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SEC Completes Inflation Adjustment To Civil Penalties

Posted by Securities Attorney Laura Anthony | March 21, 2017 Tags: CEO and CFO Certifications, Civil Monetary Penalties, CMP, Liability for Signing SEC Report, New Adjusted penalty amounts, PCAOB, Proposed SEC Penalties Act, SEC Civil Penalties, SEC Completes Inflation Adjustment To Civil Penalties, Section 302 Certification, Section 906 Certification

The SEC has completed the first annual adjustment for inflation of the maximum civil monetary penalties administered under the SEC. The inflation adjustment was mandated by the Federal Civil Penalties Inflation Adjustment Improvements Act of 2015, which requires all federal agencies to make an annual adjustment to civil penalties.

The SEC adjusted civil penalties that can be imposed under the Securities Act of 1933, Securities Exchange Act of 1934, Investment Company Act of 1040, Investment Advisors Act of 1940 and Sarbanes-Oxley Act of 2002. Under the Sarbanes-Oxley Act of 2002 civil penalties are those imposed by the PCAOB in disciplinary proceedings against its accountant members.

The penalty increase applies to civil monetary penalties (“CMP”). A CMP is defined as “any penalty, fine, or other sanction that: (1) is for a specific amount, or has the maximum amount, as provided by federal law; and (2) is assessed or enforced by an agency in an administrative proceeding or by a federal court pursuant to federal law.”

The following is a table of the new CMP’s.

U.S. Code citation	Civil monetary penalty description	New Adjusted penalty amounts
15 U.S.C. 77h-1(g)(Securities Act Sec. 8A(g))	For natural person	$8,289
	For any other person	82,893
	For natural person / fraud	82,893
	For any other person / fraud	414,466
	For natural person / fraud / substantial losses or risk of losses to others or gains to self	165,787
	For any other person / fraud / substantial losses or risk of losses to others or gain to self	801,299
15 U.S.C. 77t(d)(Securities Act Sec. 20(d))	For natural person	9,054
	For any other person	90,535
	For natural person / fraud	90,535
	For any other person / fraud	452,677
	For natural person / fraud / substantial losses or risk of losses to others	181,071
	For any other person / fraud / substantial losses or risk of losses to others	905,353
15 U.S.C. 78u(d)(3)(Exchange Act Sec. 21(d)(3))	For natural person	9,054
	For any other person	90,535
	For natural person / fraud	90,535
	For any other person / fraud	452,677
	For natural person / fraud / substantial losses or risk of losses to others or gains to self	181,071
	For any other person / fraud / substantial losses or risk of losses to others or gain to self	905,353
15 U.S.C. 78u-1(a)(3) (Exchange Act Sec. 21A(a)(3))	Insider trading – controlling person	2,011,061
15 U.S.C. 78u-2(Exchange Act Sec. 21B)	For natural person	9,054
	For any other person	90,535
	For natural person / fraud	90,535
	For any other person / fraud	452,677
	For natural person / fraud / substantial losses or risk of losses to others	181,071
	For any other person / fraud / substantial losses or risk of losses to others	905,353
15 U.S.C. 78ff(b)(Exchange Act Sec. 32(b))	Exchange Act / failure to file information documents, reports	534
15 U.S.C.78ff(c)(1)(B) (Exchange Act Sec. 32(c)(1)(B))	Foreign Corrupt Practices – any issuer	20,111
15 U.S.C.78ff(c)(2)(B) (Exchange Act Sec. 32(c)(2)(B))	Foreign Corrupt Practices – any agent or stockholder acting on behalf of issuer	20,111
15 U.S.C. 80a-9(d)(Investment Company Act Sec. 9(d))	For natural person	9,054
	For any other person	90,535
	For natural person / fraud	90,535
	For any other person / fraud	452,677
	For natural person / fraud / substantial losses or risk of losses to others or gains to self	181,071
	For any other person / fraud / substantial losses or risk of losses to others or gain to self	905,353
15 U.S.C. 80a-41(e)(Investment Company Act Sec. 42(e))	For natural person	9,054
	For any other person	90,535
	For natural person / fraud	90,535
	For any other person / fraud	452,677
	For natural person / fraud / substantial losses or risk of losses to others	181,071
	For any other person / fraud / substantial losses or risk of losses to others	905,353
15 U.S.C. 80b-3(i)	For natural person	9,054

Further Reading

Background: A Trend Towards Increased Enforcement

The SEC has demonstrated a trend to deter securities law violations through regulations and stronger enforcement including the SEC Broken Windows policy, increased Dodd-Frank whistleblower activity and reward payments, and increased bad-actor prohibitions.

The SEC Broken Windows policy is one in which the SEC is committed to pursue infractions big and small; where they are committed to investigate, review and monitor all activities and not just wait for someone to call and complain or just wait for the big cases. The idea is 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 are treated as meaningless guidelines. So the SEC thinks it is important to pursue all types of wrongdoings—not just big frauds, but negligence-based cases and the enforcement of prophylactic measures as well.

In a speech by Mary Jo White back in October 2013, she announced the policy and the SEC’s enforcement initiative. The policy is modeled after one pursued by the NYPD back in the nineties under Mayor Rudy Giuliani, which resulted in helping to clean up the streets of New York. The analogy is that if a window is broken and someone fixes it, it is a sign that disorder will not be tolerated, but if no one fixes it, the thought is that no one cares and no one is watching so why not break more windows.

Although I believe that the new chairman, commissioners and division chiefs at the SEC will be more business-friendly than their predecessors, I also think enforcement of legal infractions will always remain a priority.

SEC Civil Penalties

Under the law, penalties differ depending on whether the SEC pursues and resolves an action in an SEC administrative proceeding or through a federal court action. In SEC administrative proceedings, there are three tiers of maximum penalties. For most civil violations, the SEC can impose a first-tier money penalty for “each act or omission” violating the securities laws. Second-tier violations involve at least reckless misconduct. Third-tier violations involve fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement that resulted in substantial losses to victims or substantial pecuniary gain to the wrongdoer.

The tiers are the same when a proceeding is heard in federal court, except that the SEC also has the option of seeking, instead, a penalty equal to the wrongdoers’ “ill-gotten gain” from the violation.

According to a Yale Law Journal article published in October 2014, since 2000 penalties have grown 30% year-over-year, compared to only a 3% growth in cases filed. The article points out that Xerox’s 2002 $10 million civil penalty was then “the largest ever levied in a Commission action against a public company for financial fraud,” and that since that time, corporate penalties have skyrocketed. As I’ve noted in several prior blogs, the SEC is very vocal about its use of penalties as a deterrent and its commitment to increase that trend.

Proposed SEC Penalties Act

In July 2015 Congress passed the SEC Penalties Act to increase the per-violation caps. The Act did not move past its initial congressional passage. The Act proposed to increase penalties for first-tier violations to the greater of $10,000 for individuals or $100,000 for entities, or the gross pecuniary gain by the wrongdoer. Second-tier penalties are increased to the greater of $100,000 for individuals or $500,000 for entities, or the gross pecuniary gain by the wrongdoer. Third-tier penalties are increased to the greater of (i) $1 million per violation for individuals or $10 million per violation for entities, (ii) three times the gross pecuniary gain, or (iii) the losses incurred by victims as a result of the violation. The SEC Penalties Act also triples the penalty cap for recidivists who have been held criminally or civilly liable for securities fraud in the last five years.

The Act also provides authority to seek civil penalties for violations of previously imposed injunctions or bars with each violation and each day of continuing violation being considered a separate offense. The penalties under the proposed Act would apply in both administrative and federal court proceedings.

Particular Considerations Related to Administrative Proceedings

The SEC Penalties Act, as written in its beginning form, treats administrative court and federal court proceedings equally. However, the administrative court process is not an equal forum, and based on a barrage of negative attacks, including lawsuits, appeals and media coverage, requires review and attention. An analysis by the Wall Street Journal in 2015 indicated that in the last five years, the SEC has won 90% of cases brought in its own administrative courts but only 69% of cases brought in federal court. Part of the disparity could be that the SEC chooses to settle or drop “losing” claims, but that still leaves a large discrepancy.

Moreover, the Dodd-Frank Act, enacted in 2010, for the first time granted the SEC the authority to impose civil penalties in administrative proceedings against any person the SEC claims violated the securities laws, regardless of whether that person or firm is in the securities business. In other words, Dodd-Frank opened the doors for the SEC’s own administrative proceedings to be just another forum for the pursuit of any securities law violations. Common sense tells us that this change, seven years ago, directly relates to the uproar in the defensive bar.

Over the past years a slew of cases have been filed challenging the SEC’s power in administrative actions and the administrative process. In June 2015 in the case Hill vs. SEC, a federal district court in Atlanta granted injunctive relief preventing the SEC from proceeding with an administrative proceeding on the grounds that the proceeding was unconstitutional. Without getting overly complex, Hill argued that the SEC administrative process (i) violated Article I of the constitution by letting the SEC pick the forum in which to pursue claims (administrative court or federal court) and that power is limited to Congress; (ii) violated the Seventh Amendment right to a jury trial (administrative court proceedings are heard by an administrative court judge); and (iii) violated the Article II Appointments Clause.

The federal court rejected the first two arguments but found that the there was enough evidence and support of a violation of the Appointments Clause to support the granting of a temporary injunction. In particular, the SEC administrative law judge was an inferior officer that, under Article II, must be appointed by either the president, a court of law, or a department head. In fact, the judge had not been appointed by the SEC commissioner (department head), the president or a court.

In August 2016 the U.S. Court of Appeals for the D.C. Circuit ruled that the administrative law judge’s appointment was proper. However, in December 2016 the 10^th U.S. Circuit Court of Appeals ruled that SEC administrative law judges are not constitutionally appointed. The matter may next be heard by the Supreme Court.

Liability for Signing SEC Report, Including CEO and CFO Certifications

I am often asked about potential liability for signing SEC reports and, in particular, the CEO and CFO certifications. An officer providing a false certification potentially could be subject to SEC action for violating Section 13(a) or 15(d) of the Exchange Act and to both the SEC and private actions for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5. Each of these violations could be a first-, second- or third-tier violation depending upon the level of scienter by the signing officer or director and the damage resulting from the false report. In practice, courts consider the actual facts, including the signer’s involvement or scope of knowledge of the information in the reports, and do not consider the signing of the report itself dispositive. The SEC advocates the view that officers and directors have a proactive responsibility to ensure the accuracy of the reports they sign and have concurrent liability.

As a reminder, a public company with a class of securities registered under Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC. The underlying basis of the reporting requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Reports filed with the SEC can be viewed by the public on the SEC EDGAR website. The required reports include an annual Form 10-K, quarterly Form 10Q’s, and current periodic Form 8-K, as well as proxy reports and certain shareholder and affiliate reporting requirements.

These reports are signed by company officers and directors. A company officer signs a Form 10-Q and all company directors sign a Form 10-K. Moreover, the Sarbanes-Oxley Act of 2002 (“SOX”) implemented a requirement that the company’s principal executive officer or officers and principal financial officer or officers execute certain personal certifications included with each Form 10-Q and 10-K. Certifications are not required on a periodic Form 8-K.

Although it is the function of the officer that determines the requirement to execute the certifications, for purposes of this blog, I will refer to the principal executive officer as the “CEO” and the principal financial officer as the “CFO.” All companies that file reports under the Exchange Act, whether domestic or foreign, small business issuers or well-known seasoned issuers, are required to include the sw. Under the CEO/CFO certification requirement, the CEO and CFO must personally certify the accuracy of the information contained in reports filed with the SEC and the procedures established by the company to report disclosures and prepare financial statements.

A company’s CEO and CFO must each provide two certifications as part of the company’s quarterly Form 10-Q and annual Form 10-K. The certifications are required under Sections 302 and 906 of the SOX. The certifications are executed individually and filed as exhibits to the applicable quarterly and annual filings. Although certifications are not included in reports other than Forms 10-Q and 10-K, the disclosure controls and procedures to which the CEO and CFO certify must ensure full and timely disclosure in all current reports, as well as definitive proxy materials and definitive information statements.

Section 302 Certification

Under Section 302, the CEO and CFO make statements related to the accuracy of the reports filed with the SEC and the controls and procedures established by the company to ensure the accuracy of such reports. The certification must be in the exact form set forth in the rule, and the wording may not be changed in any respect whatsoever. The CEO and CFO must each certify that:

He or she has reviewed the report;
Based on his or her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading;
Based on his or her knowledge, the financial statements and financial information fairly present, in all material respects, the company’s financial condition, results of operations and cash flows of the company;
The certifying officer(s) is/are responsible for:
- establishing and maintaining disclosure controls and procedures;
- having designed such disclosure controls and procedures to ensure that they are informed of all material information;
- having each evaluated the effectiveness of the disclosure and financial controls and procedures as of the end of each period in which they are making the certification; and
- having disclosed their conclusions regarding the effectiveness of the controls and procedures in the subject Form 10-Q or 10-K;
He or she has disclosed to the company auditors and to the audit committee any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which could adversely affect the company’s ability to record, process, summarize and report financial data;
He or she has disclosed to the company auditors and to the audit committee any fraud, material or not, that involves employees who have a significant role in internal controls over financial reporting; and
Any changes in the internal controls or financial reporting have been disclosed in the subject Form 10-Q or 10-K, including changes designed to correct deficiencies or material weaknesses.

If a material weakness is uncovered, it must be disclosed in a Form 10-K and, as a result, management cannot conclude that its controls and procedures are effective. The SEC defines a material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The disclosure of a material weakness should include the nature of the weakness, its impact on financial reports and plans or steps and changes made to correct the disclosed material weakness.

Section 906 Certification

Under Section 906, the CEO and CFO must attest that the subject periodic report with financial statements fully complies with the Exchange Act and that information in the report fairly presents, in all material respects, the company’s financial condition and results of operations. Like the Section 302 certification, the Section 906 certification must be in the exact form set forth in the rule and the wording may not be changed in any respect whatsoever.

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The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.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.

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« The SEC Has Issued New Guidance Related To Foreign Private Issuers The Financial Choice Act 2.0 »

The SEC Has Issued New Guidance Related To Foreign Private Issuers

Posted by Securities Attorney Laura Anthony | March 14, 2017 Tags: American Depository Receipts, American Depository Receipts (ADRs), C&DI Related to use of Form 20-F, Definition of Foreign Private Issuer, F-series registration statement, Foreign Private Issuers, Form 20-F annual report, Form 6-K, India as an Emerging Market, OTC Markets, Qualified Foreign Exchange, Refresher Overview for Foreign Private Issuers, SEC

On December 8, 2016, the SEC issued 35 new compliance and disclosure interpretations (C&DI) including five related to the use of Form 20-F by foreign private issuers and seven related to the definition of a foreign private issuer.

C&DI Related to use of Form 20-F

In the first of the five new C&DI, the SEC confirms that under certain circumstances the subsidiary of a foreign private issuer may use an F-series registration statement to register securities that are guaranteed by the parent company, even if the subsidiary itself does not qualify as a foreign private issuer. In addition, the subsidiary may use Form 20-F for its annual report. To qualify, the parent and subsidiary must file consolidated financial statements or be eligible to present narrative disclosure under Rule 3-10 of Regulation S-X.

Likewise in the second of the new C&DI, the SEC confirms that an F-series registration statement may be used to register securities to be issued by the parent and guaranteed by the subsidiary. When a parent foreign private issuer issues securities guaranteed or co-issued by one or more subsidiaries that do not themselves qualify as a foreign private issuer, the parent and subsidiary may use an F-series registration statement when they are eligible to present condensed consolidating financial information or narrative disclosure.

In the third C&DI the SEC clarifies the deadline for filing a Form 20-F annual report. In particular, the Form 20-F is due 4 months to the day from the end of a company’s fiscal year-end. For example, if a company’s fiscal year-end is February 20, the Form 20-F due date would be June 20.

In the fourth C&DI, the SEC confirms that a wholly owned subsidiary can omit certain information from its Form 20-F annual report in the same manner that a wholly owned subsidiary of a U.S. company can omit information in its Form 10-K. The subsidiary would need to include a prominent statement on its cover page that it meets the requirements to and is providing reduced disclosure.

The requirements to be able to provide reduced disclosure, for both 20-F and 10-K filers, include: (i) all of the company’s equity securities are owned, either directly or indirectly, by a single entity which is subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”); (ii) such parent entity is current in its reporting requirements; (iii) the parent company specifically names the subsidiary in its description of its business; (iv) during the preceding 36 calendar months and any subsequent period of days, there has not been any material default in the payment of principal, interest or any other material default with respect to any indebtedness of the parent or its subsidiaries; and (v) there has not been any material default in the payment of rentals under material long-term leases.

The disclosure that may be omitted by a qualifying subsidiary includes: (i) selected financial data; (ii) operating and financial review prospects; (iii) the list of subsidiaries exhibit; (iv) information required by Item 6.A, Directors and Senior Management, Item 6.B, Compensation, 6.D, Employees, Item 6.E, Share Ownership, Item 7, Major Shareholders and Related Party Transactions, Item 16A, Audit Committee Financial Expert, and Item 16B, Code of Ethics; and (v) Item 4 Information on the company as long as such information is included in the parent company’s filings.

In the final new C&DI, the SEC confirms that a foreign private issuer may incorporate by reference into a Form 20-F annual report information that had previously been filed with the SEC in another report, such as a Form 6-K.

C&DI Related to Definition of Foreign Private Issuer

The first of the new guidance on the definition of a foreign private issuer relates to determining whether 50% or more of a company’s outstanding securities are directly or indirectly owned by U.S. residents when a company has multiple classes of voting stock with different voting rights. In such a case a company may either (i) calculate voting power on a combined basis; or (ii) make a determination based on the number of voting securities. A company must apply its methodology on a consistent basis.

The second C&DI provides guidance on determining whether an individual is a U.S. resident. In particular, the SEC confirms that a permanent residence with a green card would be considered a U.S. resident. A company may also consider any relevant facts including tax residency, nationality, mailing address, physical presence, the location of a significant portion of their financial and legal relationships and immigration status. The application of facts must be consistently applied to all shareholders.

The third C&DI clarifies the determination of citizenship and residency of directors and officers. A company must consider the citizenship and residency of all individual directors and officers separately and not count them as a single group. In the fourth C&DI, the SEC addresses the determination where a company has two boards of directors. In that case, the company should examine the board that most closely undertakes functions that U.S.-style boards of directors would. Where such determination cannot be made or where both boards provide these functions, both boards should be aggregated and citizenship and residency examined for both.

In the fifth C&DI the SEC confirms that a company can use the geographic segment information in its balance sheet to determine if more than 50% of its assets are located outside the U.S. A company may also use any other reasonable methodology as long as it is used consistently.

In the sixth C&DI the SEC provides guidance for determining whether a business is principally administered in the U.S. As with the theme of the other guidance, the SEC gives the company guidance to exercise reasonable discretion consistently. A company must assess the location from which its officers, partners, or managers primarily direct, control and coordinate the company business and activities.

In the seventh new C&DI the SEC confirms that holding meetings of shareholders or the board of directors on occasion, will not necessarily result in a conclusion that the company is principally administered in the U.S.

In another new C&DI the SEC confirms that all securities-trading markets in countries that are part of the European Union may be considered a single foreign jurisdiction for purposes of applying the trading market definition for purposes of determining the trading of foreign securities.

Refresher Overview for Foreign Private Issuers

Definition of Foreign Private Issuer

Both the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934, as amended (“Exchange Act”) contain definitions of a “foreign private issuer.” Generally, if a company does not meet the definition of a foreign private issuer, it is subject to the same registration and reporting requirements as any U.S. company.

The determination of foreign private issuer status is not just dependent on the country of domicile, though a U.S. company can never qualify regardless of the location of its operations, assets, management and subsidiaries. There are generally two tests of qualification as a foreign private issuer, as follows: (i) relative degree of U.S. share ownership; and (ii) level of U.S. business contacts.

As with many securities law definitions, the overall definition of foreign private issuer starts with an all-encompassing “any foreign issuer” and then carves out exceptions from there. In particular, a foreign private issuer is any foreign issuer, except one that meets the following as of the last day of its second fiscal quarter:

(i) a foreign government;

(ii) more than 50% of its voting securities are directly or indirectly held by U.S. residents; and any of the following: (a) the majority of the executive officers or directors are U.S. citizens or residents; (b) more than 50% of the assets are in the U.S.; or (c) the principal business is in the U.S. Principal business location is determined by considering the company’s principal business segments or operations, its board and shareholder meetings, its headquarters, and its most influential key executives.

That is, if less than 50% of a foreign company’s shareholders are located in the U.S., it qualifies as a foreign private issuer. If more than 50% of the record shareholders are in the U.S., the company must further consider the location of its officers and directors, assets and business operations.

Registration and Ongoing Reporting Obligations

Like U.S. companies, when a foreign company desires to sell securities to U.S. investors, such offers and sales must either be registered or there must be an available Securities Act exemption from registration. The registration and exemption rules available to foreign private issuers are the same as those for U.S. domestic companies, including, for example, Regulation D (with the primarily used Rules 506(b) and 506(c)) and Regulation S) and resale restrictions and exemptions such as under Section 4(a)(1) and Rule 144.

When offers and sales are registered, the foreign company becomes subject to ongoing reporting requirements. Subject to the exemption under Exchange Act Rule 12g3-2(b) discussed at the end of this blog, when a foreign company desires to trade on a U.S. exchange or the OTC Markets, it must register a class of securities under either Section 12(b) or 12(g) of the Exchange Act. Likewise, when a foreign company’s worldwide assets and worldwide/U.S. shareholder base reaches a certain level ($10 million in assets; total shareholders of 2,000 or greater or 500 unaccredited with U.S. shareholders being 300 or more), it is required to register with the SEC under Section 12(g) of the Exchange Act.

The SEC has adopted several rules applicable only to foreign private issuers and maintains an Office of International Corporate Finance to review filings and assist in registration and reporting questions. Of particular significance:

(i) Foreign private issuers may prepare financial statements using either US GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to US GAAP;

(ii) Foreign private issuers are exempt from the Section 14 proxy rules;

(iii) Insiders of foreign private issuers are exempt from the Section 16 reporting requirements and short swing trading prohibitions; however, they must comply with Section 13 (for a review of Sections 13 and 16, see my blog HERE);

(iv) Foreign private issuers are exempt from Regulation FD;

(v) Foreign private issuers may use separate registration and reporting forms and are not required to file quarterly reports (for example, Form F-1 registration statement and Forms 20-F and 6-K for annual and periodic reports); and

(vi) Foreign private issuers have a separate exemption from the Section 12(g) registration requirements (Rule 12g3-2(b)) allowing the trading of securities on the OTC Markets without being subject to the SEC reporting requirement.

Although a foreign private issuer may voluntarily register and report using the same forms and rules applicable to U.S. issuers, they may also opt to use special forms and rules specifically designed for and only available to foreign companies. Form 20-F is the primary disclosure document and Exchange Act registration form for foreign private issuers and is analogous to both an annual report on Form 10-K and an Exchange Act registration statement on Form 10. A Form F-1 is the general registration form for the offer and sale of securities under the Securities Act and, like Form S-1, is the form to be used when the company does not qualify for the use of any other registration form.

A Form F-3 is analogous to a Form S-3. A Form F-3 allows incorporation by reference of an annual and other SEC reports. To qualify to use a Form F-3, the foreign company must, among other requirements that are substantially similar to S-3, have been subject to the Exchange Act reporting requirements for at least 12 months and have filed all reports in a timely manner during that time. The company must have filed at least one annual report on Form 20-F. A Form F-4 is used for business combinations and exchange offers, and a Form F-6 is used for American Depository Receipts (ADR). Also, under certain circumstances, a foreign private issuer can submit a registration statement on a confidential basis.

Once registered, a foreign private issuer must file periodic reports. A Form 20-F is used for an annual report and is due within four months of fiscal year-end. Quarterly reports are not required. A Form 6-K is used for periodic reports and captures: (i) the information that would be required to be filed in a Form 8-K; (ii) information the company makes or is required to make public under the laws of its country of domicile; and (iii) information it files or is required to file with a U.S. and foreign stock exchange.

As noted above, a foreign private issuer may elect to use either U.S. GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to U.S. GAAP in the preparation and presentation of its financial statements. Regardless of the accounting standard used, the audit firm must be registered with the PCAOB.

All filings with the SEC must be made in English. Where a document or contract is being translated from a different language, the SEC has rules to ensure that the translation is fair and accurate.

The SEC rules do not have scaled disclosure requirements for foreign private issuers. That is, all companies, regardless of size, must report the same information. A foreign private issuer that would qualify as a smaller reporting company or emerging growth company should consider whether it should use and be subject to the regular U.S. reporting requirements and registration and reporting forms. The company should also consider that no foreign private issuer is required to provide a Compensation Discussion & Analysis (CD&I). If the foreign company opts to be subject to the regular U.S. reporting requirements, it must also use U.S. GAAP for its financial statements. For further discussions on general reporting requirements and rules related to smaller reporting and emerging growth companies, see my blogs HERE and HERE and related to ongoing proposed changes HERE, which includes multiple related links under the “further background” subsection.

Deregistration

The deregistration rules for a foreign private issuer are different from those for domestic companies. A foreign private issuer may deregister if: (i) the average daily volume of trading of its securities in the U.S. for a recent 12-month period is less than 5% of the worldwide average daily trading volume; or (ii) the company has fewer than 300 shareholders worldwide. In addition, the company must: (i) have been reporting for at least one year and have filed at least one annual report and be current in all reports; (ii) must not have registered securities for sale in the last 12 months; and (iii) must have maintained a listing of securities in its primary trading markets for at least 12 months prior to deregistration.

American Depository Receipts (ADRs)

An ADR is a certificate that evidences ownership of American Depository Shares (ADS) which, in turn, reflect a specified interest in a foreign company’s shares. Technically the ADR is a certificate reflecting ownership of an ADS, but in practice market participants just use the term ADR to reflect both. An ADR trades in U.S. dollars and clears through the U.S. DTC, thus avoiding foreign currency issuers. ADR’s are issued by a U.S. bank which, in turn, either directly or indirectly through a relationship with a foreign custodian bank, holds a deposit of the underlying foreign company’s shares. ADR securities must either be subject to the Exchange Act reporting requirements or be exempt under Rule 12g3-2(b). ADR’s are always registered on Form F-6.

OTC Markets

OTC Markets allows for the listing and trading of foreign entities on the OTCQX and OTCQB that do not meet the definition of a foreign private issuer as long as such company has its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days subject to OTC Markets’ ability to waive such requirement upon application. If the company does not meet the definition of foreign private issuer, it still must fully comply with Exchange Act Rule 12g3-2(b). For details on the OTCQX listing requirements for international companies, see my blog HERE and for listing requirements for OTCQB companies, including international issuers, see HERE.

India as an Emerging Market

India is widely considered the world’s fastest-growing major economy. The small- and micro-cap industry has been eyeing India as an emerging market for the U.S. public marketplace for several years now. In my practice alone, I have been approached by several groups that see the U.S. public markets as offering incredible potential to the exploding Indian start-up and emerging growth sector. Taking advantage of this opportunity, however, was stifled by strict Indian laws prohibiting or limiting foreign investment into Indian companies. In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian-owned and -domiciled companies, opening up the country to foreign investment, including by U.S. shareholders.

The new rules allow for up to 100% foreign investment in certain sectors. U.S. investors who already invest heavily in Indian-based defense, aviation, pharmaceutical and technology companies will see even greater opportunity in these sectors, which will now allow up to 100% foreign investment. Although certain sectors, including defense, will still require advance government approval for foreign investment, most sectors will receive automatic approval. U.S. public companies will now be free to invest in and acquire Indian-based subsidiaries. Likewise, more India-based companies will be able to trade on U.S. public markets, attracting U.S. shareholders and the benefits of market liquidity and public company valuations.

Indian companies are slowly starting to take advantage of reverse-merger transactions with U.S. public companies. In July 2016, online travel agency Yatra Online, Inc., entered into a reverse-merger agreement with Terrapin 3 Acquisition Corp, a U.S. SPAC. The transaction is expected to close in October 2016. Yatra is structured under a U.S. holding company with operations in India though an India-domiciled subsidiary.

Last year Vidocon d2h became the first India-based company to go public via reverse merger when it completed a reverse merger with a U.S. NASDAQ SPAC. In January, 2016 Bangalore-based Strand Life Sciences Pvt. Ltd. became the second India-based reverse merger when it went public in the U.S. in a transaction with a NASDAQ company.

In addition, U.S.-based public companies, venture capital and private equity firms, and hedge funds and family offices have been investing heavily in the Indian start-up and emerging growth boom. Yatra and Strand Life had both received several rounds of U.S. private funding before entering into their reverse merger agreements. NASDAQ-listed firm Ctrip.com International recently invested $180 million into another India-based online travel company, MakeMyTrip.

India’s Mumbai/Bombay Stock Exchange is already a Qualified Foreign Exchange for purposes of meeting the standards to trade on the U.S. OTCQX International. For details on all OTCQX listing requirements, including for international companies, see my blog HERE and related directly to international companies including Rule 12g3-2(b), see HERE. At least 5 companies currently trade on the OTCQX, with their principal market being in India.

Exchange Act Rule 12g3-2(b)

Exchange Act Rule 12g3-2(b) permits foreign private issuers to have their equity securities traded on the U.S. over-the-counter market without registration under Section 12 of the Exchange Act (and therefore without being subject to the Exchange Act reporting requirements). The rule is automatic for foreign issuers that meet its requirements. A foreign issuer may not rely on the rule if it is otherwise subject to the Exchange Act reporting requirements.

The rule provides that an issuer is not required to be subject to the Exchange Act reporting requirements if:

the issuer currently maintains a listing of its securities on one or more exchanges in a foreign jurisdiction which is the primary trading market for such securities; and
the issuer has published, in English, on its website or through an electronic information delivery system generally available to the public in its primary trading market (such as the OTC Market Group website), information that, since the first day of its most recently completed fiscal year, it (a) has made public or been required to make public pursuant to the laws of its country of domicile; (b) has filed or been required to file with the principal stock exchange in its primary trading market and which has been made public by that exchange; and (c) has distributed or been required to distribute to its security holders.

Primary Trading Market means that at least 55 percent of the trading in the subject class of securities on a worldwide basis took place in, on or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer’s most recently completed fiscal year.

In order to maintain the Rule 12g3-2(b) exemption, the issuer must continue to publish the required information on an ongoing basis and for each fiscal year. The information required to be published electronically is information that is material to an investment decision regarding the subject securities, such as information concerning:

(i) Results of operations or financial condition;

(ii) Changes in business;

(iii) Acquisitions or dispositions of assets;

(iv) The issuance, redemption or acquisition of securities;

(v) Changes in management or control;

(vi) The granting of options or the payment of other remuneration to directors or officers; and

(vii) Transactions with directors, officers or principal security holders.

At a minimum, a foreign private issuer shall electronically publish English translations of the following documents:

(i) Its annual report, including or accompanied by annual financial statements;

(ii) Interim reports that include financial statements;

(iii) Press releases; and

(iv) All other communications and documents distributed directly to security holders of each class of securities to which the exemption relates.

Click Here To Print- PDF Printout The SEC Has Issued New Guidance Related To Foreign Private Issuers

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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The SEC Has Proposed The Use Of Universal Proxy Cards

Posted by Securities Attorney Laura Anthony | February 28, 2017 Tags: Proxy Rules, SEC, SEC Proposed Rule, Section 14 of the Exchange Act, Section 14 proxy requirements, The SEC Has Proposed The Use Of Universal Proxy Cards, Universal Proxy Cards

The SEC has seen a huge exodus of key officials and employees since the recent change in administration, and the ultimate effect of these changes on pending or proposed rule making remains to be seen. However, some proposed rules, whether published or still in drafting process, will remain largely unaffected by the political changes. This could be one of them. In particular, on October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. The proposed card would include the names of both the company and opposed nominees. The SEC also proposed amendments to the rules related to the disclosure of voting options and standards for the election of directors.

Currently where there is a contested election of directors, shareholders likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e. all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned the second would cancel out and replace the first under state corporate law.

Shareholders can always appear in person and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. In an effort to provide the same voting rights to shareholders utilizing a proxy card instead of in person appearance, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.

Opposition to the proposed rule is concerned that it will give more power to shareholder activists groups and encourage additional proxy contests ultimately damaging the corporation that pays the price, both directly and indirectly, by such adversarial processes.

In an era of strong shareholder activism, the regulation of a company’s obligation in the face of a shareholder proposal has been complex, populated with a slew of no-action letters, SEC guidance through C&DI, and court rulings. In October 2015, the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years (see my blog HERE) and on the same day the SEC issued specific guidance related to merger and acquisition transactions (see my blog HERE).

SEC Proposed Rule

Introduction and Background

Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Company’s subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. Private companies, and companies that voluntarily file reports with the SEC (called ’33 Act companies) are not subject to the Section 14 proxy requirements. The SEC views its regulatory authority over the proxy process as “preventing the recurrence of abuses which have frustrated the free exercise of the voting right of stockholders.”

Currently shareholders that appear in person for a meeting, can vote from any of the choices for a director. However, shareholders voting by proxy, which is the vast majority (as high as 99.9%) can only choose from the candidates on the proxy card provided by the party soliciting such vote. In a contested election a shareholder will receive two separate proxy cards and solicitations, one from the company and one from the opposition. Under state law, a shareholder cannot submit two separate proxy cards as the second cancels out and replaces the first.

Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally in a contested election the opposing candidates will not agree presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.

As mentioned, shareholders appearing in person can vote for any duly nominated directors, regardless of whether supported by a company or the opposition. However, in today’s world shareholders rarely appear in person. Besides the time and expense of traveling to and appearing at a meeting, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition.

In 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e. those prepared by the company) to get those names.

In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. As a response, the SEC issued the new rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.

In its rule release the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”

Companies have a concern that dissident board representation can be counter-productive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve. The SEC rule release solicits comments on this point.

Moreover, there is a concern that shareholders could be confused as to which candidates are endorsed by who, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.

Proposed Amendments

In order to provide for the use of universal proxy cards, the SEC has proposed amendments to the proxy rules related to the solicitation of proxies, the preparation and use of proxy cards and the dissemination of information about all director nominees in a contested election. In particular the proposed rules:

Revise the consent required of a bona fide nominee such that a consent for nomination with include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
Eliminates the short slate rule for companies other than funds and BDC’s as the rule would no longer have an effect or be necessary;
Requires the use of universal proxy cards in all non-exempt solicitations in connection with contested elections. The universal proxy card would not be required where the election of directors is uncontested. There may be cases where shareholder proposals are contested by a company in which case a shareholder would still receive two proxy cards, however, in such case, all director nominees must be included in each groups proxy cards.
Requires dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
Requires companies to provide dissidents with notice of the names of the company’s nominees;
Provides for a filing deadline for the dissidents’ definitive proxy statement;
Requires dissidents to solicit the holders of shares representing at least a majority of the voting power of shares entitled to vote on the election of directors;
Prescribes requirements for the universal proxy cards, including form, content and disclosures;
Makes changes to the form of proxy including requiring an “against” and “abstain” voting option; and
Makes changes to the proxy statement disclosure to require a better explanation of the effect of a “withhold” vote in an election.

The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:

Due Date	Action Required
No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [proposed Rule 14a-19(b)(1)]	Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees.
No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [proposed Rule 14a- 19(d)]	Registrant must notify the dissident of the names of the registrant’s nominees.
No later than 20 business days before the record date for the meeting. [current Rule 14a-13]	Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners.
By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [proposed Rule 14a-19(a)(2)]	Dissident must file its definitive proxy statement with the Commission.

The proposed new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« SEC Issues White Paper On Penny Stock Risks SEC Announces Examination Priorities For 2017 »

SEC Issues White Paper On Penny Stock Risks

Posted by Securities Attorney Laura Anthony | February 21, 2017 Tags: micro-cap, OTC Markets, OTC Pink, OTCBB, OTCQB, OTCQX, SEC

On December 16, 2016, the SEC announced several new settled enforcement proceedings against market participants including issuers, attorneys and a transfer agent, related to penny stock fraud. On the same day the SEC issued a new white paper detailing the risks associated with investing in penny stocks. This blog summarizes the SEC white paper.

As I have written about on numerous occasions, the prevention of micro-cap fraud is and will always be a primary focus of the SEC and other securities regulators. In fact, the SEC will go to great lengths to investigate and ultimately prosecute micro-cap fraud. See my blog HERE regarding the recent somewhat scandalous case involving Guy Gentile.

Introduction

The SEC Division of Economic and Risk Analysis published a white paper on the risks and consequences of investing in stocks quoted in the micro-cap markets versus those listed on a national securities exchange. The paper reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns.

The white paper notes that the incidence of and amount of negative returns, as well as alleged market manipulation increase with the fewer disclosure-related requirements associated with the company. The white paper, on the whole, is very negative towards OTC Markets securities. However, off the top, I think the white paper is skewed unfairly against OTC Markets securities when it should target those lower-tier securities that do not provide disclosures to the public.

This blog will summarize the white paper, including many of its facts and figures, but will find issue with its framework. The white paper does not give fair distinction to the higher OTCQX tier of OTC Markets. In fact, “OTCQX” only appears twice in the entire white paper, both in a footnote that purports to list the OTCQX requirements, but fails to mention the quantitative requirements, including that the security not be a penny stock as defined by the federal securities laws. The shortened “QX” does appear 13 times in the white paper, providing some factual and statistical information such as market size and trading patterns, but again, ignores the meaningful distinction related to the penny stock definition. For a review of the OTCQX tier of OTC Markets and its listing requirements, see my blog HERE.

It is axiomatic that the vast majority of new jobs are created by small and emerging companies and that these companies are critical to the economic well being of the United States. See, for example, my blog on the SEC report on the definition of accredited investor HERE and its study on private placements HERE.

According to both Bloomberg and Forbes, 8 out of 10 new businesses fail within 18 months and that number jumps to 96% in the first 10 years. However, despite that failure rate, it is indisputable that we need entrepreneurs to continue forming new businesses and access supportive capital, to have a healthy economy.

Likewise, it is axiomatic to all micro-cap market participants that those companies that fail to provide meaningful disclosure to the public, are more likely to result in investment losses. Those companies are also more likely to engage in market manipulation and other securities law violations. However, those companies that do provide meaningful disclosure to the public, whether through SEC reporting or alternatively to the OTC Markets, and especially those companies that trade on the OTCQX, are the very small and emerging companies that are necessary and vital to our healthy economy. They may be the 8 out of 10 or the 96%, but some will also be the 2 out of 10 and 4% – and all are necessary.

Also, the fact is that bank financing is not readily available for these companies, and they have no choice but to try to access capital through the public. That public wants an exit strategy and that exit strategy tends to be the public markets. Where the companies are small and immature in their business life cycle, the OTC Markets provide that secondary trading market. In discussing this aspect of the economies of these small public companies, they are more positively referred to by the SEC as “venture” companies and the trading market as a “venture exchange” (see my blog HERE).

Many times when a company ceases to provide disclosure or information to the public and remains dark for a period of time, its business operations have failed, it has gone private, or otherwise has been abandoned. These companies continue to trade, and sometimes with high volume with no public information. The SEC makes an effort to eliminate these companies through its Operation Shell-Expel (see HERE), but unfortunately many remain and new ones are added all the time as the 8-out-of-10 cycle continues.

Although all penny stocks are risky, and are undeniably the highest-risk investments, grouping all OTC Markets into the white paper, in the fashion that the SEC has done, strikes me as fundamentally unfair. Throughout my summary of the SEC White Paper, I provide thoughts and commentary.

SEC White Paper

The SEC White Paper begins with an introduction on some high-level differences between an exchange traded security and one on the OTC Markets. One of the biggest distinctions is that the majority of ownership and trading of an exchange listed security is by institutional investors, whereas the majority of ownership and trading on the OTC Markets is by individuals. The SEC points out that institutions tend to be more proactive in research and shareholder activism, creating a check on corporate governance. As an aside, these institutions are also more sophisticated and able to assert greater influence and power over a company than an individual small shareholder.

The SEC quickly highlights the negative literature on OTC Markets securities, including that they have poor liquidity, generate negative and volatile returns and are often subject to market manipulation, including by the dissemination of false and misleading information. Although OTC securities offer the opportunity to invest in early-stage companies that may grow to be larger successful ones, the number that do exceed is small (such as the 2 out of 10 in my summary above).

One portion of the white paper’s information I find interesting is that despite the risks, OTC Markets continue to grow and investor demands for these stocks continues to rise. The SEC offers two hypotheses for this. The first is that OTC investors are simply gambling for the big return, just as they do with the lottery. The second is that OTC Markets investors simply make bad investment decisions. However, the report does admit that little is known about the characteristics of OTC investors and that this is likely the first comprehensive study trying to determine those demographics. Personally, I also think that many OTC Markets investors are day traders and that although a particular stock may go down over time, those day traders are taking advantage of the small intraday price changes to make a profit.

The SEC reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative, with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns, and are also worse for elderly and retired investors and those with lower levels of income and education. The SEC white paper purports to be the first study of its kind that examines investor outcomes around stock promotions and level of disclosure.

I would suggest that the exact same results (i.e., lower returns on less transparent investments and those engaged in improper promotional campaigns and lower returns for the elderly and lower income and education demographic) would be found for any investments in any studied market and are not unique to OTC Markets securities. To be clear, I don’t think the correlation is necessarily improper activity, though that could be the case especially when looking at some stock promotions. Companies that provide less disclosure may have less capital and financial resources to further their business plan and, as such, are far riskier investments. Also, companies that provide less disclosure may be less interested in furthering the public aspect of their business. Even if the underlying business is sound, if they are not providing public disclosure, the stock price and liquidity are unlikely to reflect the underlying business, which could result in poor investor returns.

The SEC white paper continues with a three-part discussion: (i) OTC Market structure and size; (ii) review of academic literature; and (iii) analysis of OTC investor demographics and outcomes.

OTC Market Structure and Size

The SEC white paper describes the basic makeup of OTC Markets including its three tiers of OTC Pink, OTCQB and OTCQX. I’ve written about these market tiers many times. For a review of the three tiers, see my blog HERE, though I note that both the OTCQB and OTCQX have updated their listing standards since that blog was written. The OTC Pink remains unchanged. For the most current listing standards on the OTCQX see HERE and for the OTCQB see HERE.

The SEC white paper also references the OTCBB, which technically still exists, but has fewer than 400 listed securities and does not have a readily accessible quote page.

The SEC white paper has a lot of information on the market size and its growth over the years. Without getting into a lot of facts and figures, I note that the OTC Markets grew by 47% from 2012 through 2015, with $238 billion of trading in 2015. There are approximately 10,000 securities quoted on OTC Markets, as compared to approximately 2,700 on NASDAQ, of which only approximately 675 are micro-cap companies.

The OTC Markets monthly newsletter gives a complete review and breakdown of the size of OTC Markets. For the one month of December 31, 2016, the following is the number of traded securities and volume:

Monthly Trade Summary – December 2016

Market Designations	Number of Securities*	Monthly $ Volume	Monthly $ Volume per Security	2016 $ Volume*

OTCQX	461	$3,844,835,942	$8,340,208	$36,847,879,435
OTCQB	933	$3,249,939,872	$3,483,322	$13,638,584,206
Pink	8,234	$14,648,939,577	$1,779,079	$142,411,521,245
Total	9,628	$21,743,715,392	$2,258,383	$192,897,984,887

Literature Review

The SEC white paper continues with a summary of recent academic research and analysis including on OTC Markets securities’ liquidity, returns, market manipulation, transition to an exchange and investor participation.

Liquidity refers to the ability of shareholders to quickly buy and sell securities near the market price without substantial price impact. Where there is a lack of liquidity, it is difficult to sell. Also, low-volume stocks tend to have wider price fluctuations and bid-ask spreads, and are more expensive for dealers to hold in inventory. OTC Markets securities are less liquid than those listed on a national exchange such as the NYSE MKT or NASDAQ. Research also shows that there tends to be lower liquidity with less transparency and disclosure. None of this is surprising, though many of us that work in the OTC Markets space have seen the anomaly of a company with no information, and likely no underlying business or management, trading on heavy volume.

The returns on OTC Markets securities are also very different than exchange traded securities. Returns on OTC Markets are often negative, volatile and skewed (the lottery factor). Where the majority of trades have negative returns, there is the incidence of extremely high, lottery-like returns on some of the securities. This, again, is not surprising. OTC Markets-traded companies tend to be smaller companies and thus would naturally have a smaller market capitalization and smaller returns as well as the potential for larger upside.

Again, returns on companies that provide less transparency and public information tend to be lower. Interestingly, another hypothesis as to why returns are lower is the short-sale constraints on OTC Market securities. Many OTC Market securities are ineligible for margin (and thus short sales), and locating shares for borrow can be challenging. Those that are margin-eligible usually have a very high carry interest and per-share transaction cost for short sales. The argument is that short sales create an equilibrium and thus help reflect a truer stock price such that the stock will be less vulnerable to negative price adjustments. However, unfortunately, sophisticated traders can open offshore accounts that will allow for short selling of OTC Market securities, opening those same securities up to manipulation by those investors.

OTC Markets securities are relatively often the target of market manipulation, including outright fraudulent disclosures and pump-and-dump schemes. Generally these schemes are conducted in the trading of those companies that are less transparent in disclosures. A market manipulation scheme can involve the dissemination of false information followed by taking advantage of the price changes that result. The scheme can be perpetrated by the company and its insiders, or by unaffiliated investors. Examples include spam and email campaigns, rumors and false information in Internet chat rooms or forums, and false “analyst reports.” Research shows these schemes are effective – that is, the price increases while the stock is being touted and falls when the campaign is over.

Obviously not all increases in stock prices are a result of improper behavior. OTC Markets stocks react to legitimate news and growth as well. In fact, the majority of extreme increases in trading price and volume are the result of changes in company fundamentals and not market manipulation. Moreover, not investor relations and stock promotion is perfectly legal and can be completely legitimate. It is when false or misleading information is being disseminated, or targeted marketing aimed at vulnerable investor groups is used, that it is problematic. The key is recognizing the difference, which generally involves transparency from companies that provide steady, consistent disclosure with apparent credible information.

Many OTC investors are hoping to “bet” on the company that will grow and move to an exchange where it is likely the stock price will increase substantially, as will liquidity. The SEC white paper gives dismal statistics on the rates of graduation. However, it does note that the rate of movement to an exchange is much higher for OTCQX or OTCQB (9%) than OTC Pink companies (less than 1%). The SEC white paper also suggests that companies that graduate to an exchange from the OTC Markets underperform those companies that go public onto an exchange in the first instance.

The last area that the SEC white paper discusses in this section is investor participation and, in particular, why that investor participation continues to grow year over year. The SEC white paper gives two hypotheses, the first being that investors are drawn by the opportunity for lottery-like payoff and the second is that investors are “duped about the stock return probabilities.” Although this sounds harsh, the white paper is not actually referring to market manipulation, but rather suggests that all OTC investors, including the most sophisticated, make poor estimates on return probabilities. No reason for this is offered.

Studies show that although investors frequently lose small investments in OTC stocks, they also occasionally receive an extremely large return. As such, the SEC white paper suggests that these investors are really just gamblers. I’m sure that oftentimes is correct.

Data Analysis and Investor Demographics

The Division of Economic and Risk Analysis studied a sampling of trades for specific securities and time periods which included information on the issuer, trade and investor. The purpose of the review was to determine a relationship between investor returns on the one hand and stock promotions, company transparency and investor demographics on the other hand. However, the information used for the analysis is admittedly biased in that such information was taken from the SEC enforcement files for the year 2014. Since one or more parties to the trades were the subject of enforcement proceedings, this information would not be indicative of the usual OTC company.

The SEC white paper comes to the conclusion that there is a positive correlation between losses and market manipulation and lack of transparency. As discussed above, this is not surprising and is actually quite logical. The white paper also found a positive correlation between losses and elderly, lower-income and poorly educated investors.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

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What Does The SEC Do And What Is Its Purpose?

Posted by Securities Attorney Laura Anthony | February 14, 2017 Tags: SEC, What Does The SEC Do?, what is the sec, what is the sec and what does it do, what is the securities and exchange commision, what is the securities and exchange commission sec

As I write about the myriad of constantly changing and progressing securities law-related policies, rules, regulations, guidance and issues, I am reminded that sometimes it is important to go back and explain certain key facts to lay a proper foundation for an understanding of the topics which layer on this foundation. In this blog, I am doing just that by explaining what the Securities and Exchange Commission (SEC) is and its purpose. Most of information in this blog comes from the SEC website, which is an extremely useful resource for practitioners, issuers, investors and all market participants.

Introduction

The mission of the SEC is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. Although each mission should be a priority, the reality is that the focus of the SEC changes based on its Chair and Commissioners and political pressure. Outgoing Chair Mary Jo White viewed the SEC enforcement division and task of investor protection as her top priority. Jay Clayton will likely shift the top priority to capital formation.

In addition to regulating and overseeing the processes involved in capital formation (registration and exemptions), the SEC regulates the market participants themselves, including securities exchanges, brokers and dealers, investment advisors, investment companies, issuers and investors, and civilly enforces the law as to each of these participants. Related to securities exchanges, brokers and dealers and investment advisors, the SEC is primarily concerned with disclosure, fair dealing and protecting against fraud. The SEC brings hundreds of enforcement proceedings each year. For a review of the SEC 2016 enforcement results, see my blog HERE.

The federal securities laws are based on the premise that all investors, whether large institutions or private individuals, should have access to disclosure and information about an investment both before they buy it and during the time they hold the investment. The public company reporting requirements are designed to provide meaningful, comparable information and data about public companies so that investors can conduct due diligence and make an analysis as to whether to buy, sell or hold a particular security.

In order to be effective in its mission in an ever-changing global economy, the SEC must stay connected with market participants and their needs, and be abreast of, and utilize, technological advances. Moreover, the SEC considers the education of investors as a key component to its mission. Educated investors make better decisions. The majority of leads and ultimate evidence on wrongdoing come from investors themselves and, as such, better educated investors provide a more useful resource for enforcement.

History

The SEC was formed as a response to the stock market crash of October 1929 and the following period of the Great Depression. First, Congress passed the Securities Act of 1933, which was designed to regulate disclosure and truth in the purchase and sale of securities. Second, Congress passed the Securities Exchange Act of 1934, which created the SEC and was designed to regulate the people who sell and trade securities, including public companies, brokers, dealers and exchanges. Joseph Kennedy, John F. Kennedy’s father, was the first Chairman of the SEC.

Organization

The SEC is controlled by five commissioners appointed by the president. Each commissioner serves a five-year term and the terms are staggered as to the individual commissioners. One of the commissioners is designated as the chairman by the president. By law, and in an effort to ensure bipartisan policies, no more than three of the commissioners can belong to the same political party.

The SEC is divided into five divisions and 23 offices, all of which are headquartered in Washington, D.C., although there are 11 regional offices throughout the country. A brief summary of each division follows.

Divisions

Division of Corporation Finance

The Division of Corporation Finance (CorpFin) oversees disclosure documents filed by companies with the SEC, including, for example, registration statements on Form S-1, 1-A or Form 10, SEC reports on Forms 10-Q, 10-K and 8-K, and proxy materials related to annual and special shareholder meetings. CorpFin routinely reviews the documents filed with the SEC and may provide comments on the filings. For information on responding to SEC comments, see my blog HERE.

CorpFin provides administrative interpretations and guidance on the federal securities laws for the public and makes specific recommendations to the SEC for rule implementation and changes. In addition to the more formal written no-action letter process, CorpFin maintains staff that is available to answer calls by potential issuers and investors to provide guidance and interpretations on the federal securities laws, including related to whether a particular offering would qualify for an exemption from the registration requirements. CorpFin also works with the Office of Chief Accountant to monitor accounting activities, including the Financial Accounting Standards Board (FASB), which formulates generally accepted accounting principles (GAAP).

Division of Enforcement

The Division of Enforcement conducts investigations and brings civil and administrative proceedings on behalf of the SEC to enforce the federal securities laws. The Division of Enforcement is not itself a criminal prosecutory authority but does work with law enforcement agencies such as the Department of Justice and Attorney General offices around the U.S. to recommend and assist with criminal cases.

All SEC investigations are private. Once an investigation is completed, the SEC will decide to take no action, pursue a civil complaint or pursue an administrative proceeding. Matters that may result in civil or administrative proceedings are often settled first. Although this firm does not represent clients in enforcement proceedings, I have written about the topic in general on numerous occasions. For further reading on enforcement penalties, see HERE. Related to the SEC Whistleblower program, see HERE. For reading related to the SEC’s efforts to prevent microcap fraud, see HERE.

Division of Trading and Markets

The Division of Trading and Markets is responsible for the SEC’s role of maintaining fair, orderly and efficient markets. In executing its duties, the Division provides daily oversight of major market participants, including the securities exchanges, broker-dealers, self-regulatory organizations including FINRA and the MSRB, clearing agencies, transfer agents, securities information processors and credit rating agencies. This Division also oversees the Securities Investor Protection Corporation (SIPC), which provides insurance against loss in customer accounts due to the bankruptcy or other overall failure of brokerage firms. SIPC does not ensure against individual losses from market declines or negligent or fraudulent broker conduct.

The Division of Trading and Markets also assists with financial integrity programs for broker-dealers, reviewing rules proposed by self-regulatory organizations, drafting and proposing rules and interpretations related to market operations and surveilling the markets.

Division of Investment Management

The Division of Investment Management helps oversee the investment management industry, including mutual funds, fund managers, analysts and investment advisors. The Division of Investment Management is responsible for both investor protection and promoting capital formation in the industry balancing between disclosure by funds and limiting regulatory costs that ultimately reduce gains.

The Division of Investment Management assists the SEC in promulgating and interpreting laws and regulations in the investment management industry, responds to no-action letter and exemptive relief requests, reviews investment company and investment advisor filings with the SEC, and assists in enforcement proceedings.

Division of Economic and Risk Analysis

The Division of Economic and Risk Analysis helps with all aspects of the SEC’s mission through its economic analysis and data analytics. This Division interacts with all other divisions and offices of the SEC, providing economic and risk analyses related to policymaking, rulemaking, enforcement and examinations. The Division also provides advance risk assessments as to litigation, examinations, registrants reviews and general economic support.

Offices of the SEC

The SEC has several offices that perform functions related to the SEC’s overall mission, including, but not limited to, the Office of General Counsel, the Office of the Chief Accountant, the Office of Compliance Inspections and Examinations, the Office of Investor Education and Advocacy, the Office of Credit Ratings, the Office of International Affairs, the Office of Municipal Securities, the Office of Ethics Counsel, the Office of the Investor Advocate, the Office of Women and Minority Inclusion, the Office of the Chief Operating Officer, the Office of Legislative and Intergovernmental Affairs, the Office of Public Affairs, the Office of the Secretary, the Office of Equal Employment Opportunity, the Office of the Inspector General and the Office of Administrative Law Judges, a few of which deserve explanation.

The General Counsel, as part of the Office of the General Counsel, is appointed by the Chairman, is the chief legal officer of the SEC and provides legal advice and counsel to all divisions, other offices, commissioners and the Chairman on all matters within the SEC’s jurisdiction. The General Counsel office also represents the SEC in all civil and administrative litigation matters.

The Chief Accountant, as part of the Office of the Chief Accountant, is also appointed by the Chairman and advises the SEC on all accounting and auditing matters, including approving PCAOB auditing rules. In addition, the Office of the Chief Accountant assists the SEC in establishing accounting principles and overseeing the private sector accounting standards-setting process. The Chief Accountant liaises with FASB, which in turn establishes GAAP. It also liaises with the PCAOB, the International Accounting Standards Board and the American Institute of Certified Public Accountants.

The Office of Investor Education and Advocacy responds to questions, complaints and suggestions from the public. The Office also publishes information and holds seminars and other outreach educational programs to educate the public on the securities laws and their rights.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« House Passes Creating Financial Prosperity For Business And Investors Act SEC Issues White Paper On Penny Stock Risks »

House Passes Creating Financial Prosperity For Business And Investors Act

Posted by Securities Attorney Laura Anthony | February 7, 2017 Tags: Accelerating Access to Capital Act Accelerating Access to Capital Act, Capital Markets Improvement Act of 2016 Capital Markets Improvement Act of 2016, Crowdfunding SPV, Financial Choice Act, Hous, House Passes Creating Financial Prosperity For Business And Investors Act, Remove term: Title II: The SEC Small Business Advocate Act (H.R. 3784) Title II: The SEC Small Business Advocate Act (H.R. 3784), Remove term: Title IV: The Fix Crowdfunding Act (H.R. 4855) Title IV: The Fix Crowdfunding Act (H.R. 4855), Special Purchase Vehicle (SPV), SPV Structure, Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168), Title III: The Supporting America’s Innovators Act (H.R. 4854), Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187), Title VI: The U.S. Territories Investor Protection Act (H.R. 5322), U.S. House of Representatives

ABA Journal’s 10th Annual Blawg 100

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On December 5, 2016, the U.S. House of Representatives passed the Creating Financial Prosperity for Businesses and Investors Act (H.R. 6427) (the “Act”), continuing the House’s pro-business legislation spree. The Act is actually comprised of six smaller acts, all of which have previously been considered and passed by the House in 2016. The Act is comprised of: (i) Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168); (ii) Title II: The SEC Small Business Advocate Act (H.R. 3784); (iii) Title III: The Supporting American’s Innovators Act (H.R. 4854); (iv) Title IV: The Fix Crowdfunding Act (H.R. 4855); (v) Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187); and (vi) Title VI: The U.S. Territories Investor Protection Act (H.R. 5322).

Title I: The Small Business Capital Formation Enhancement Act (H.R. 4168)

This Act requires the SEC to respond to the findings and recommendations of the SEC’s annual Government-Business Forum on Small Business Capital Formation, which forum I attended in 2016 and found very interesting and productive. The Act would require the SEC to respond to recommendations by issuing a public statement evaluating the finding or recommendation and indicating what action the SEC intends to take as a result. Currently, the SEC is required to hold the annual Government-Business Forum to review the current status of problems and programs related to small business capital formation. The SEC is also required to prepare summaries of the Forum and any findings made by the Forum but is not required to comment or take a position on same.

The SEC is already legally required to review and respond to findings of the Investor Advisory Committee but currently is not required to take this additional step related to the small business forum. As with the Investor Advisory Committee, the SEC’s action on recommendations could be simply to review the matter further, conduct a study, consider or propose a rule change, or the SEC could state that it is taking no action at all. The Act does not limit, direct or require any particular response, just that a response be made. This Act was originally passed as part of the Financial Choice Act.

Title II: The SEC Small Business Advocate Act (H.R. 3784)

This legislation establishes the Office for Small Business Capital Formation within the SEC to assist small businesses and their investors in resolving problems and to provide a forum to identify issues and propose changes to statutes, regulations and rules to benefit small businesses and their investors and generally facilitate capital formation. The SEC would be required to review and respond to any recommendations by the committee. However, like similar rules, including the proposed H.R. 4168, the SEC’s response could be to review the matter further, conduct a study, consider or propose a rule change, or the SEC could state that it is taking no action at all.

The new Office for Small Business Capital Formation would be responsible for planning and holding the annual Government-Business Forum on Small Business Capital Formation. The new office would also analyze the effects of new and proposed rules on small businesses. The purpose would be to create an office in the SEC that would advocate for rule and policy changes on behalf of small businesses and their investors. In order to give the office independence in its role, the office would provide its reports directly to various committees of Congress without review or oversight by the SEC itself.

The legislation also establishes the SEC Small Business Advisory Committee to provide the SEC with advice on rules, regulations and policies related to capital formation, securities trading, public reporting and corporate governance for emerging, privately held and smaller reporting companies with less than $250 million in public float. This new SEC Small Business Advisory Committee would essentially replace the voluntarily created SEC Advisory Committee on Small and Emerging Companies. The Advisory Committee on Small and Emerging Companies was last renewed by the SEC Chair and Commissioners on September 24, 2015 for a period of two years and accordingly, unless renewed again, will dissolve later this year.

As a reminder, the Advisory Committee on Small and Emerging Companies was organized by the SEC 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.”

The SEC would have the same mandate to review and respond to recommendations by the new committee. My prior blog discussing this act is HERE.

Title III: The Supporting America’s Innovators Act (H.R. 4854)

This legislation creates a new small “qualifying venture capital fund” under the Investment Company Act of 1940 and increases the current registration exemption under Section 3(c)(1) of the Investment Company Act to allow for up to 250 investors in such qualifying venture capital fund. Currently Section 3(c)(1) of the Investment Company Act exempts pooled funds, such as hedge funds, from registering under the Act as long as they have fewer than 100 equity holders. There is no limit on the amount of invested capital in a fund to qualify for the 3(c)(1) exemption. H.R. 4854 would create a new class of pooled fund, called a “qualifying venture capital fund,” which would be defined as any venture fund with $10 million or less of invested capital and allow up to 250 investors in such fund.

Title IV: The Fix Crowdfunding Act (H.R. 4855)

From the time the SEC published the final Regulation Crowdfunding rules and regulations on October 30, 2015, the regulatory framework has met with wide criticism, including that the process is too costly considering the $1 million raise limitation. The most commonly repeated issues with the current structure include: (i) the $1 million annual minimum is too low to adequately meet small business funding needs; (ii) companies cannot “test the waters” in advance of or at the initial stages of an offering; and (iii) companies cannot currently use a Special Purchase Vehicle (SPV) in a crowdfunding offering. The Fix Crowdfunding Act only addresses one of these three complaints.

The Fix Crowdfunding Act would also allow for the use of special purpose vehicles (SPV’s) in the fundraising process. The Act would allow for SPV’s by amending the Investment Company Act of 1940 to add a newly defined “crowdfunding vehicle” which is limited by its organizational and charter documents to one that acquires, holds and disposes of securities of a single issuing company in one or more crowdfunding transactions conducted under Section 4(a)(6) and Regulation Crowdfunding.

In addition, the newly defined “crowdfunding vehicle” would need to meet the following requirements: (i) have only one class of securities; (ii) neither the vehicle nor any person associated with the vehicle can receive any compensation in connection with the purchase, holding or sale of securities of the investment target; (iii) the vehicle can only purchase securities issued in a transaction under Section 4(a)(6) and Regulation Crowdfunding; (iv) both the crowdfunding vehicle and investment target must remain current in their respective disclosure obligations under Regulation Crowdfunding; and (v) the crowdfunding vehicle must be advised by either a state or federally registered investment advisor (RIA).

A crowdfunding SPV will be exempt from the current per-investor investment limits under Regulation Crowdfunding (i.e., (a) if either annual income or net worth is less than $100,000, the investment limitation is the greater of $2,000 or 5% of the lesser of annual income or net worth; or (b) if both annual income and net worth are equal to or greater than $100,000, the investment limitation is 10% of the lesser of annual income or net worth). However, investments into the crowdfunding SPV would remain subject to the per-investor limitations.

It is thought that an SPV structure helps protect the smaller investors by allowing them to pool funds together with larger investors in an entity that offers separate protections than the offering company itself. The SPV structure has become prevalent in Rule 506(c) offerings where the company is utilizing a platform to advertise and attract investors. However, under Rule 506(c), which is limited to accredited investors, it has not been problematic for SPV’s to stay within the current exemptions to registration under the Investment Company Act of 1940 by having fewer than 100 investors.

The Fix Crowdfunding Act also modifies the current exemption from the Exchange Act Section 12(g) registration requirements under Regulation Crowdfunding. The Exchange Act and Regulation Crowdfunding currently provide that security holders who acquired their securities in a crowdfunded offering are not counted for purposes of the registration threshold, provided that the issuer is current in its required annual reports and has engaged a transfer agent for its securities. The Fix Crowdfunding Act would remove the annual report and transfer agent conditions if the issuer had a public float for the last semi-annual period of less than $75 million, or if the public float is zero for such period annual revenues of less than $50 million in the most recently completed fiscal year.

One of my colleagues in the world of corporate finance, Dara Albright, wrote a great letter to Representative McHenry supporting the Fix Crowdfunding Act. Ms. Albright’s letter can be read HERE.

Title V: The Fair Investment Opportunities for Professionals Experts Act (H.R. 2187)

This legislation amends the definition of “accredited investor” under the Securities Act of 1933 to include: (i) persons whose individual net worth, together with their spouse, exceeds $1,000,000, adjusted for inflation, excluding the value of their primary residence; (ii) persons with an individual income greater than $200,000, or $300,000 for joint income, both adjusted for inflation; (iii) any person currently licensed or registered as a broker or investment adviser by the SEC, FINRA, an equivalent SRO, or state securities regulator; and (iv) persons whom the SEC determines have demonstrable education or job experience to qualify as having professional subject-matter knowledge related to a particular investment (FINRA or an equivalent self-regulatory organization must verify the person’s education or job experience).

My prior blog discussing this act is HERE.

Title VI: The U.S. Territories Investor Protection Act (H.R. 5322)

This legislation amends the Investment Company Act to terminate an exemption for investment companies located in Puerto Rico, the Virgin Islands and other territories of the United States. Currently an exemption applies for entities located in these territories that limits sales of securities to residents of the particular territory in which they operate. The Act contains a three-year phase-in safe harbor.

Other 2016 House Legislation

Earlier in 2016 I wrote about: (i) H.R. 1675 – the Capital Markets Improvement Act of 2016, which has 5 smaller acts embedded therein; (ii) H.R. 3784, establishing the Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee within the SEC; and (iii) H.R. 2187, proposing an amendment to the definition of accredited investor. See my blog HERE.

In early July, the House passed H.R. 2995, an appropriations bill for the federal budget for the fiscal year beginning October 1. No further action has been taken. The 259-page bill, which is described as “making appropriations for financing services and general government for the fiscal year ending September 30, 2017, and for other purposes” (“House Appropriation Bill”), contains numerous provisions reducing or eliminating funding for key aspects of SEC enforcement and regulatory provisions. My discussion on this provision can be read as part of my blog on the Financial Choice Act, a link to which is below.

On September 8, 2016, the House passed the Accelerating Access to Capital Act. Unlike many of the House bills that passed in 2016, this one gained national attention, including an article in the Wall Street Journal. The Accelerating Access to Capital Act is actually comprised of three bills: (i) H.R. 4850 – the Micro Offering Safe Harbor Act; (ii) H.R. 4852 – the Private Placement Improvement Act; and (iii) H.R. 2357 – the Accelerating Access to Capital Act. See my blog HERE.

On September 13, 2016, the House passed the Financial Choice Act, which is an extreme anti-regulation act that would dramatically change the current SEC regime and dismantle a large portion of the Dodd-Frank Act. Read my blog on the Financial Choice Act HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

« SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers What Does The SEC Do And What Is Its Purpose? »

SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers

Posted by Securities Attorney Laura Anthony | January 31, 2017 Tags: C&DI, Five-Day Tender Offer, SEC, Should I accept a Tender Offer, Tender Offer Example, Tender Offer Private Company, Tender Offer Process, Tender Offer Rules, Tender Offer vs Merger, What does it mean to tender shares, What is a Tender Offer?

ABA Journal’s 10th Annual Blawg 100

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The SEC has been issuing a slew of new Compliance and Disclosure Interpretations (“C&DI”) on numerous topics in the past few months. On November 18, 2016, the SEC issued seven new C&DI providing guidance on tender offers in general as well as on abbreviated debt tender and debt exchange offers, known as the Five-Day Tender Offer. The guidance related to the Five-Day Tender Offer clarifies a previously issued January 2015 no-action letter on the subject. As I have not written on the subject of tender offers previously, I include a very high-level summary of tender offers in general and together with specific discussion on the new C&DI.

What Is a Tender Offer?

A tender offer is not statutorily defined, but from a high level is a broad solicitation made by a company or a third party to purchase a substantial portion of the outstanding debt or equity of a company. A tender offer is set for a specific period of time and at a specific price. The purchase offer can be for cash or for equity in either the same or another company (an exchange offer). Where a tender offer is an exchange offer, the offeror must either register the securities being offered for exchange or there must be an available exemption from registration such as under Section 4(a)(2) or Rule 506 of Regulation D.

A tender offer must be made at a fixed price and can include conditions to a closing, such as receiving a certain minimum percentage of accepted tenders. If the person making the tender may own more than 5% of the company’s securities after the tender offer is completed, they must file a Schedule TO with the SEC, including certain delineated disclosures.

Where a tender offer is being made by a company or its management, it is often in association with a going private transaction. Where it is being made by a third party, it is generally for the purpose of acquiring control over the target company and can be either a friendly or hostile takeover attempt.

As mentioned, a tender offer is not statutorily defined but rather can be applied to a broad array of transactions that include the change of ownership of securities. Over the years, a judicially established eight-factor test is used to determine whether the tender offer rules have been implicated and need to be complied with. In particular, in Wellman v. Dickinson, 475 F. Supp. 783 (S.D,N.Y. 1979) the court listed the following eight factors in determining whether a transaction is a tender offer:

An active and widespread solicitation of public shareholders for the shares of a company is made;
A solicitation is made for a substantial percentage of the company’s securities;
The offer to purchase is made at a premium to prevailing market price;
The terms of the offer are firm rather than negotiable;
The offer is contingent on the tender of a fixed number of minimum shares and may be subject to a fixed maximum;
The offer is open for a limited period of time;
The offeree is subjected to pressure to sell their securities; and
Public announcements are made regarding the offer.

Not all factors need be present for a transaction to be considered a tender offer, but rather all facts and circumstances must be considered. The SEC has historically focused on whether an investor is being asked to make an investment decision and whether there is pressure to sell. Once it is determined that a transaction involves a tender offer, the tender offer rules and regulations must be complied with.

Tender offers are governed by the Williams Act, which added Sections 13(d), 13(e), 14(d) and 14(e) to the Securities Exchange Act of 1934. The principle behind the regulatory framework is to ensure proper disclosures to, and equal treatment of, all offerees and to prevent unfair selling pressure. Section 14(d) and Regulation 14D govern tender offers by third parties. Section 14(d) and Regulation 14D set forth the SEC filing requirements and information that must be delivered to those being solicited in association with a tender offer, including the requirement to file a Schedule TO with the SEC.

As with any disclosure document relating to the solicitation or sale of securities, a Schedule TO is comprehensive and includes:

(i) A summary term sheet;

(ii) Information about the issuer;

(iii) The identity and background of the filing persons;

(iv) The terms of the transactions;

(v) Any past contacts, transactions and negotiations involving the filing person and the target company and offerees;

(vi) The purposes of the transactions and plans or proposals;

(vii) The source and amount of funds or other consideration for the tender offer;

(viii) Interests in the subject securities, including direct and indirect ownership;

(ix) Persons/assets retained, employed, compensated or used in the tender process. In its November 18, 2016 C&DI the SEC clarifies that the terms of employment and compensation to financial advisors engaged by an issuer’s board or independent committee to provide financial advice, would need to be disclosed in this section even if such financial advisor is not soliciting or making recommendations to shareholders. In addition, another of the new C&DI clarifies the specificity needed related to compensatory disclosure for financial advisors that are active in soliciting or making recommendations to shareholders. Such disclosure may not always need to include the exact dollar figure of the fees paid or payable to the financial advisor but must include a detailed discussion of the types of fees (such as independence fees, sale or success fees, advisory fees, discretionary fees, bonuses, etc.), when and how such fees will be paid, including any contingencies and any other information that would reasonably be material for a shareholder to judge the merits and objectivity of the financial advisor’s recommendations.

(x) Financial Statements;

(xi) Additional information as appropriate; and

(xii) Exhibits.

Section 14(e) and Regulation 14E contain the antifraud provisions associated with tender offers and apply to all tender offers, whether by insiders or third parties, for cash or an exchange, and whether full or mini offers. Section 14(e) prohibits an offeror from making any untrue statement of a material fact, or omitting to state any material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Section 14(e) also prohibits any fraudulent, deceptive or manipulative acts in connection with a tender offer.

Regulation 14E contains certain requirements designed to prevent fraudulent conduct and must be complied with in all tender offers. Regulation 14E requires:

(i) A tender offer must be open for at least 20 days;

(ii) The percentage of the class of securities being sought and the consideration offered cannot change unless the offer remains open for at least an additional 10 business days following notice of such change;

(iii) The offeror must promptly make full payment, or return the tendered securities, upon the termination, withdrawal or closing of the offering. Prompt payment is generally considered to be within 3 days;

(iv) Public notice must be made of any extension of an offer, and such notice must disclose the amount of any securities already tendered. Public notice is usually made via a press release in a widely disseminated publication such as the Wall Street Journal;

(v) The company subject to a tender offer must disclose its position on the tender offer (for, against, or expresses no opinion) to its shareholders. The disclosure must be made within 10 days of notice of the tender offer being provided to the target shareholders;

(vi) All parties must be mindful of insider trading rules and avoid trading when in possession of information related to the launch of a tender offer. Where the company is tendering for its own shares, it must be extra careful and cannot conduct a tender while in possession of insider information;

(vii) Tendering persons must have a net long position in the subject security at the time of tendering and at the end of the proration period in connection with partial tender offers (and not engage in short-tendering and hedged tendering in connection with their tenders); and

(viii) Subject to certain exceptions, no covered person can purchase or arrange to purchase any of the subject securities from the time of announcement of the tender until its completion through closing, termination or expiration. A covered person is broadly defined to include the offeror and its affiliates, including its dealer-manager and advisors.

Section 13(e) governs the information delivery requirements for the repurchase of equity securities by an issuer company and its affiliates. Rule 13e-4 sets forth disclosure, filing and procedural requirements for a company tendering for its own equity securities, including the filing of a Schedule TO with the SEC. An equity security is broadly defined and includes securities convertible into equity securities such as options, warrants and convertible debt but does not include non-convertible debt. Companies often use the SEC no-action letter process for relief as to whether a particular security is an equity security invoking Rule 13e-4 or similar enough to debt as to not require compliance with the rule.

In addition to an initial Schedule TO, which must be filed with the SEC on the commencement date of the offer, under Rule 13e-4, a company must file any of its written communications related to the tender offer, an amendment to the Schedule TO reporting any material changes, and a final amendment to the Schedule TO reporting the results of the tender offer. Moreover, a company must further disseminate information through either mail or widely distributed newspaper publications or both.

Where a company or affiliate is the offeror, Rule 13e-4 requires that such offeror allow a tendering shareholder the right to withdraw their tender at any time while the tender offer remains open. The tender offer must be made to all holders of the subject class of securities and where an offer is oversubscribed, the company must accept tenders up to its disclosed limit on a pro rata basis.

There are several exemptions from the Section 13(e) and Rule 13e-4 requirements. Also, careful consideration should be given when a company embarks on a stock repurchase program under Rule 10b-18 to ensure that such program does not actually result in a tender offer necessitating compliance with the tender offer rules. For a summary of Rule 10b-18, see my blog HERE.

Where the target company remains public, upon acquiring 5% or more of the outstanding securities, Section 13(d) requires that a Schedule 13D must be filed by the acquirer. For more information on Schedule 13D disclosure requirements, see my blog HERE.

Mini-tenders

Many provisions of the Williams Act, including Sections 13(d), 13(e), 14(d) and Regulation 14D do not have to be complied with for a tender offer that will result in less than 5% ownership (“mini-tender”); however, the antifraud provisions still apply. Mini-tenders are really just a bid for the purchase of stock, usually through a purchase order with a broker, which bid must remain open for a minimum of 20 days. A mini-tender bidder must make payment in full promptly upon a closing. Bidders in a mini-tender do not have to file documents with the SEC or provide the delineated disclosures required by a full tender offer.

Key differences between a mini-tender and full tender offer include: (i) a mini-tender is not required to file a Schedule TO with the SEC, and thus a target company is not given the opportunity to file a responsive Schedule 14d-9; (ii) a mini-tender bidder is not required to treat all offerees equally; (iii) a mini-tender bidder is not required to carve back offerees on a pro rata basis if oversubscribed; (iv) a mini-tender is not required to allow investors to change their minds and withdraw shares prior to a full closing; (v) a mini-tender deadline can be extended indefinitely.

Mini-tenders tend to be at or below market price, whereas full tenders tend to be at a premium to market price, reflecting the increased value in obtaining a control position over the target company. As a result of the lack of investor protections, and that mini-tenders are generally below market price, they are considered predatory and have a high level of negative stigma. The primary criticism against a mini-tender is that target shareholders are likely confused about the distinctions between the mini and full tender and do not realize that the offer is below market, irrevocable, and does not require equal and fair treatment for all shareholders, although all of this information would be required to be disclosed under the still applicable tender offer antifraud provisions.

There does not appear to be a rational reason as to why an investor in a liquid market would choose to sell to a bidder below market price unless there is confusion as to the terms of the offer being presented. The SEC even has a warning page on mini-tenders urging investors to carefully review all terms and conditions. Where a market is not liquid, a mini-tender could be a viable exit strategy, though in practice, mini-tenders are largely launched for the purchase of larger, highly liquid securities.

Abbreviated Debt Tender Offers (Five Business Day Tender Offer)

As discussed above, Section 14(e) of the Exchange Act and Regulation 14E set forth certain requirements for all tender offers designed to prevent fraud and manipulative acts and practices. One of those requirements is that a tender offer be open for a minimum of 20 business days and remain open for at least an additional 10 business days after notice of any change in the consideration offered.

Beginning in 1986, the SEC began issuing a series of no-action letters providing relief from the 20-day rule for certain non-convertible, investment-grade debt tender offers. The SEC recognized that tender offers in a straight debt transaction are often effectuated to refinance debt at a lower interest rate or to extend looming maturity dates. The tender is often at a small premium to the prevailing market or pay-off price and does not include any equity upside or kicker considerations. All parties to a debt tender offer are motivated to move quickly and without the equity considerations; the SEC recognized that the same investor protections are not necessary as in an equity tender offer.

The SEC relief generally required that the debt tender remain open for 7-10 days. In January 2015, in response to a request from numerous top industry law firms, the SEC granted further no-action relief establishing a Five Business Day Tender Offer for non-convertible debt securities, which meets certain delineated terms and conditions.

The conditions to a Five Business Day Tender Offer include:

(i) Immediate Widespread Dissemination – the debt tender must begin with immediate (prior to 12:00 noon on the first day of the offer) widespread dissemination of the offer including by press release and Form 8-K containing certain disclosures and including a hyperlink to an Internet address where the offeree can effectuate the tender. The November 18, 2016 C&DI clarifies that a foreign private issuer may satisfy this requirement by filing a Form 6-K instead of Form 8-K.

(ii) Be made for non-convertible debt securities only;

(iii) Only be initiated by the issuer of the debt securities or a direct or indirect wholly owned subsidiary or parent company;

(iv) Be made solely for cash consideration or an exchange for Qualified Debt Securities. Qualified Debt Securities means non-convertible debt securities that are identical in all material respects (including issuer, guarantor, collateral, priority, and terms and covenants) to the debt securities that are the subject of the tender offer except for the maturity date, interest payment and record dates, redemption provisions and interest rate, and provided further that to be Qualified Debt Securities, all interest payments must be solely in cash (no equity) and the weighted average life to maturity must be longer than the debt that is subject to the offer.

(v) Be open to all record and beneficial holders of the debt securities, provided that in an exchange offer, the exchange offer can be limited to Qualified Institutional Buyers as defined in Rule 144A and/or non-U.S. persons as defined in Regulation S under the Securities Act, and as long as all other record and beneficial holders are offered cash with a value reasonably equal to the value of the exchange securities being offered to those qualified to receive such exchange. The November 18, 2016 C&DI clarifies that although the offer has to be made equally to all holders, like other tender offers, it can have conditions to closing such as that a minimum number of debt holders accept the tender.

(vi) The November 18, 2016 C&DI clarifies that where the offer includes an exchange of Qualified Debt Securities to Qualified Institutional Buyers as defined in Rule 144A of the Securities Act, the cash consideration to the other record holders can be calculated by reference to a benchmark as long as it is the same benchmark used to calculate the value of the Qualified Debt Securities.

(vii) Not be made in connection with the solicitation of consents to amend the outstanding debt securities;

(viii) Not be made if a default exists with respect to the subject tender, or any other, material credit agreement to which the company is a party;

(ix) Not be made if at the time of the offer the company is in bankruptcy or insolvency proceedings;

(x) Not be financed with the proceeds of a Senior Indebtedness;

(xi) Permits tender procedures through a certificate as long as the actual debt security is delivered within 2 business days of closing;

(xii) Provide for certain withdrawal rights until the expiration of the offer or any extension;

(xiii) Provide that consideration will be promptly paid for the tendered debt securities; and

(xiv) Not be made in connection with a change of control, merger or other extraordinary transaction involving the company and not be commenced within ten business days of an announcement of the purchase, sale or transfer of a material subsidiary or amount of assets. The November 18, 2016 C&DI clarifies that a company could announce a plan to conduct a Five Business Day Tender Offer but could not commence the offer until the ten-business-day period had passed.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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SEC Issues New C&DI Clarifying The Use Of Form S-3 By Smaller Reporting Companies; The Baby Shelf Rule

Posted by Securities Attorney Laura Anthony | January 17, 2017

The SEC has been issuing a slew of new Compliance and Disclosure Interpretations (“C&DI”) on numerous topics in the past few months. I will cover each of these new C&DI in a series of blogs starting with one C&DI that clarifies the availability of Form S-3 for the registration of securities by companies with a public float of less than $75 million, known as the “baby shelf rule.”

The Baby Shelf Rule

Among other requirements, to qualify to use an S-3 registration statement a company must have filed all Exchange Act reports in a timely manner, including Form 8-K, within the prior 12 months and trade on a national exchange. An S-3 also contains certain limitations on the value of securities that can be offered. Companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, may offer the full amount of securities under an S-3 registration. For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, Instruction 1.B.6(a) limits the amount that the company can offer to up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.”

To calculate the non-affiliate float for purposes of S-3 eligibility, a company may look back 60 days and select the highest of the last sales prices or the average of the bid and ask prices on the principal exchange. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold under the same S-3 in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases.

New C&DI

On November 2, 2016, the SEC issued a new C&DI clarifying the calculation of the one-third limitation under the baby shelf rule. In particular, some companies were effecting an S-3 shelf takedown with an investor while simultaneously completing a private placement with the same investor and registering the private placement securities via a new resale S-3 filing. Although the shelf takedown was a primary direct issuance from the company and the resale registration filed on behalf of the selling shareholder, the combined effect was the use of S-3 for an amount of securities in excess of the $75 million limitation.

This workaround had become somewhat commonplace until the SEC issued the new C&DI on November 2, 2016 clarifying that this will no longer be allowed. The new C&DI provides in total:

Question: An issuer with less than $75 million in public float is eligible to use Form S-3 for a primary offering in reliance on Instruction I.B.6, which permits it to sell no more than one-third of its public float within a 12-month period. May it sell securities to the same investor(s), with a portion coming from a takedown from its shelf registration statement for which it is relying on Instruction I.B.6 and a portion coming from a separate private placement that it concurrently registers for resale on a separate Form S-3 in reliance on Instruction I.B.3, if the aggregate number of shares sold exceeds the Instruction I.B.6 limitation that would be available to the issuer at that time?

Answer: No. Because we believe that this offering structure evades the offering size limitations of Instruction I.B.6, the securities registered for resale on Form S-3 should be counted against the issuer’s available capacity under Instruction I.B.6. Accordingly, an issuer may not rely on Instruction I.B.3 to register the resale of the balance of the securities on Form S-3 unless it has sufficient capacity under Instruction I.B.6 to issue that amount of securities at the time of filing the resale registration statement. If it does not, it would need to either register the resale on Form S-1 or wait until it has sufficient capacity under that instruction to register the resale on Form S-3.

Although the SEC has made it clear that the private placement and shelf takedown shares will both count towards the $75 million baby shelf limit, a company can still conduct concurrent shelf takedowns and private placements with the same investor. In such case the investor can either hold the private placement shares for the applicable Rule 144 holding period, or the shares can be registered for resale on Form S-1.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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« SEC Issues Guidance On Integration With A 506(c) Offering The SEC Has Issued New C&DI Guidance On Regulation A+ »

SEC Issues Guidance On Integration With A 506(c) Offering

Posted by Securities Attorney Laura Anthony | January 10, 2017 Tags: 506 C offering, 506(c) Offering, Integration With A 506(c) Offering, SEC

ABA Journal’s 10th Annual Blawg 100

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On November 17, 2016, the SEC Division of Corporation Finance issued a new Compliance and Disclosure Interpretations (C&DI) related to the integration of a completed 506(b) offering with a new 506(c) offering. The new C&DI confirms that 506(c) offering will not integrate with a previously completed 506(b) offering.

Effective September, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. The enactment of new 506(c) resulting in the elimination of the prohibition against general solicitation and advertising in private offerings to accredited investors has been a slow but sure success. Trailblazers such as startenging.com, realtymogul.com, circleup.com, wefunder.com and seedinvest.com proved that the model can work, and the rest of the capital marketplace has taken notice. Recently, more established broker-dealers have begun their foray into the 506(c) marketplace with accredited investor-only crowdfunding websites accompanied by the use of marketing and solicitation to draw investors.

The historical Rule 506 was renumbered to Rule 506(b) and issuers have the option of completing offerings under either Rule 506(b) or 506(c). Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors, provided however that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.

The new Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly the issue of integration, or when the 506(c) offering could be deemed to taint the previously completed 506(b) offering, is extremely important for companies utilizing these types of corporate finance transactions.

Integration and the New C&DI

In general the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. The new C&DI effectively treats a 506(c) offering as a public offering and provides in total:

Question: An issuer has been conducting a private offering in which it has made offers and sales in reliance on Rule 506(b). Less than six months after the most recent sale in that offering, the issuer decides to generally solicit investors in reliance on Rule 506(c). Are the factors listed in the Note to Rule 502(a) the sole means by which the issuer determines whether all of the offers and sales constitute a single offering?

Answer: No. Under Securities Act Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently decides to make a public offering. Therefore, we believe under these circumstances that offers and sales of securities made in reliance on Rule 506(b) prior to the general solicitation would not be integrated with subsequent offers and sales of securities pursuant to Rule 506(c). So long as all of the applicable requirements of Rule 506(b) were met for offers and sales that occurred prior to the general solicitation, they would be exempt from registration and the issuer would be able to make offers and sales pursuant to Rule 506(c). Of course, the issuer would have to then satisfy all of the applicable requirements of Rule 506(c) for the subsequent offers and sales, including that it take reasonable steps to verify the accredited investor status of all subsequent purchasers.

Rule 502(a) of Regulation D provides a five-factor test to determine whether separate offerings should be integrated (and thus whether an exemption is available for the private offering and there have been no violations of Section 5 for the registered offering). The five factors are: (1) whether the offerings are part of a single plan of financing; (2) whether the offerings involve issuance of the same class of security; (3) whether the offerings are made at or about the same time; (4) whether the same type of consideration is to be received; and (5) whether the offerings are for the same general purpose. The five-factor test is subjective, and the SEC staff has not provided definitive guidance as to what weight to give to the various factors or, indeed, how many of them have to be met.

Rule 502(a) also provides for a six-month safe harbor wherein multiple private offerings that are conducted at least six (6) months apart will not be integrated. A private offering that is conducted at least six (6) months before or after a registered or exempt public offering will not be integrated with the public offering.

Rule 152 is a safe harbor for issuers undertaking a registered public offering after conducting a private offering. As interpreted by the SEC, a completed private offering will not be integrated with a subsequently commenced registered public offering. Clearly as a result of the ability to publicly solicit, the SEC is treating a Rule 506(c) offering as a public offering in making an integration analysis.

Brief Summary of 506(c)

Effective September 23, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. For a complete discussion of the final rules, please see my blog HERE. For a discussion on the use of general solicitation and advertising, including when a solicitation may not be considered “general solicitation” for purposes of the 506 Rules, see my blog HERE.

Title II of the JOBS Act required the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors. The JOBS Act required that the rules necessitate that the issuer take reasonable steps to verify that purchasers of the securities are accredited investors using such methods as determined by the SEC. Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transactions by an issuer not involving a public offering. In a Rule 506 offering, an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors. The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer.

Rule 506(c) permits the use of general solicitation and advertising to offer and sell securities under Rule 506, provided that the following conditions are met:

the issuer takes reasonable steps to verify that the purchasers are accredited;
all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.

Rule 506(c) includes a non-exclusive list of methods that issuers may use to verify that investors are accredited. An issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors. An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

« SEC Issues Report On Regulation S-K SEC Issues New C&DI Clarifying The Use Of Form S-3 By Smaller Reporting Companies; The Baby Shelf Rule »

SEC Issues Report On Regulation S-K

Posted by Securities Attorney Laura Anthony | January 3, 2017 Tags: SEC Issues Report On Regulation S-K

As required by Section 72003 of the Fixing America’s Surface Transportation Act (the “FAST Act”), on November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K (the “Report”) including detailed recommendations for changes.

The Report continues the ongoing review and proposed revisions to Regulations S-K and S-X as related to reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”). Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act. Regulation S-X contains specific financial statement preparation and disclosure requirements.

The Disclosure Effectiveness Initiative began in December 2013, when the SEC, as required by the JOBS Act, issued its first report on the Regulation S-K disclosure requirements. The Disclosure Effectiveness Initiative is intended to evaluate the rules related to disclosure, how information is presented and disclosed and how technology can be utilized in the process and to implement changes to improve the current disclosure-related rules and regulations.

Since the initiative began, the SEC has been issuing reports, an in-depth concept release, and proposed rule changes as part of the Disclosure Effectiveness Initiative. However, as of the date of this blog, none of the proposed changes have been implemented. I have included a summary of the various proposals and SEC publications at the end of this blog. I suspect that following the change in administration, and re-staffing of the SEC, including the as of yet to be announced replacements for SEC Chair Mary Jo White, Division of Corporation Finance Director Keith Higgins, and Trading and Markets Director Stephen Luparello, there will be significant progress in many of the outstanding proposals as well as new and different proposals on the subject. It is my belief that the new leadership will take a pro-business viewpoint and that we will see that flow through to the disclosure requirements, especially as it impacts smaller reporting companies and emerging-growth companies.

The Report

The FAST Act, passed in December 2015, contains two sections requiring the SEC to modernize and simplify the requirements in Regulation S-K. Section 72002 requires the SEC to amend Regulation S-K to “further scale or eliminate requirements… to reduce the burden on emerging growth companies, accelerated filers, smaller reporting companies, and other smaller issuers, while still providing all material information to investors.” In addition, the SEC was directed to “eliminate provisions… that are duplicative, overlapping, outdated or unnecessary.” In accordance with that requirement, On July 13, 2016, the SEC issued proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded. The S-K and S-X Amendments also seek comment on certain disclosure requirements that overlap with U.S. GAAP and possible recommendations to FASB, the regulatory body that drafts and implements GAAP, for conforming changes. See my blog on the proposed rule change HERE. The proposal remains pending.

Section 72003 required the SEC to conduct a study on Regulation S-K and, in that process, to consult with the SEC’s Investor Advisory Committee (the “IAC”) and the Advisory Committee on Small and Emerging Companies (the “ACSEC”) and then to issue a report on the study findings, resulting in the Report issued on November 23, 2016. As required, the SEC consulted with the IAC and ACSEC as part of the process.

Section 72003 specifically requires that the Report include: (i) the finding made in the required study; (ii) specific and detailed recommendations on modernizing and simplifying the requirements in Regulation S-K in a manner that reduces the costs and burdens on companies while still providing all material information; and (iii) specific and detailed recommendations on ways to improve the readability and navigability of disclosure documents and to reduce repetition and immaterial information.

The SEC Report includes a high level review of the rule proposals issued by the SEC specifically in response to their mandate under the FAST Act. In particular, the proposed rule changes related to mining companies, proposed amendment to the definition of a smaller reporting company, the July 13, 2016 proposed amendments to Regulation S-K and the August 31, 2016 proposed amendment to Item 601 were all required by the FAST Act. In the Further Reading section below, I have included links to my blogs on these proposals.

Specific SEC Staff Recommendations

A. Item 10(d) Related to Incorporation by Reference

The SEC staff recommends revising Item 10(d) to permit incorporation by reference to documents that have been filed with the SEC for at least 5 years, but require a detailed description of and hyperlink to such documents. Currently the rule specifically prohibits incorporation of documents that have been filed more than five years prior.

The SEC staff recommends allowing incorporation by reference to financial statement footnotes where such disclosures satisfy other Regulation S-K item requirements. For example, disclosures related to related party transactions (Item 404), selected financial data (Item 301) and off-balance-sheet arrangements (Item 303) are all repeated in financial statement footnotes. The SEC staff notes that allowing incorporation by reference from financial statements to other documents would increase audit costs and burdens and accordingly specifically recommends disallowing outside incorporation from the financial statements.

In addition, currently incorporation-by-reference rules are not consistent. For example, Rule 411 related to Securities Act registration statements has different requirements than Rule 12b-23 related to Exchange Act registration statements. Different forms also have different rules and requirements. The SEC recommends consolidating all the incorporation-by-reference rules into Item 10(d) and that such rules apply to all filings under the both the Securities Act and Exchange Act.

B. Business Information

The SEC staff recommends revising Item 102 to clarify that a description of property is only required to the extent that physical properties are material to the company’s business. Currently, Item 102 requires companies to “state briefly the location and general character of the principal plants, mines and other materially important physical properties of the registrant and its subsidiaries.” The SEC could also streamline the disclosure requirement by adding a description of material property to the Item 101 business description as opposed to leaving it as a stand-alone item.

C. Management Discussion and Analysis

The SEC staff recommends revising Item 303 to clarify that a company need only provide a period-to-period comparison for the two most recent years and that it may hyperlink to the prior year’s annual report for prior comparisons. The SEC staff also recommends considering requiring a discussion of material changes and known trends and uncertainties that impacted those changes, as opposed to the current granular line-item comparisons. In that regard, the MD&A focus would shift to longer-term trends and how those trends impacted the reported financial statements and may impact future results.

The SEC staff also recommends eliminating the requirement to provide a tabular disclosure of contractual obligations. I note that smaller reporting companies are not required to provide this disclosure. The staff recommends that instead of the table, a company should provide a hyperlink to financial statement footnotes and a liquidity discussion that describes material changes to contractual obligations and the ability to pay and perform such obligations.

D. Management, Security Holders, Corporate Governance

The SEC staff recommends clarifying the rules as to when and where the business experience of executive officers is required in proxy statements. In particular, the rules should clarify that the information is not required in a proxy statement when it is otherwise contained in a Form 10-K.

The SEC staff recommends allowing a company to simply review EDGAR filings to determine compliance with Section 16. Currently a Section 16 filer is required to also furnish a company with their filings. Similarly, the staff recommends eliminating the Section 16 disclosure requirement altogether where there are no delinquencies to report.

The SEC staff makes multiple recommendations to clarify and clean up certain corporate governance reporting requirements including further aligning the smaller reporting company and emerging-growth company requirements.

E.Registration Statements

As related to registration statements, the SEC staff makes several recommendations to clean up redundancies, allow for hyperlinks, and add consistencies to the requirements related to registration statements. The following is a brief description of some of those recommendations.

The SEC staff recommends eliminating the provision of Item 501 related to the name of the company. In particular, the SEC rules have provisions related to the use of a name that is the same as a “well-known” company or could be misleading. The concept is already covered by intellectual property laws and it is not necessary for the SEC to have a specific regulation addressing same.

The staff recommends eliminating the requirement to provide an explanation of the method of determining the price of an offering in a registration statement from the cover page and allowing a hyperlink to the same disclosure elsewhere in the document.

The staff recommends adding a disclosure to specify if the company already trades on the OTC Markets and to provide the trading symbol. Currently the disclosure is only required for exchange-traded companies. In practice, OTC-traded companies already do this.

The staff recommends reducing the length of the “subject to completion” disclaimer on the front page by eliminating reference to state law where it is not applicable, such as when the offering pre-empts state law under the National Securities Market Improvement Act (NSMIA).

The staff recommends eliminating several of the Item 512 undertakings provisions as duplicative, redundant or obsolete.

F. Exhibits

The staff recommends adding a description of the company’s outstanding securities as an exhibit to Form 10-K. The staff also recommends adding the requirement that a subsidiaries legal entity identifier number (LEI) be included in the subsidiary list exhibit.

The staff recommends permitting the omission of attachments and schedules from exhibits unless the schedule or attachment has material information that is not disclosed elsewhere.

G. Manner of Delivery Requirements

The staff recommends adding XBRL tagging to the cover page of reports. The staff also recommends allowing the use of hyperlinks to websites when a disclosure of such website URL is required.

Further Reading

The following is a recap of the ongoing Disclosure Effectiveness Initiative-related reports and proposals. The Disclosure Effectiveness Initiative began in December 2013, when the SEC, as required by the JOBS Act, issued its first report on the Regulation S-K disclosure requirements. The Disclosure Effectiveness Initiative is intended to evaluate the rules related to disclosure, how information is presented and disclosed and how technology can be utilized in the process and to implement changes to improve the current disclosure-related rules and regulations.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes. The proposal remains pending.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE. The changes remain pending.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. The proposal remains pending.

On June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

On June 16, 2016, the SEC proposed revisions to Item 102 of Regulation S-K and Industry Guide 7 related to the property disclosure requirements for mining companies. The revisions are intended to modernize the disclosure obligations to be better aligned with current industry and global regulatory practices. The SEC also proposed rescinding Industry Guide 7 and including the substantive provisions in a new subpart in Regulation S-K.

On April 15, 2016, the SEC issued a concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements. See my two-part blog on the S-K Concept Release HERE and HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

As part of the Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

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