which was created in 2008 by a person or group using the pseudonym “Satoshi Nakamoto” as an electric payment system based on cryptographic proof allowing any two parties to transact directly without the need for a trusted third party, such as a bank or credit card company. Bitcoin is partially anonymous, with individuals being identified by an alphanumeric address. Bitcoin runs on a blockchain-decentralized network of computers and uses open-source software and “miners” to validate transactions through solving complex algorithmic mathematical equations.

A virtual currency can be used as a store of value; however, virtual currencies are not a yield asset in that they do not generate dividends or interest. Virtual currencies can generally be traded with resulting capital gains or losses. The CFTC, like all regulators, points out the significant speculation and volatility risk. The CFTC reiterates the large incidents of fraud involving crypto marketplaces. Furthermore, there is a significant cybersecurity risk. If a “wallet” holding cryptosecurities is hacked, they are likely gone without a chance of recovery.

Although many virtual currencies, including Bitcoin, market themselves as a payment method, the ability to utilize Bitcoin and other virtual currencies for everyday goods and services has not yet come to fruition. In fact, the trend toward Bitcoin being a regularly accepted payment has seemed to have gone the other way, with payment processor Stripe, tech giant Microsoft and gaming platform Steam discontinuing Bitcoin support due to lengthy transaction times and increased transaction failure rates.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICO’s, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.

For an update on state distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

To read about the SEC and CFTC joint statements and the Wall Street Journal op-ed article, see HERE.

The Author

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

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« The New Auditor Report The Treasury Department Report To The President On Capital Markets »

The New Auditor Report

Posted by Securities Attorney Laura Anthony | February 13, 2018 Tags: CAM, CAM Requirements, CAMs, PCAOB, SEC, The Auditor’s Report, The New Audit Report Rules, The New Auditor Report

In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. Among other additions, an audit report will need to include critical audit matters (CAMs) and disclosure the tenure of the auditor. The new rule and requirements related to audit reports are significant as the audit report is the document in which the auditor itself communicates to the public and investors.

The new standard will require auditors to describe CAMs that are communicated to a company’s audit committee. Critical audit matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.

The new audit report standard also adds information related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks.

The process in finalizing the rule has been lengthy, having begun in 2010 in response to investor- and public-initiated comments. Once proposed, the rule went through three rounds of public solicitation for comment. Of particular concern is whether the new requirements will result in increased nuisance shareholder litigation, costing the company and its investors, and whether it will result in a chill on auditor-company communications. In a statement related to the new auditor report, SEC Chairman Jay Clayton expressly addressed this concern, stating:

“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”

As an aside, as with any rule making, SEC rules and regulations can and do result in unintended consequences. This is an issue I’ve raised many times over the years in my blogs, including, for example, the multitude of differences between requirements for smaller reporting companies and emerging growth companies, a topic the SEC is now working on addressing and rectifying. It is great to see Chair Clayton discuss this phenomenon directly and for the rule itself to take measures to monitor and initiate changes based on implementation analysis.

There are certain carve-outs from some of the rule requirements, including the CAM requirements. In particular, the CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans; however, they do specifically apply to smaller reporting companies. Moreover, the rule requires extensive post-implementation review, in light of the potential for negative unintended consequences, and such review could result in changes to the rule itself and its implementation schedule.

The New Audit Report Rules

The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.

The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. A CAM is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”

For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.

The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.

Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed. The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.

The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.

In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.

All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.

The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.

The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.

Effective Dates

All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.

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« The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In The CFTC And Cryptocurrencies »

The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In

Posted by Securities Attorney Laura Anthony | February 6, 2018 Tags: CFTC, cryptocurrencies, SEC, The SEC And CFTC Joint Statements On Cryptocurrencies

On January 19, 2018 and again on January 25, 2018, the SEC and CFTC divisions of enforcement issued joint statements regarding cryptocurrencies. The January 19 statement was short and to the point, reading in total:

“When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.”

The January 25, 2018 statement was issued by SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo and was published as an op-ed piece in the Wall Street Journal. In summarizing the statements, I add my usual commentary and facts and information on this fast-moving marketplace.

Distributed ledger technology, or DLT, is the advancement that underpins an array of new financial products, including cryptocurrencies and digital payment services. Clearly the regulators understand the technological disruption, pointing out that “[S]ome have even compared it [DLT] to productivity-driving innovations such as the steam engine and personal computer.”

The regulators are careful not to discourage the technological advancement or investments themselves but rather are concerned that only those that are sophisticated and can afford a loss, participate. Likewise, unfortunately with every boom comes fraudsters, and investors have to ask the right questions and perform the right due diligence.

Like the dot-com era, of the hundreds (or thousands) of companies popping up in this space, few will survive and investments in those that do not, will be lost. The message from the regulators remains consistent, cautioning investors about the high risks with investments in this new space and stating that “[T]he CFTC and SEC, along with other federal and state regulators and criminal authorities, will continue to work together to bring transparency and integrity to these markets and, importantly, to deter and prosecute fraud and abuse.”

While the initial cryptocurrencies, like bitcoin and ether, were likened to a payment alternative to fiat currencies like the dollar and euro, these alternative currencies are very different. None are backed by a sovereign government, and they lack governance standards, accountability and oversight, reliable reporting of trading, or consistent reporting of price and other financial metrics.

Of course, this is an exciting era of development and Chairs Clayton and Giancarlo know that, stating:

“This is not a statement against investments in innovation. The willingness to pursue the commercialization of innovation is one of America’s great strengths. Together Americans embrace new technology and contribute resources to developing it. Through great human effort and competition, strong companies emerge. Some of the dot-com survivors are the among the world’s leading companies today. This longstanding, uniquely American characteristic is the envy of the world. Our regulatory efforts should embrace it.”

The SEC and CFTC are considering whether the historic approach to the regulation of currency transactions is appropriate for the cryptocurrency markets. Check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC. For example, Coinbase has money transmitting licenses from the majority of states. Gemini is a licensed trust company with the New York State of Financial Services. Furthermore, the Bank Secrecy Act and its anti-money laundering (AML) requirements apply to those in the business of accepting and transmitting, selling or storing cryptocurrencies.

Not a single cyptocurrency trading platform is currently registered by the SEC or CFTC. However, two CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms. In my next blog I will drill down on the CFTC’s regulatory role and position on cryptocurrencies including a discussion of its October 17, 2017 published article, “A CFTC Primer on Virtual Currencies.”

The SEC does not have jurisdiction over transactions involving currencies or commodities; however, where an offering of a cryptocurrency has characteristics of a securities offering, the SEC and state securities regulators have, and have exercised, jurisdiction. In addition to the many SEC enforcement proceedings I have written about, state regulators have likewise been very active in the enforcement arena against those offering cryptocurrency- or blockchain-related investments. The SEC is carefully monitoring the entire marketplace including issuers, broker-dealers, investment advisors and trading platforms. On January 18, 2018, the SEC issued a no-action letter prohibiting the registration under the Investment Company Act of 1940 of U.S. investment funds that desire to invest substantially in cryptocurrency and related products. I will provide further details on this letter in an upcoming blog.

As the boom has continued, many cryptocurrencies are simply being marketed for their potential increase in value on secondary trading platforms, again none of which are licensed by the SEC or CFTC. The utility side of the tokens (if any) has taken a back seat to the craze. Although a few trading platforms are licensed by state regulators as payment processors, many overseas are not licensed by any regulator whatsoever.

As the SEC has been repeating, the op-ed piece again clearly states that “federal securities laws apply regardless of whether the offered security—a purposefully broad and flexible term—is labeled a ‘coin’ or ‘utility token’ rather than a stock, bond or investment contract. Market participants, including lawyers, trading venues and financial services firms, should be aware that we are disturbed by many examples of form being elevated over substance, with form-based arguments depriving investors of mandatory protections.”

While attending the North American Bitcoin Conference in Miami a few weeks ago, I was amazed at the thousands of attendees and companies. I go to a lot of financial conferences and had never seen anything like this. I understand the concerns of the regulators and the need to issue constant warnings. While I met some extremely smart people and learned about great companies that could have hugely successful futures, many others were obviously trying to ride a boom, with nothing to offer. They lacked a strong management team, technological know-how, engineers and programmers, a real business, a real plan, or anything to support lasting value of the token issued in their ICO, or being touted for a future issuance. The sole opportunity for an investor was a potential increase in secondary trading value, which was being propped up with hundreds of thousands of dollars (raised in the ICO) of marketing, including crews of people paid to talk about the token on chat boards such as Telegram.

Like many practitioners, I am fascinated with the technology and disruption it will bring to many aspects of our lives including the arenas of corporate finance and trading markets, and have even invested.

International Organization of Securities Commissions Issues Warning on ICO’s

On January 18, 2018, the Board of the International Organization of Securities Commissions (“IOSCO”) issued a warning on ICO’s including the high risk associated with these speculative investments and concerns about fraud. The IOSCO is the leading international policy forum for securities regulators and is a recognized standard setter for securities regulation. The group’s members regulate more than 95% of the world’s securities markets in more than 115 jurisdictions.

The statement from IOSCO points out that ICO’s are not standardized and their legal and regulatory status depends on a facts and circumstances analysis. ICO’s are highly speculative and there is a chance that an entire investment will be lost. The warning continues: “[W]hile some operators are providing legitimate investment opportunities to fund projects or businesses, the increased targeting of ICOs to retail investors through online distribution channels by parties often located outside an investor’s home jurisdiction — which may not be subject to regulation or may be operating illegally in violation of existing laws — raises investor protection concerns.”

The IOSCO has provided its members with information on approaches to ICO’s and related due diligence. The IOSCO has also established an ICO Consultation Network with its members to continue the discussion.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.

For an update on state distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

The Author

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

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« SEC Issues C&DI On Use Of Non-GAAP Measures The New Auditor Report »

SEC Issues C&DI On Use Of Non-GAAP Measures

Posted by Securities Attorney Laura Anthony | January 30, 2018 Tags: Definition of non-GAAP financial measure and exclusions, New C&DI, Refresher on Regulation G and Item 10(e) of Regulation S-K, Regulation G and Item 10(e) requirements

On October 17, 2017, the SEC issued two new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

My prior two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE and HERE.

GAAP continues to be criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number. I expect continued friction between the SEC’s enforcement of GAAP requirements and a company’s need to present non-GAAP numbers to satisfy the investment community.

New C&DI

The first of the new C&DI addresses whether forecasts provided to a financial advisor in relation to a business combination transaction would be considered non-GAAP financial measures requiring compliance with applicable rules. In particular, the SEC confirms that providing forecasts to a financial advisor in connection with a business combination transaction would not be considered non-GAAP financial measures.

Item 10(e)(5) of Regulation S-K and Rule 101(a)(3) of Regulation G provide that a non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, SEC rules, or pursuant to specific government regulations or SRO rules that are applicable to a company. Accordingly, financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (i) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (ii) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

Although the disclosure of projections to a financial advisor in a business combination transaction does not implicate rules related to non-GAAP financial measures, that same disclosure in a registration statement, proxy statement or tender offer statement would need to comply with Regulation G and Item 10(e) of Regulation S-K.

In the second new C&DI, the SEC addresses the limited exemptions from the non-GAAP rules for communications relating to business combination transactions. In particular, Rule 425 of the Securities Act requires that certain business combination communications, that would not be considered solicitation materials in other contexts, be filed with the SEC, generally as part of a registration statement on Form S-4, proxy statement or tender offer statement. Likewise, limited solicitations under Exchange Act Rule 14a-12 and 14d-2(b)(2) that are made prior to filing a proxy statement are exempted from the non-GAAP measure requirements.

Other than the limited exemptions set forth in the rules listed above, and communications to a financial advisor, business combination communications must comply with Regulation G and Item 10(e) of Regulation S-K related to non-GAAP financial measures, including a reconciliation to comparable GAAP numbers and the reasons for presenting the non-GAAP numbers.

Refresher on Regulation G and Item 10(e) of Regulation S-K

Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K.

Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

Definition of non-GAAP financial measure and exclusions

A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

Regulation G and Item 10(e) requirements

Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading.

As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.

« Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI) The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In »

SEC and NASAA Statements on ICOs and More Enforcement Proceedings

Posted by Securities Attorney Laura Anthony | January 16, 2018 Tags: cryptocurrencies, DAO, ICO, ICOs, Initial Coin Offerings, NASAA, SEC, SEC and NASAA Statements on ICOs, SEC and NASAA Statements on ICOs and More Enforcement Proceedings

The message from the SEC is very clear: participants in initial coin offerings (ICO’s) and cryptocurrencies in general need to comply with the federal securities laws or they will be the subject of enforcement proceedings. This message spreads beyond companies and entities issuing cryptocurrencies, also including securities lawyers, accountants, consultants and secondary trading platforms. Moreover, the SEC is not the only watchdog. State securities regulators and the plaintiffs’ bar are both taking aim at the crypto marketplace. Several class actions have been filed recently against companies that have completed ICO’s.

After a period of silence, on July 25, 2017, the SEC issued a Section 21(a) Report on an investigation and related activities by the DAO, with concurrent statements by both the Divisions of Corporation Finance and Enforcement. On the same day, the SEC issued an Investor Bulletin related to ICO’s. For more on the Section 21(a) Report, statements and investor bulletin, see HERE. Since that time, the SEC has engaged in a steady flow of enforcement proceedings and statements on the subject.

The DAO report centered on a traditional analysis to determine whether a token is a security and thus whether an ICO is a securities offering. In particular, the nature of a digital asset (“coin” or “token”) must be examined to determine if it meets the definition of a security using established principles, including the Howey Test. See HERE for a discussion on the Howey Test. The report also pointed out that participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements, and that securities exchanges providing for trading must register unless an exemption applies.

On November 1, 2017, the SEC issued a warning to the public about the improper marketing of certain ICO’s, token offerings and investments, including promotions and endorsements by celebrities. Celebrities, like any other promoter, are subject to the provisions of Section 17(b) of the Securities Act, including the requirement to disclose the nature, scope, and amount of compensation received in exchange for the promotion. For more on Section 17(b) and securities promotion in general, see HERE.

On December 11, 2017, SEC Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings. In that statement, Clayton drilled down on the sudden rise of “non-security” ICO’s, now being referred to as “utility tokens,” clearly conveying the message that if a token has attributes of a security, it will be governed as a security. To make the message even clearer, also on December 11, 2017, the SEC halted the ICO by Munchee, Inc., disagreeing with Munchee’s statements and conclusions that its token was a “utility token” and not a security.

This was not the first ICO halt. On December 4, 2017, the SEC halted the ICO by PlexCorps, including outright fraud with the claims of an unregistered offering. The SEC has also taken aim at companies that are in the crypto space in general, having halting the trading of The Crypto Company on December 19, 2017 after a 2,700% stock price increase. This was not the first trading halt, either. Others include American Security Resources Corp, halted on August 24, 2017; First Bitcoin Capital, halted on August 23, 2017; CIAO Group, halted on August 9, 2017; and Sunshine Capital on June 7, 2017.

More recently, on January 5, 2018, the SEC halted the trading of UBI Blockchain Internet, Ltd. citing questions regarding the accuracy of information in SEC filings and concerns about market activity, which was the epitome of an unexplained stock surge.

On August 28, 2017, the SEC issued an investor alert warning about public companies making ICO-related claims. The alert specifically mentioned the trading suspensions and warned that ICO claims could be a sign of a pump-and-dump scheme.

On January 4, 2018, Chair Clayton issued another statement, this time joined by Commissioners Kara Stein and Michael Piwowar, commenting on the North American Securities Administrators Association (NASAA) statement made the same day. The NASAA is a group comprised of state securities regulators, which, among other functions, acts as a communication arm for the individual state regulators on important marketplace topics.

Jay Clayton’s December 11, 2017 Statement

Jay Clayton begins his December 11, 2017 statement with an acknowledgement of the “tales of fortunes made and dreamed to be made,” which is a perfect description of ICO mania. Keeping with the SEC theme under Clayton, he then addresses ICO considerations for Main Street investors. In addition to warning of fraud and misrepresentations, ICO’s and cryptocurrency trading is a national marketplace; invested funds may quickly move overseas. Furthermore, the SEC may not be able to gain jurisdiction or pursue bad actors or lost funds in other countries.

The fact is that as of today, no cryptocurrency offerings have been registered with the SEC. Although Jay Clayton doesn’t talk about what registration will really mean for an ICO, I note that, since registration is the process of ferreting out disclosures, it will force an entity issuing an ICO to be clear about the usefulness of its token, if any, and the risk factors not only associated with its token, but the marketplace as a whole. My firm is currently working on registration statements as well as private offering documents for ICO’s and blockchain technology entities and the complexity of this new industry and technology, and uncertainty associated with legalities (including not only securities matters, but the implication of swap and commodity transactions, tax ramifications, intellectual property matters, etc.) is confounding to even the best and brightest.

The importance of the involvement and efforts by market professionals is not lost on the SEC. In the beginning, many ICO’s, believing that this new investment vehicle was somehow not a security and therefore outside the parameters of the securities laws and SEC jurisdiction, forewent the advice of legal counsel and other professionals. Now that this belief has been rectified, in his statement, Jay Clayton reminds market professionals of their gatekeeping duties. Chair Clayton states, “[I] urge market professionals, including securities lawyers, accountants and consultants, to read closely the investigative report we released earlier this year (the “21(a) Report”) and review our subsequent enforcement actions.”

He continues: “[F]ollowing the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security….. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.” The bold emphasis was from the SEC, not added by me. The message could not be clearer.

Attorneys and other professionals are not the only groups that the SEC is taxing with gatekeeper responsibilities. Jay Clayton adds: “[I] also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of ‘scalping,’ ‘pump and dump’ and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.” Again, the bold emphasis is not mine. Although Jay Clayton does not indicate so, I am unaware of any properly licensed secondary market or exchange for the trading of cryptocurrencies at this time. TZero is properly licensed, but not up and functioning as of the date of this blog.

Jay Clayton’s statement is not all negative. He recognizes that ICO’s can be an effective method to raise capital and fund projects. He also recognizes that not all cryptocurrencies are securities. A specific example would be an in-app game with token purchases that can only be used to reach another level. However, Clayton points out that “[B]y and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

The Division of Enforcement has been instructed to vigorously police the ICO marketplace. Finally, the SEC encourages investors to conduct thorough due diligence before making an ICO investment. In that regard, he provides a list of basic questions that should be asked and considered before making any investment.

January 4, 2018 Statements by Chair Clayton and Commissioners Kara Stein and Michael Piwowar

On January 4, 2018, Chair Clayton, Commissioners Kara Stein and Michael Piwowar issued a statement commending the North American Securities Administrators Association’s (NASAA) own statement made the same day addressing concerns with ICO’s and cryptocurrencies. The NASAA is a group comprised of state securities regulators.

The SEC’s top brass specifically point out that cryptocurrencies are not, in fact, currencies in that they are not backed or regulated by sovereign governments and seem to be focused on a method of capital raising as opposed to mediums of exchange. Reiterating its other messaging, the SEC reminds the public that offerings and their participants must comply with the state and federal securities.

NASAA Statement on Cryptocurrencies and ICO’s

NASAA begins its statement with a consistent theme to the SEC, warning Main Street investors to be cautious about investments involving cryptocurrencies. NASAA, also like the SEC, encourages potential investors to conduct due diligence and ask questions before making an ICO (or any) investment.

NASAA includes a laundry list of risks and issues with ICO’s and crypto-related investments. NASAA points out that unlike FIAT or traditional currencies, cryptocurrencies have no physical form and typically are not backed by tangible assets (though I note that this is a void that is quickly being addressed by new tokens backed by physical assets and commodities).

Furthermore, cryptocurrencies are not insured, not controlled by a central bank or other governmental authority, are subject to very little if any regulation, and cannot be easily exchanged for other commodities. Cryptocurrencies are susceptible to breaches, hacking and other cybersecurity risks, including on both the ICO issuer side and the investor side through direct breaches into a wallet or other digital storage. ICO’s are a global investment vehicle and, as such, US regulators may have no ability to recover lost funds or pursue bad actors. Likewise, private civil proceedings could prove futile.

Moreover, the high volatility and high risk of cryptocurrency investments make them unsuitable for most investors. In both its statement and a very simple investor-directed animated video on the subject, NASAA clearly states that investors could lose all of their money in a crypto-related investment.

Regulators almost unanimously believe that cryptocurrencies involve a high risk of fraud. NASAA includes a list of obvious red flags, including guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy immediately, and unlicensed sellers.

NASAA now lists ICO’s and cryptocurrency-related investment products as an emerging investor threat for 2018.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.

For an update on state distributed ledger technology and blockchain regulations, see HERE.

The Author

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

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« The SEC’s 2017 Enforcement Priorities And Results Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI) »

The SEC’s 2017 Enforcement Priorities And Results

Posted by Securities Attorney Laura Anthony | January 9, 2018 Tags: 2017, SEC, The SEC's 2017 Enforcement Priorities And Results

No more broken windows! In a series of speeches by various top brass at the SEC followed by the publication of the SEC Enforcement Division 2017 Report on results and priorities, the SEC has confirmed both directly and through its actions that the era of “broken windows” enforcement is over. The broken windows policy was first shepherded by Mary Jo White in 2013 and was one in which the SEC committed to pursue infractions big and small and to investigate, review and monitor all activities. The idea was that small infractions lead to bigger infractions, and the securities markets have had the reputation that minor violations are overlooked, creating a culture where laws were treated as meaningless guidelines.

Michael Piwowar has been a critic of broken windows since its inception. In a speech to the Securities Enforcement Forum in 2014, Mr. Piwowar stated, “[I]f every rule is a priority, then no rule is a priority.” He continued, “[I]f you create an environment in which regulatory compliance is the most important objective for market participants, then we will have lost sight of the underlying purpose for having regulation in the first place. Rather than enabling vital and important economic activity, we will have unnecessarily shackled it – and our country will be far worse off from the absence of such activity.”

Given the power to make a change, Commissioner Michael Piwowar and Chair Jay Clayton have signaled an adjustment in enforcement priorities throughout the year. In February 2017, then acting Chair Michael Piwowar revoked the subpoena authority from SEC staff, leaving the Division of Enforcement with the sole authority to approve a formal order of investigation and issue subpoenas. Mr. Piwowar had been a vocal critic of both the staff subpoena power and the manner in which the power was created since its inception. He has also been a vocal critic of the SEC’s investigative power, believing it has too much power and too little oversight. For more on the SEC subpoena power, Mr. Piwowar’s views, and the early stage setting for the current enforcement priorities, see HERE.

In his October 4, 2017 testimony on the SEC’s Agenda, Operations and Budget before the Committee on Financial Services, Chair Jay Clayton reiterated his commitment to rooting out bad actors and fraud, including pump-and-dump schemes, insider trading, and serious reporting and disclosure violations. Certainly, a review of published enforcement proceedings has illustrated that commitment. Mr. Clayton also laid the groundwork for more focused enforcement, stating, “I have asked the Division of Enforcement to evaluate regularly whether we are focusing appropriately on retail investor fraud and investment professional misconduct, insider trading, market manipulation, accounting fraud and cyber matters. I believe our Main Street investors would want us to focus on these areas.”

In July 2017, Chair Clayton announced a top priority and philosophy of protecting “Main Street investors,” which buzzwords are now repeated often in SEC communications, including press releases and speeches.

On October 26, 2017, Steven Peikin, co-director of the SEC Division of Enforcement, confirmed the death knell for the broken windows policy. In a speech, Mr. Peiken told conference attendees that the SEC would “have to be selective and bring a few cases to send a broader message rather than seep the entire field.” Mr. Peiken also suggested stronger communication between the Division of Enforcement and investigative targets, and an environment that fosters cooperation. In that regard, the SEC should communicate the benefits of cooperation and specifically how a company can merit cooperation credit. In that regard, the SEC will again encourage self-reporting and remediation, a prior policy that lost its wind in the 2001 Enron crisis.

Clearly, the change is driven by more than philosophy. The SEC budget has effectively been frozen, and more money needs to be spent on cybersecurity matters than ever before. See HERE. The SEC Division of Enforcement could have at least 100 fewer investigators and supervisors over the next year, as those lost to attrition will not be replaced.

Mary Jo White’s policy of forcing admissions of guilt in enforcement settlements may also have reached its pinnacle. In June 2013, the SEC announced that it would require that a settling party admit wrongdoing as part of a settlement to act as a further deterrent and bolster public accountability. In addition to reputational damage, this policy had legal evidentiary significance that could be used in civil matters, including shareholder lawsuits. For more on this, see HERE.

In his October 2017 speech, Mr. Piekin talked about the admissions policy, stating, “I think when people resolve cases with the commission [and] neither admit nor deny but agree to all the points of relief, I don’t think most people in the world say, ‘Boy, they really got away with that.’” That doesn’t mean the policy will disappear, but it may revert to its prior reiteration, where only those with related criminal cases will be asked for a guilt admission.

Division of Enforcement Annual Report on Results and Priorities

On November 15, 2017, the Division of Enforcement issued its annual report (Annual Report) on results and priorities, reiterating the mission and focus on the protection of Main Street investors. The Annual Report cites five core principles, including: (i) focus on Main Street (retail) investors, including accounting fraud, sales of unsuitable products, pursuit of unsuitable trading strategies, pump-and-dump schemes and Ponzi schemes; (ii) focus on individual accountability to maximize deterrence and prevent recidivists from continuing improper activities; (iii) keeping pace with technological changes, including all cybersecurity matters; (iv) imposing sanctions that support enforcement goals; and (v) constantly assessing the allocation of resources.

The Annual Report reiterates initiatives announced earlier this year, including the new Cyber Unit and Retail Strategy Task Force (see HERE), while confirming its commitment to long-standing enforcement goals. The top current goals include risks posed by cyber-related misconduct; issues raised by the activities of investment advisers, broker-dealers, and other registrants; financial reporting and disclosure issues involving public companies; and insider trading and market abuse.

During fiscal year ended (FYE) September 2017, the SEC brought 754 enforcement proceedings, returned $1.07 billion to harmed investors and obtained judgment and orders for more than $3.789 billion in disgorgement and penalties. During FYE ended September 2016, the SEC brought 868 actions and obtained judgements and orders for more than $4 billion in disgorgement and penalties. For more on the 2016 report, see HERE.

Broken down by type of case, the most cases were brought related to issuer reporting violations including audit and accounting problems, followed by securities offerings, then investment advisor or investment company violations, then broker-dealer violations, followed by insider trading, then market manipulation. A number of cases were also brought for public finance abuse, FCPA violations and transfer agent issues.

Interestingly, the SEC suspended trading in 309 companies in FYE 2017, a 55% increase from 2016. Trading suspensions are generally related to market manipulation and microcap fraud, and are a very successful tool to stop these problems in their tracks. Asset freezes were pretty even in both years, with 35 court-ordered asset freezes in 2017 and 33 in 2017. Likewise, the imposition of bars and suspensions has remained a constant, with 625 in 2017 and 650 in 2016.

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The Investment Adviser Advertising Rule

Posted by Securities Attorney Laura Anthony | December 27, 2017 Tags: Advertising Rule, C Office of Compliance Inspections and Examinations, Investment Adviser Advertising Rule, Rule 206(4)-1, The Investment Adviser Advertising Rule, the SEC Office of Compliance Inspections and Examinations

On September 14, 2017, the SEC Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert identifying the most frequent compliance violations to the investment adviser’s advertising rule.

The Advertising Rule

The “Advertising Rule” found in Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”) prohibits an adviser from directly or indirectly publishing, circulating or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading. “Advertising” includes any “notice, circular, letter or other written communicated addressed to one or more persons or any notice or other announcement published or made by radio or television which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

The Advertising Rule specifically prohibits: (i) any advertisement that directly or indirectly refers to any testimonial concerning the adviser or any report or service rendered by the adviser; (ii) an adviser from advertising past specific recommendations that were profitable to any person; (iii) any advertisements claiming that any graph, chart or formula can by itself determine whether to buy or sell a security; and (iv) advertisements that offer purportedly free reports, analysis or services.

In addition to the Advertising Rule itself, guidance on adviser advertising can be found in SEC-issued guidance updates, opinions and no-action letters, and settled or adjudicated court and administrative proceedings.

Most Frequent Advertising Rule Violations

The OCIE risk alert identified the following most frequent violations of the Advertising Rule:

Misleading Performance Results. The OCIE often observed advertisements with misleading performance results. As an example, any advertisement of results that do not deduct the advisory fee from the presented performance, is deemed misleading. As another example, advertisements that compared results from a particular benchmark were often misleading as the parameters or strategies involved in the two comparisons were often materially different. Finally, hypothetical and back-tested performance results could be misleading where information on how returns were derived or other material information was not included.

Misleading One-on-One Presentations. An example of a misleading one-on-one presentation would be where the adviser advertised performance results gross of fees without necessarily additional material disclosures. Again, the mere failure to disclose that advisory fees had not been deducted from an advertisement would also be misleading.

Misleading Claim of Compliance with Voluntary Performance Standards. The OCIE staff observes cases in which an adviser claims compliance with voluntary performance standards, when in fact, they were not compliant.

Cherry-Picked Profitable Stock Selections. An advertisement that cherry-picks profitable stock selections without a balanced presentation, including disclosure related to unprofitable selections, is misleading.

Misleading Selection of Recommendations. The OCIE staff often finds adviser advertisements that include past specific investment recommendations in a misleading way. In the TCW Group no-action letter, the SEC specifically found that it was not misleading to include five or more best-performing holdings or stock picks, as long as an equal number of worst performers were also disclosed. Moreover, an adviser would have to also include other materially relevant information about its strategy. In the Franklin no-action letter, the SEC staff allowed advertisements including past specific performance results that used consistently applied, objective, non-performance based selection criteria, as long as the adviser included certain disclosures such as that the included results were not all results or all securities purchased or sold, and did not include profits related to specific recommendations. Many advisers fail to follow the guidance in these no-action letters.

Compliance Policies and Procedures. Many advisers do not have adequate compliance policies and procedures to prevent deficient advertising practices. Adequate procedures would include a process for reviewing and approving advertisement materials prior to publication or dissemination; determining parameters for inclusion in performance calculations; and confirming the accuracy of performance results.

OCIE Touting Initiative

In 2016 the OCIE launched a Touting Initiative to examine adviser advertisements that touted awards, ranking lists or professional designations and accolades in their marketing materials. Where an adviser includes third-party rankings or awards in their advertisements, they must include material facts related to the award or ranking, so as not to be misleading, including the date of the award, selection criteria, who created or gave the award or ranking, and whether the adviser paid to be included. Furthermore, the OCIE found that advisers sometimes obtained a ranking or award by providing false information in their application or nomination for the award in the first place. Finally, another commonly found touting violation involved improper client testimonials.

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SEC Advisory Committee On Small And Emerging Companies Holds Final Meeting

Posted by Securities Attorney Laura Anthony | December 19, 2017 Tags: SEC Advisory Committee On Small And Emerging Companies Holds Final Meeting

On September 13, 2017, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) held its final meeting and issued its final report. The Committee was organized by the SEC for a two-year term to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

As the two-year term is expiring, Congress has determined to establish an Exchange Act-mandated, perpetual committee to be named the Small Business Capital Formation Advisory Committee. The SEC is also setting up a new Office of Advocate for Small Business Capital Formation and is actively seeking to fill both the advocate and Committee positions.

The September 13, 2017 Advisory Committee meeting discussed: (i) the auditor attestation report under Section 404(b) of the Sarbanes Oxley Act (“SOX”); (ii) the proposed amendments to the definition of a “smaller reporting company”; (iii) amendments to the definition of an “accredited investor”; (iv) potential updates to modernize Securities Act Rule 701 of the Securities Act related to employee stock compensation from private companies; (v) finders in private placement transaction; (vi) disclosure of board diversity; and (vii) the creation of a new secondary market for accredited investors to trade small-cap equities.

Amendment to Smaller Reporting Company Definition

The Advisory Committee believes that public company disclosure requirements disproportionately burden smaller reporting companies. In July 2015 the Advisory Committee made specific recommendations to the SEC for changes to the definition of a “smaller reporting company” (see HERE). Under the current rules a “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues. Similarly, a company is considered a non-accelerated filer if it has a public float of less than $75 million as of the last day of the most recently completely second fiscal quarter. The Advisory Committee has made the following recommendations:

The SEC should revise the definition of “smaller reporting company” to include companies with a public float of up to $250 million. This will increase the class of companies benefiting from a broad range of benefits to smaller reporting companies, including (i) exemption from the pay ratio rule; (ii) exemption from the auditor attestation requirements; and (iii) exemption from providing a compensation discussion and analysis. I note that the SEC proposed rules conforming to this recommendation and in the most recent meeting urged the SEC to finalize the rule. For more on the SEC proposed rule change, see HERE.

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

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

As an aside, one of the recommendations flowing from the 2016 SEC Government-Business Forum on Small Business Capital Formation is that the definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies.

Amendment to Definition of an Accredited Investor

Previously on June 19, 2016, and in early 2015, the Advisory Committee made specific recommendations for changes to the definition of an “accredited investor.” See here for my prior blog on the subject HERE. The Advisory Committee has reiterated its prior recommendations, including:

The core of prior recommendations remain the same with the added statement that “the overarching goal of any changes the Commission might consider should be to ‘do no harm’ to the private offering ecosystem.”

The SEC should not change the current financial thresholds in the definition except to adjust for inflation on a going-forward basis.

The definition should be expanded to take into account measure of non-financial sophistication, regardless of income or net worth, thereby expanding rather than contracting the pool of accredited investors.

“Simplicity and certainty are vital to the utility of any expanded definition of accredited investor. Accordingly, any non-financial criteria should be able to be ascertained with certainty”; and

The SEC should continue to gather data on this subject and, in particular, what “attributes best encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”

Amendment to Rule 701

The Advisory Committee heard presentations and made recommendations to the SEC to amend Rule 701. Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Exchange Act. The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. However, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701 a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the company must provide the following disclosures to investors within a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors within a reasonable time before the date of the irrevocable election to defer is made.

The Advisory Committee made the following recommendations related to Rule 701:

Eliminate the Requirement that consultants be natural persons. The original limitation was intended to prevent Rule 701 from being used for capital-raising transactions; however, many smaller companies use outside employees or employee rental services that are run through entities. The Advisory Committee believes that this change will bring Rule 701 more in line with the realities of today’s business operations and that other provisions of the rule adequately address the prohibition against improper use of the Rule, such as for capital-raising transactions.

Remove the Rule 701 limits of the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. The Advisory Committee believes that the analysis required by these limits outweigh any benefits.

Increase the $5 million disclosure requirement cap to at least $10 million. Note that bills have now passed both the House and Senate that would increase the cap to $10 million and are expected to be signed by the President in the near future.

Exclude “material amendments” from the calculation of the limits in the Rule. Currently SEC CD&I on the Rule require repriced options to be counted as new grants or sales. However, it is argued that repricing merely keeps options within the intended use of the Rule, i.e., as compensation. Moreover, it is thought that companies avoid repricing when it would be beneficial, to avoid reaching the Rule limits.

Clarify the application of the Rule to Restricted Stock Units (RSU’s). RSU’s are not currently addressed in the Rule. It is recommended that they be treated the same as options. In addition, it is recommended that any disclosure obligations be triggered by exercise or settlement and not the grant itself. Note, however, that a CD&I does include RSU’s under Rule 701 and requires disclosure, and limit analysis, as of the date of grant.

Require disclosure only after the threshold has been exceeded. Currently, expanded disclosure must be provided to any person who receives securities under Rule 701 during the 12-month period in which the company sells securities under Rule 701 with a value over $5 million. As disclosure is required prior to a grant, a company could inadvertently fail to comply with the Rule when it did not properly predict it would reach the cap, or future amendments result in reaching the cap. This is another reason that amendments should be excluded from the cap calculation. Moreover, it was recommended that the disclosure requirements be simplified to require only a current balance sheet and income statement, and only requiring updates upon a material change or once a year.

Clarify timing and delivery requirements for disclosure documents. Currently disclosure is required to be delivered “a reasonable period of time prior to the sale.” It is recommended that disclosure be clearly allowed to be delivered at any time prior to the sale and that “access equals delivery” satisfy deliver requirements. Since Rule 701 only applies to private companies, companies sometimes do, and could be formally allowed to set up data rooms accessible to equity recipients. Note that on November 6, 2017, the SEC issued a new CD&I on the subject which specifically allows a company to implement cyber security safeguards when electronically transmitting or providing disclosure in accordance with Rule 701.

For more on Rule 701, see my blog HERE.

Private Placement Finders

In a repeated and ongoing theme, the Advisory Committee once again recommended that the SEC take action to provide regulatory certainty to finders in private placement transactions. The Advisory Committee has previously made recommendations to the SEC and sought regulatory action on May 15, 2017 and on September 23, 2015. In addition to a plea for any guidance and support, in 2015 the Advisory Committee had made the following specific recommendations:

The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act;

The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level;

The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and

The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

For a review of my ongoing discussion on finder’s fees, see my blog HERE.

Board Diversity

The Advisory Committee believes that board diversity improves competitiveness and creates greater access to capital, more sustainable profits and better shareholder relationships. As such, the Advisory Committee recommends that the SEC amend its current very broad rule on board diversity disclosure to require companies to describe their policies with respect to diversity and to disclose the extent to which their boards are diverse. As with the current rule, the definition of diversity can be left to the company; however, disclosure should include information regarding race, gender and ethnicity.

Market Structure – Secondary Trading

The Advisory Committee recognizes that liquidity is an issue for smaller companies. The Advisory Committee advocates for a new U.S. equity market for the trading by accredited investors in smaller company securities. The Advisory Committee also advocates for federal law preemption over the secondary trading of Tier 2 Regulation A securities. Moreover, the Advisory Committee recommends that the SEC allow for smaller exchange-listed companies to voluntarily choose larger trading increments or tick sizes. It is thought that widening spreads from the current one-penny increments could provide economic incentives that would encourage the provision of trading support to the equity securities of small and mid-cap companies. More flexibility and larger tick sizes could also encourage IPO’s for small companies. For more on the SEC tick size pilot program, see HERE.

Sarbanes-Oxley Section 404(b)

The Advisory Committee has heard presentations on the Sarbanes-Oxley Section 404(b) requirement for an auditor attestation and report on management’s assessment of internal control over financial reporting. Among other things, Section 404(b) of SOX requires companies to include in their annual reports filed with the SEC, an accompanying auditor’s attestation report on the effectiveness of the company’s internal control over financial reporting. In other words, reporting companies must employ their auditor to audit and attest upon their financial internal control process, in addition to the financial statements themselves.

Section 404(b) has been a hot topic recently, with those already or soon to be required to comply almost unilaterally requesting relief, and those that benefit from its application, including accountants and auditors, almost unilaterally touting its benefits. The Financial Choice Act, which is not likely to pass in its complete form, includes a provision that would increase the Rule 404(b) compliance threshold from a $250 million public float to $500 million.

In one Advisory Committee presentation, a representative from a large accounting firm supported Section 404(b) and touted improvements in accounting quality. According to studies, companies that have control audits have fewer restatements, higher valuations and lower costs of debt.

However, in the second presentation by the CEO of a relatively small pre-revenue biotech company, the reality of the onerous cost and effort involved to comply with Section 404(b) was illustrated. The cost of 404(b) compliance took away from R&D, growth, and additional employees, and could add 1% or more to the company’s overall burn rate. That CEO advocated for an exemption from 404(b) for all companies with either a public float under $250 million or annual revenues under $100 million.

The Advisory Committee seems to agree that 404(b) is not necessary or helpful for smaller companies but did not make a specific recommendation as suggested by the biotech CEO. Rather, the Advisory Board has recommended a change in the definition of “accelerated filer” as noted above, which would include a higher threshold for Section 404(b) compliance.

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SEC Publishes Report on Access to Capital and Market Liquidity

Posted by Securities Attorney Laura Anthony | December 13, 2017 Tags: Access to Capital and Market Liquidity, Changes and Trends in Market Liquidity, Changes and Trends in Primary Issuance, SEC Publishes Report on Access to Capital and Market Liquidity

On August 8, 2017 the SEC Division of Economic and Risk Analysis (DERA) published a 315-page report describing trends in primary securities issuance and secondary market liquidity and assessing how those trends relate to impacts of the Dodd-Frank Act, including the Volcker Rule. The report examines the issuances of debt, equity and asset-backed securities and reviews liquidity in U.S. treasuries, corporate bonds, credit default swaps and bond funds. Included in the reports is a study of trends in unregistered offerings, including Regulation C and Regulation Crowdfunding.

This blog summarizes portions of the report that I think will be of interest to the small-cap marketplace.

Disclaimers and Considerations

The report begins with a level of disclaimers and the obvious issue of isolating the impact of particular rules, especially when multiple rules are being implemented in the same time period. Even without the DERA notes that noted trends and behaviors could have occurred absent rule changes or reforms. The financial crisis that resulted in the implementation of Dodd-Frank, necessarily resulted in changes in market trends in and of itself, as did post crisis changes other than Dodd-Frank such as much lower interest rates. Furthermore, observed changes could be a result of numerous other factors such as various regulations (besides the studies Dodd-Frank and JOBS Act), non-regulatory market structure changes and technological advances.

Moreover, five broad economic considerations shaped the DERA analysis. First, capital raising in primary markets and liquidity in secondary markets are inextricably intertwined. There is a direct correlation between the ability to exit investments on the secondary market and the inflow of new investments for primary issuances. Second, alternative credit risk products impact activity and liquidity in bond markets. Third, liquidity is an important characteristic of capital markets, impacting the ability of investors to execute trades of different sizes, quickly and at a low cost. Fourth, although large sample analysis is used to study the markets, this information may not reflect the behaviors of smaller market segments. For example, since the sample size and offering size for companies relying on the JOBS Act provisions is relatively small, and its time of use is relatively short, the DERA declines to reach conclusions regarding future trends related to these offerings. Fifth, regulations that affect one group over another, affect the ability to observe overall changes in market indicators and links to such regulations.

Changes and Trends in Primary Issuance

As I reiterate in many of my blogs, all offers and sales of securities must be either registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or conducted under an exemption from registration. All offerings require disclosure to potential investors with registered offerings requiring detailed disclosures and financial information delineated by regulations, including Regulations S-K and S-X. Companies completing registered offerings become subject to ongoing reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”). For more information on Exchange Act reporting requirements, see HERE.

One of the purposes of exempt offerings is to reduce the burden on companies during the capital-raising process and thereafter. Certainly not all companies can afford, nor should take on the expense of, a registered offering and ongoing SEC reporting requirements. Since exempt offerings require fewer disclosures and have far less regulatory oversight, they are subject to investor limitations, such as accreditation, and for some, offering limits. The investor protection provisions of the exemption claimed must be met to qualify for the exemption from registration.

The JOBS Act, enacted in 2012, was designed to promote registered and exempt offerings. The JOBS Act created emerging growth companies (EGC’s), expanded Rule 506 of Regulation D by creating Rule 506(c) allowing general solicitation and advertising in exempt offerings limited to accredited investors, amended Rule 144A to allow general solicitation and advertising, revamped Regulation A completely and created Regulation CF (Title III Crowdfunding). The DERA notes that these changes would be expected to have important effects on the amount of capital being raised and personally, I think that the changes have had a dramatic impact on primary issuances and especially for smaller companies.

As noted above, the DERA is reluctant to directly tie increases in primary market issuances to the JOBS Act because it involves relatively newer regulations (the provisions were enacted over time from 2012 through 2016), and smaller sample sizes for analysis, but the report can’t deny the uptick, noting the increase in activity around its implementation.

The DERA analyzed the primary issuance of debt, equity and asset-backed securities. The DERA reviewed changes in IPO’s, seasoned follow-on offerings, Regulation A and exempt offerings of debt and equity under Regulation D. Total capital formation from the signing of Dodd-Frank into law in 2010 through the end of 2016 was $20.20 trillion, of which $8.8 trillion was raised through registered offerings and the balance through private offerings. The DERA did not find a decrease in total primary market security issuances as a result of Dodd-Frank, though it did find that there was an increase around the implementation of the JOBS Act in 2012.

The DERA did note several trends, including that capital raised through initial public offerings (IPO’s) ebbs and flows over time, reaching highs in 1999, 2007 and 2014 and lows in 2003, 2008 and 2016. The number of small company IPO’s has increased in recent years. IPO’s of less than $30 million increased from 17% of total IPO’s to 22% following passage of the JOBS Act. Although I do not believe that emerging growth companies (EGC’s) are necessarily small companies, more than 75% of IPO’s were by EGC’s in 2016. The use of Regulation A also continues to increase.

In addition, private offerings have increased substantially over the years. The amount raised through private offerings in the period from 2012 through 2016 was more than 26% higher than the amount raised in registered offerings in the same time period.

Changes and Trends in Market Liquidity

The DERA found it more difficult to tie changes in market liquidity to regulatory reform, citing other factors such as the electronification of markets, changes in macroeconomic conditions, and post-crisis changes in dealer risk preferences as influencers.

The report focused on treasuries, corporate bonds, single-name credit default swaps and funds in its liquidity analysis, devoting 191 pages to these topics. A discussion of this areas is beyond the scope of this blog.

The DERA does state that it found no empirical evidence that U.S. Treasury market liquidity deteriorated after regulatory reforms. Trading activity in corporate bond markets has generally improved or remained flat. Furthermore, transaction costs have decreased over the years on whole. Dealers in corporate bond markets have reduced their capital commitment since 2007, which is consistent with the Volcker Rule.

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