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SEC Proposes Shortening Trade Settlement

Posted by Securities Attorney Laura Anthony | December 27, 2016 Tags: DTC, DTC Process, SEC, SEC Proposes Shortening Trade Settlement

On September 28, 2016, the SEC proposed a rule amendment to shorten the standard broker-initiated trade settlement cycle from three business days from the trade date (T+3) to two business days (T+2). The change is designed to help reduce risks, including credit, market and liquidity risks, associated with unsettled transactions in the marketplace. Outgoing SEC Chair, Mary Jo White was quoted as saying that the change “is an important step to the SEC’s ongoing efforts to enhance the resiliency and efficiency of the U.S. clearance and settlement system.” I have previously written about the clearance and settlement process for U.S. capital markets, which can be reviewed HERE.

Background

DTC provides the depository and book entry settlement services for substantially all equity trading in the US. Over $600 billion in transactions are completed at DTC each day. Although all similar, the exact clearance and settlement process depends on the type of security being traded (stock, bond, etc.), the form the security takes (paper or electronic), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

All securities trades involve a legally binding contract. In general, the “clearing” of those trades involves implementing the terms of the contract, including ensuring processing to the correct buyer and seller in the correct security and correct amount and at the correct price and date. This process is effectuated electronically.

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In 1993, Exchange Act Rule 15c6-1 was adopted requiring that settlement occur three business days after the trade date, commonly referred to as “T+3.” Delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts. Technology, of course, plays an important role in the process and ability to efficiently manage settlements.

There may be two brokerage firms between DTC and the customer account holder. Brokerage firms that are direct members with DTC are referred to as “clearing brokers.” Many brokerage firms make arrangements with these DTC members (clearing brokers) to clear the securities on their behalf. Those firms are referred to as “introducing brokers.” A clearing broker will directly route an order through the national exchange or OTC Market, whereas an introducing broker will route the order to a clearing broker, who then routes the order through the exchange or OTC Market.

The Dodd-Frank Act added a definition of, and responsibilities associated with, a “financial market utility” or FMU. Clearing brokers are FMU’s. FMU’s provide the actual functions associated with clearing trades through the DTC system. As part of that process, a division of DTC, the National Securities Clearing Corporation (“NSCC”), becomes the buyer and seller of each contract, netting out and settling all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. When one of the counterparties in the process does not fulfill its settlement obligations by delivering the securities, there is a “failure to deliver.” Overall, failures to deliver are less than 1% of all transactions.

Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. These accounts can be in the billions. Clearing firms can either settle each day or carry their open account forward until the next business day. Because all transactions are netted out, 99% of all trade obligations do not require the exchange of money, which helps reduce some risk. NSCC’s role in this process is referred to as a central counterparty or CCP. This process is continuous.

Looking at the process from the top down, the CCP carries the risk that the clearing firm (or FMU) will not have the financial resources to perform its obligations. In turn, the clearing firms have risks from their customers, including introducing brokers, who in turn ultimately have risks from the individual account holders. The risks are compounded by changing values of the securities being traded, during the settlement process. The faster a trade settles, the lower the cumulative risk at each level of the process.

This is a very simplified high-level description of the process. Technically, the roles of DTC and its subsidiaries, CEDE and NSCC, as well as clearing agencies and introducing brokers involve a complex set of regulations, with different definitions, obligations and roles for the different hats the entities wear depending on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the form the security takes (paper or electronic), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved (retail or institutional). For those interested, the SEC rule release provides an excellent in-depth review of the settlement and clearing process.

Exchange Act Rule 15c6-1

Exchange Act Rule 15c6-1 prohibits a broker-dealer from effecting or entering into a contract for the purchase or sale of a security, subject to certain exemptions, that provides for the payment of the funds or delivery of the securities later than the third business day after the contract (i.e., trade) date unless expressly agreed upon by both parties at the time of the transaction. Exempted securities include government and municipal securities, commercial paper, limited partnership units that are not listed on an exchange or automated quotations system (OTC Markets), and sales in a firm commitment underwritten offering that are priced after market close.

Firm commitment offerings can rely on an extended T+4 settlement cycle. It is unclear what impact the proposed rule change will have on this exception. The SEC rule release has sought comment on the question.

One of the SEC’s roles is to enhance the resilience and efficiency of the clearance and settlement process such that the system itself does not add to, but rather subtracts from, the risks associated with trading in securities. The SEC is proposing to amend Rule 15a6-1(a) to shorten the settlement cycle to T+2. The SEC believes this change will reduce various risks in the marketplace, including: (i) the credit risk that one party will be unable to fulfill its delivery obligations (of either cash or the securities) on the settlement date; and (ii) the market risk that the value of the securities will change between the trade and settlement such as to result in a loss to one of the parties.

To drill down further on the summary of the settlement and clearing process described in the background section of this blog, the following is a high-level description of what happens following the execution of a trade. First, when the trade is submitted to an exchange or alternative trading system (such as OTC Markets), it is matched with a counterparty. That is, a buy order is electronically matched to a sell order. As long as there is a match, the trade is locked in and sent to NSCC.

On the trade date (T), NSCC validates the trade data and communicates receipt of the transaction. At that moment the parties are legally committed to complete the trade. At midnight on the first day (T+1), NSCC substitutes itself as the legal buyer and legal seller. Technically, the first buy/sell contract is replaced by two new contracts, one between NSCC and the buyer and the other between NSCC and the seller. On the second day (T+2), NSCC issues a trade summary report to its members which summarizes all securities and cash to be settled that day, and shows the net positions for each. NSCC also sends an electronic instruction to DTC to process the net security and cash settlements. Finally, on the third day (T+3), DTC process the electronic settlement by transferring cash and securities between the broker-dealer accounts and the broker-dealers, in turn, put the securities and/or cash in their customer accounts.

Although institutional trading is similar, there are unique aspects and there can be additional participants. For example, an institution may have a custodian of its securities in addition to its broker, may use a matching provider and may avail itself of different netting and settling processes within the brokerage and DTC systems. Although the detailed process may differ, ultimately both retail and institutional trades currently fully settle in the T+3 timeline.

As mentioned, the length of the settlement cycle impacts the exposure to credit, market and liquidity risks for the participants. The participants, including NSCC, take measures to reduce these risks, including by requiring funds to be kept on deposit by clearing and brokerage firms effecting such participants’ liquidity. Even then, however, all participants are exposed to market risk during the settlement process, including a decline in value of the traded securities and the risk that such decline could exceed the broker’s capital deposit or result in a failure to deliver.

A reduction in risks would reduce the necessity to mitigate such risk, including reducing the funds that must be kept on deposit by participants. It is undisputed that reducing the settlement cycle reduces these risks.

Also, obviously if funds are tied up for three days pending a settlement of a transaction, whether you are the retail investor or clearing agency, there is a lack of available liquidity to participate in other transactions during that time.

The reduction of the settlement cycle to T+2 will also assist in aligning global clearing of securities as many markets including the United Kingdom and many European countries are already on the T+2 schedule.

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.

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

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« SEC Eliminates The “Tandy Letter” SEC Issues Report On Regulation S-K »

SEC Eliminates The “Tandy Letter”

Posted by Securities Attorney Laura Anthony | December 20, 2016 Tags: Reg S-K, Regulation S-K, Regulation S-X, responding to sec comments, SEC Comment Letter, sec comment process, SEC Response Letter, Tandy Language, Tandy Letter

ABA Journal’s 10th Annual Blawg 100

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On October 5, 2016, the SEC Division of Corporation Finance (CorpFin) announced that, effective immediately, it would no longer require companies to include “Tandy” letter representations in comment letter response or registration acceleration requests addressed to the SEC.

Background

Beginning in the 1970s the SEC began to require an affirmative statement from the company acknowledging that the company cannot use the SEC’s comment process as a defense in any securities-related litigation. Named after the first company required to provide the affirmations, this language is referred to as a “Tandy” letter. By 2004 the “Tandy” letter was required in all comment letter responses to the SEC as well as registration acceleration requests. The “Tandy” portion of a response was required to be agreed to by the company itself, so if the response letter was on attorney letterhead, a signature line was required to be included for the company or the company could submit a separate letter. The Tandy language for an Exchange Act filing was as follows:

The company acknowledges that:

the company is responsible for the adequacy and accuracy of the disclosure in the filing;

staff comments or changes to disclosure in response to staff comments do not foreclose the Commission from taking any action with respect to the filing; and

the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

Tandy language for a Securities Act registration statement was as follows:

The company acknowledges the following:

Should the commission or the staff, acting pursuant to delegated authority, declare the filing effective, it does not preclude the commission from taking any action with respect to the filing;

the action of the Commission or the staff, acting pursuant to the delegated authority, in declaring the filing effective does not relieve the company from its full responsibility for adequacy and accuracy of the disclosure in the filing; and

the company may not assert staff comments and the declaration of effectiveness as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

The End of Tandy Letters

On October 5, 2016, CorpFin announced that it would no longer require companies to include “Tandy” letter representations in comment letter response or registration acceleration requests addressed to the SEC. In its release the SEC notes that “while it remains true that companies are responsible for the accuracy and adequacy of the disclosure in their filings, the staff does not believe that it is necessary for them to make the affirmative representations in their filing review correspondence.”

Rather than require “Tandy” representations, the SEC will now include the following statement in all comment letters:

We remind you that the company and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff.

The end of the “Tandy” letter requirements was effective on October 5, 2016. As the requirement was a staff policy and not a rule, no rule release or other formal publication from the SEC was required.

Although the written “Tandy” letter is no longer required, the meaning of the words has not changed. That is, regardless of the writing, a company may still not assert staff comments, the clearing of such comments, or the fact of an SEC review of any filing, as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

As a securities attorney it is important to educate clients on what the comment and review process means, and does not mean. The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and to enhance such disclosures as to each particular issuer. CorpFin will also be cognizant of the antifraud provisions of the federal securities laws and may refer a matter to the Division of Enforcement where material concerns arise over the adequacy and accuracy of reported information or other securities law violations, including violations of the Section 5 registration requirements. CorpFin has an Office of Enforcement Liason in that regard.

However, neither the SEC nor CorpFin evaluates the merits of any transaction or makes an assessment or determination as to whether a transaction or company is appropriate for any particular investor or the marketplace as a whole. The purpose of a review is to ensure compliance with the disclosure requirements of the securities laws. In that regard, CorpFin may ask for increased risk factors and clear disclosure related to the merits or lack thereof of a particular transaction, but they do not assess or comment upon those merits beyond the disclosure.

As the “Tandy” Letter made clear to companies, they are still responsible for the contents of their filings, and both private litigation and enforcement proceedings may be brought regardless of an SEC review. With the end of the “Tandy” Letter, it is incumbent upon SEC counsel to remind clients of their obligations and the role of the SEC.

Further Reading

For further reading on the comment and review process, see my blog HERE .

Also, I have been keeping on ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.

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.

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.

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.

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

As part of the same initiative, 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.

As part of the ongoing 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.

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.

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 Cracks Down On Failure To File 8-K For Financing Activities; An Overview Of Form 8-K SEC Proposes Shortening Trade Settlement »

SEC Cracks Down On Failure To File 8-K For Financing Activities; An Overview Of Form 8-K

Posted by Securities Attorney Laura Anthony | December 13, 2016

Introduction and Background

On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these two actions, I have been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. Using this as a backdrop, this blog will also address Form 8-K filing requirements in general.

Back in August 2014, the SEC did a similar sweep related to 8-K filing failures associated with 3(a)(10) transactions. See my blog HERE for a discussion of those actions and 3(a)(10) proceedings in general. The 8-K filing deficiency actions were a precursor to a larger SEC investigation on 3(a)(10) transactions themselves which culminated in two well-known enforcement actions against active 3(a)(10) participants (the Ironridge companies and IBC Funds) and resulted in a chill on the 3(a)(10) activity in the industry as a whole. 3(a)(10) actions continue today but the volume of transactions has dramatically reduced and the attention to due diligence, detail and reporting requirements has likewise increased.

The SEC rarely takes enforcement action or expends time or resources on investigating the failure to file an 8-K. When such issues arise, it is usually in connection with a routine review of a company’s SEC reports or as part of the comment and review process associated with the filing of a registration statement. All reports filed with the SEC are subject to SEC review and comment and the Sarbanes-Oxley Act requires that the SEC undertake some level of review of every reporting company at least once every three years.

As was the case with the SEC’s investigation into 3(a)(10) transactions, it is my belief that the SEC is reviewing the PIPE industry as a whole and in particular the process, procedure and effects associated with convertible instruments. The majority of these transactions involve the issuance of convertible notes which then convert into common stock following a holding period in reliance on Rule 144 and Section 3(a)(9) of the Securities Act of 1933 (“Securities Act”). For a review of the use of Section 3(a)(9) related to convertible notes, see my blog HERE. Any convertible instrument can be used in the same manner, such as preferred stock and warrants.

The use of convertible instruments in PIPE transactions is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. My belief is that the SEC is using the investigation into the failure to file 8-K’s in association with these transactions to assist in a larger investigation into related fraud and other violations. If a company is failing to file an initial 8-K for the transaction and subsequent 8-K’s to report the issuance of securities upon a conversion, there may also be other issues and violations. Examples of abusive or improper activity could include: (i) backdating of notes or failure to provide the funding associated with the note; (ii) improper undisclosed affiliations between investors and the company or its officers and directors; (iii) manipulative trading practices; (iv) improper stock promotion (although a topic for another blog, stock promotion itself is not illegal as long as, among other things, the information disseminated is true and accurate, there is no pump-and-dump activity, and Securities Act Section 17(b) disclosures are used); or (v) trading on insider information.

During a conversion process, the number of issued and outstanding shares of common stock can increase dramatically, causing dilution to existing shareholders and a decrease in stock price from large selling pressure. In an action against Connexus Corporation, the SEC noted that the unreported issuances of securities increased the amount of common stock by more than 600% from the last reported number.

The ability of an investor to convert and trade responsibly makes the difference between a successful financing relationship with the investment community and one that can cause long-term damage to a company.

To be clear, I do not think there is anything inherently wrong, illegal or improper with these corporate finance transactions. The exact same structure is used for PIPE investments in companies big and small, whether traded on the OTC Markets, NASDAQ or NYSE. However, smaller companies often do not have the volume and liquidity to bear the effect of sudden enormous selling pressure. Larger companies are not immune to issues, though. Nuanced provisions negotiated in these convertible derivative instruments can be problematic as well, such as the recent use of the Black-Scholes put option in warrants (see Vapor Corp. as a prime example).

When considering a PIPE transaction, companies are often presented with numerous term sheets and investors to choose from. The terms will only vary slightly and many investors will match terms from a competitor. In choosing a transaction it is incumbent upon the company to conduct due diligence on the investor, including their reputation in the industry and trading history associated with other investments and conversions.

Form 8-K Filing Requirements Related to PIPE Transactions

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file reports with the SEC. For an overview of these reporting requirements, see my blog HERE. For a running update on the state of proposed changes to the specific reporting requirements in Regulations S-K and S-X, see my summary at the end of this blog.

Exchange Act Rule 13a-11 requires the filing of current reports on Form 8-K. Subject to certain exceptions, a Form 8-K must be filed within four (4) business days after the occurrence of the event being disclosed. No extension is available for an 8-K. Companies file this report with the SEC to announce major or extraordinary events that shareholders should know about, including entry into material agreements and the issuance of unregistered securities. It is these two specific events that are implicated with the entry into corporate financing transactions, and subsequent conversions of convertible instruments such as convertible debt or preferred stock.

In particular, Item 1.01 of Form 8-K requires that a company report if it has entered into “a material definitive agreement not made in the ordinary course of business…” Under Item 1.01, the company must report: (a) the date of the agreement; (b) the parties to the agreement; (c) a description of any material relationship between the parties, other than the reported agreement; and (d) a brief description of the terms and conditions of the agreement.

Item 3.02 of Form 8-K requires that a company report the unregistered sale of securities. Under Item 3.02, the company must report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. The report must disclose: (a) the date, title and amount of securities sold; (b) the nature and amount of consideration paid; (c) the Securities Act exemption being relied upon and a brief explanation of the facts relied upon to support the exemption; and (d) where applicable, the terms of conversion or exercise.

The Item 3.02 filing requirement is triggered if the volume threshold of the underlying equity securities issuable upon conversion is exceeded, even if those issuances are structured as takedowns over time, such as where a convertible note is partially converted in multiple tranches. That is, if it is foreseeable that the total number of securities issued in a corporate finance transaction will exceed 5% of the current outstanding securities, an Item 3.02 8-K must be filed. Likewise, where the actual conversions and issuances of common stock exceed the 5% threshold in aggregate, an 8-K is required.

The Item 3.02 8-K must disclose all unregistered issuances that resulted in increasing the total outstanding securities by the 5% threshold. As a simple example, if a company reports 10,000,000 shares of outstanding common stock in its 10-Q and then proceeds to issue 100,000 shares each in a series of conversions, as soon as the total outstanding reaches 10,500,000, the 8-K filing requirement would be triggered and each of the conversions would need to be reported.

Form 8-K Filing Requirements: A Broad Overview

As mentioned above, any U.S. reporting company must file periodic reports on Form 8-K. A foreign issuer uses a Form 6-K, which has different requirements. The following is a brief description of each of the events that trigger an 8-K filing requirement. Many transactions will require the filing under multiple Item numbers, in which case the company can set forth all the material information and cross-reference the disclosure under each Item. Also, a Form 8-K can serve double duty and satisfy certain other filing requirements, such as those related to proxy proceedings or business combination transactions. The front page of the form 8-K provides check boxes to disclose such double use.

Section 1 – Registrant’s Business and Operations

Item 1.01 Entry into a Material Definitive Agreement – Material agreements are those that create material obligations that are enforceable by or against a company. As a rule of thumb, if an agreement is material enough to require separate board or shareholder consent, it requires an 8-K filing. Non-binding term sheets or letters of intent generally do not trigger a filing requirement, though material binding provisions contained therein may, such as significant breakup fees. A company is not required to file a copy of the agreement itself with the 8-K, but if it does not, the agreement must be filed with the next periodic report on either Form 10-Q or 10-K. As is encouraged by the SEC, I usually recommend that the agreement be filed with the 8-K. The determination of an 8-K filing requirement that is made at the time the agreement is entered into such that if the agreement becomes material through the passage of time or events, an 8-K filing is not later triggered.

Item 1.02 Termination of a Material Definitive Agreement – The termination of an agreement that is reported or reportable in Item 1.01, other than by its own terms, must be reported.

Item 1.03 Bankruptcy or Receivership – An 8-K must be filed for bankruptcy or receivership actions involving either the company or its parent (majority shareholder).

Item 1.04 Mine Safety – Reporting of Shutdowns and Patters of Violations – The requirement for an 8-K is triggered by the receipt of a notice under the Federal Mine Safety and Health Act of 1977 or from the Mine Safety and Health Administration.

Section 2 – Financial Information

Item 2.01 Completion of Acquisition or Disposition of Assets – In addition to reporting the particular acquisition or disposition transaction, this section triggers the requirement to provide financial statements and information under Regulation S-X, including historical and/or pro forma financial statements. If the report also involves a change of shell status, the financial statements must be included with the initial report under Item 2.01. If the company was not a shell, the financial statements may be filed by amendment within 71 days of the initial 8-K reporting the Item 2.01 event.

Item 2.02 Results of Operations and Financial Conditions – An Item 2.02 is triggered by the disclosure of any material non-public financial information about a completed quarter of fiscal year-end. An Item 2.02 disclosure is usually accompanied by a press release, which can be “furnished” and not “filed.” See below for a discussion on the difference. Also, an Item 2.02 filing must be made prior to any associated earnings call.

Item 2.03 Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement of a Registrant – An example of an off-balance sheet transaction would be one where the company guarantees or lease or other obligation of a third party.

Item 2.04 Triggering Events that Accelerate or Increase a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement – An example would be the default by the primary party to a guaranteed obligation.

Item 2.05 Costs Associated with Exit or Disposal Activities – An example would be the termination of a business division or manufacturing plant. Another example would be material write-offs or restructuring costs.

Item 2.06 Material Impairments – An example would be a material impairment to the value of assets such as goodwill or investment securities. Another example could be the loss of value to technology inventory due to obsolescence.

Section 3 – Securities and Trading Markets

Item 3.01 Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing – An example would be a notice of delinquency with the listing requirements of an exchange such as the NASDAQ or NYSE MKT. If such notice culminates in an actual delisting, another 8-K would need to be filed under this item. Likewise, a company’s decision to delist and move to the OTC Markets would be reportable.

Item 3.02 Unregistered Sales of Equity Securities – For a smaller reporting company, this Item requires that a company report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. For all other companies, the threshold is triggered at a 1% change.

Item 3.03 Material Modification to Rights of Security Holders – Examples would be amendments to preferred stock preferences or the issuance of senior securities.

Section 4 – Matters Related to Accountants and Financial Statements

Item 4.01 Changes in Registrant’s Certifying Accountant – An 8-K filing under this Item will always be reviewed by the SEC and must meet the exact particular disclosure requirements.

Item 4.02 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review – A filing on this Item is usually accompanied by or quickly followed by an amendment to the subject report and financial statements. Moreover, if the amended underlying report is not concurrently filed, an Item 4.02 filing in essence reports that the company is delinquent in its filing requirements, as an unreliable report is equivalent to no report. An Item 4.02 filing is due within 2 days of receipt of an auditor’s restatement letter.

Section 5 – Corporate Governance and Management

Item 5.01 Changes in Control of Registrant – Control includes changes in the board of directors, officers or control shareholders.

Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers – This Item includes any and all changes in officers or directors, whether by resignation, termination, refusal to stand for re-election or completion of a change of control transaction.

Item 5.03 Amendments to Articles of Incorporation or Bylaws; Changes in Fiscal Year – When completing a corporate action that is processed by FINRA, this item filing requirement is triggered when the amended articles are filed with the state, regardless of the timing of FINRA’s review and processing of the change with the markets. A restatement that does not make material changes does not trigger an 8-K filing, such as where a company is combining multiple amendments for ease of reference or cleaning up otherwise ambiguous language.

Item 5.04 Temporary Suspension of Trading Under Registrant’s Employee Benefits Plans – This item filing requirement is triggered by the receipt of a notice under the Employment Retirement Income Security Act of 1974 (ERISA).

Item 5.05 Amendments to the Registrant’s Code of Ethics, or Waiver of a Provision of the Code of Ethics – In addition to filing an 8-K, the company must carry through the change to the documents posted on its website.

Item 5.06 Change in Shell Company Status – An Item 5.06 filing is usually accompanied by an Item 2.02 disclosure and triggers the filing of Form 10 information, including financial statements.

Item 5.07 Submission of Matters to a Vote of Security Holders – This Item requires the reporting of voting results and is thus a retrospective report of a vote as opposed to a prospective notice of a matter to be submitted for vote. Item 5.07 also requires the disclosure of say-on-pay votes and the frequency on say-on-pay votes.

Item 5.08 Shareholder Director Nominations – This Item requires a company to inform shareholders of the date in which they must submit director nominations on Schedule 14N.

Section 6 – Asset-Backed Securities

Item 6.01 ABS Informational and Computational Materials

Item 6.02 Change of Servicer or Trustee – Requires a report of any changes, whether through resignation or termination.

Item 6.03 Change in Credit Enhancement or Other External Support – Requires a report of any material changes, whether through the loss, addition or change in support.

Item 6.04 Failure to Make a Required Distribution – Only requires the report of material failures to distribute in a timely manner.

Item 6.05 Securities Act Updating Disclosure – Includes material changes in an offering of AB securities.

Item 6.06 Static Pool – Alternative to filing a prospectus supplement required by Item 1105 of Regulation AB.

Section 7 – Regulation FD

Item 7.01 Regulation FD Disclosure – Information should be furnished and not filed. Where the information is material non-public information, such as in a press release, the filing must be made immediately prior to or simultaneously with the issuance of the release. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day. Regulation FD disclosures are an exception to the usual four-day filing rule.

Section 8 – Other Events

Item 8.01 – Other Events – This is a catch-all voluntary filing by companies that wish to report information that does not otherwise fit within an 8-K category. Because the information is voluntary and not otherwise required, there is no four-day filing rule.

Section 9 – Financial Statements and Exhibits

Item 9.01 Financial Statements and Exhibits – Requires the filing of all financial statements and exhibits required by other Items on Form 8-K and specifies such financial statement requirements. In addition, Item 9.01 sets forth the timing of filing of the financial statements for both shell and non-shell companies.

Penalties for Failure to File

Late or missed filings carry severe consequences to companies. To qualify to use Form S-3, a company must have filed all SEC reports in a timely manner, including Form 8-K, for the prior 12 months. Moreover, filing failures can result in enforcement proceedings and the conclusion of and disclosure related to inadequate controls and procedures.

Difference Between Filed and Furnished

Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The SEC allows certain information to be furnished as opposed to filed; however, it is incumbent upon the company to clearly disclose that it is avowing itself of the ability to furnish and not file. That is, unless otherwise specifically disclosed, information in a report made with the SEC will be deemed filed, not furnished. Note, however, that other liability provisions under the Exchange Act may apply that are not dependent on the filing of documents, such as the anti-fraud provisions under Rule 10b-5.

Further Reading

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. However, I note that with the recent election, and the GOP sweeping control of both the House and Senate, it is unclear what the future of these initiatives holds.

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.

« Yahoo Hacking Scandal And Obligations Related To Cybersecurity SEC Eliminates The “Tandy Letter” »

Yahoo Hacking Scandal And Obligations Related To Cybersecurity

Posted by Securities Attorney Laura Anthony | December 6, 2016 Tags: Obligations Related To Cybersecurity, Yahoo Hacking Scandal

On September 26, 2016, Senator Mark R. Warner (D-VA), a member of the Senate Intelligence and Banking Committees and cofounder of the bipartisan Senate Cybersecurity Caucus, wrote a letter to the SEC requesting that they investigate whether Yahoo, Inc., fulfilled its disclosure obligations under the federal securities laws related to a security breach that affected more than 500 million accounts. Senator Warner also requested that the SEC re-examine its guidance and requirements related to the disclosure of cybersecurity matters in general.

The letter was precipitated by a September 22, 2016, 8-K and press release issued by Yahoo disclosing the theft of certain user account information that occurred in late 2014. The press release referred to a “recent investigation” confirming the theft of user account information associated with at least 500 million accounts that was stolen in late 2014. Just 13 days prior to the 8-K and press release, on September 9, 2016, Yahoo filed a preliminary 14A filing with the SEC related to the sale of Yahoo’s operating business to Verizon Communications, Inc., in which it stated that it did not have any knowledge of “any incidents of, or third party claims alleging… unauthorized access” of personal data of its customers that could have a material effect on the Verizon-Yahoo transaction.

The September 22 filing was the first disclosure by Yahoo of the hack and has raised many questions as to when it knew about the 2014 cyberattack and what its duties were to make public disclosure of same. The hack has also raised questions related to the SEC’s current rules and thresholds for how and when companies need to report a material data breach.

This blog provides a summary of the current SEC guidelines related to disclosures of cybersecurity risks and incidents as well as a summary of current disclosure practices among reporting companies.

SEC Guidance on Disclosure of Cybersecurity Matters

Introduction

On October 13, 2011, the SEC issued a Disclosure Guidance related to cybersecurity risks and cyber incidents. The guidance attempts to find a balance between satisfying the disclosure mandates of providing material information related to risks to the investing community with a company’s need to refrain from providing disclosure that could, in and of itself, provide a road map to the very breaches a company attempts to prevent. In that regard, the SEC is clear that disclosure of actual detailed security measures is not required. As with the rules on disclosure in general, companies must consider their specific facts and circumstances in determining the required disclosure, if any.

Cyber-incidents can take many forms, both intentional and unintentional, and commonly include the unauthorized access of information, including personal information related to customers’ accounts or credit information, data corruption, misappropriating assets or sensitive information or causing operational disruption. A cyber-attack can be in the form of unauthorized access or a blocking of authorized access.

The purpose of a cyber-attack can vary as much as the methodology used, including for financial gain such as the theft of financial assets, intellectual property or sensitive personal information on the one hand, to a vengeful or terrorist motive through business disruption on the other hand. A primary example of the latter is the famous hacking of the Sony Pictures Entertainment email system in 2014.

When victim to a cyber-attack or incident, a company will have direct financial and indirect negative consequences, including but not limited to:

Remediation costs, including liability for stolen assets, costs of repairing system damage, and incentives or other costs associated with repairing customer and business relationships;
Increased cybersecurity protection costs to prevent both future attacks and the potential damage caused by same. These costs include organizational changes, employee training and engaging third-party experts and consultants;
Lost revenues from unauthorized use of proprietary information and lost customers;
Litigation; and
Reputational damage.

Disclosure Guidance

Consistent with all disclosure guidance, the SEC begins its guideline with the basic premise that the disclosure requirements are meant to “elicit disclosure of timely, comprehensive, and accurate information about risks and events that a reasonable investor would consider important to an investment decision.” With that said, as of the date of the guidance, and as of today, there is no specific disclosure requirement or rule under either Regulation S-K or S-X that addresses cybersecurity risks, attacks or other incidents.

However, as discussed further in this blog, many of the disclosure rules encompass these disclosures indirectly, such as risk factors, internal control assessments, management discussion and analysis, legal proceedings and financial statement loss contingencies. Moreover, as with all other disclosure requirements, an obligation to disclose cybersecurity risks, attacks or other incidents may be triggered to make other required disclosures not misleading considering the circumstances.

Risk Factors

Obviously, where appropriate, cybersecurity risks need to be included in risk factor disclosures. The SEC guidance in this regard is very common-sense. The SEC expects companies to “evaluate their cybersecurity risks and take into account all available relevant information, including prior cyber incidents and the severity and frequency of those incidents.” In addition, companies should consider the probability of an incident and the quantitative and qualitative magnitude of the risk, including potential costs and other consequences of an attack or other incident. Consideration should be given to the potential impact of the misappropriation of assets or sensitive information, corruption of data or operational disruptions. A company should also consider the adequacy of preventative processes and plans in place should an attack occur. Material actual threatened attacks may be material and require disclosure.

As with all risk-factor disclosures, the company must adequately describe the nature of the material risks and how such risks affect the company. Likewise, generic risk factors that could apply to all companies should not be included. Risk factor disclosure may include:

Discussion of the company’s business operations that give rise to material cybersecurity risks and the potential costs and consequences;
Discussion of any outsourcing of functions that give rise to risks or preventative measures;
Description of past incidents, including their costs and consequences;
Risks of cyber-incidents that could remain undetected for a period of time; and
Description of insurance coverage.

Management Discussion and Analysis (MD&A)

A company would need to include discussion of cybersecurity risks and incidents in its MD&A if the costs or other consequences associated with one or more known incidents or the risk of potential future incidents result in a material event, trend or uncertainty that is reasonably likely to have a material effect on the company’s results of operations, liquidity or financial condition, or could impact previously reported financial statements. The discussion should include any material realized or potential reduction in revenues, increase in cybersecurity protection costs, and related litigation. Furthermore, even if an attack did not result in direct losses, such as in the case of a failed attempted attack, but does result in other consequences, such as a material increase in cybersecurity expenses, disclosure would be appropriate.

Business Description; Legal Proceedings

Disclosure of cyber-related matters may be required in a company’s business description where they effect a company’s products, services, relationships with customers and suppliers or competitive conditions. Likewise, material litigation would need to be included in the “legal proceedings” section of a periodic report or registration statement.

Financial Statements

Cyber-matters may need to be included in a company’s financial statements prior to, during and/or after an incident. Costs to prevent cyber-incidents are generally capitalized and included on the balance sheet as an asset. GAAP provides for specific recognition, measurement and classification treatment for the payment of incentives to customers or business relations, including after a cyber-attack. Cyber-incidents can also result in direct losses or the necessity to account for loss contingencies, including those related to warranties, breach of contract, product recall and replacement, indemnification or remediation. Furthermore, incidents can result in loss of, and therefore accounting impairment to, goodwill, intangible assets, trademarks, patents, capitalized software and even inventory.

Controls and Procedures

To the extent that cyber-matters effect a company’s ability to record, process, summarize and report financial and other information in SEC filings, management will need to consider whether there is a reportable deficiency in disclosure controls and procedures.

Disclosure in Practice

The Yahoo hacking incident resulted in numerous media articles and blogs related to the disclosure of cyber-matters in SEC reports. One such blog was written by Kevin LaCroix and published in the D&O Diary. Mr. LaCroix’s blog points out that according to a September 19, 2016, Wall Street Journal article, cyber-attacks are occurring more frequently than ever but are rarely reported. The article cites a report that reviewed the filings of 9,000 public companies from 2010 to the present and found that only 95 of these companies had informed the SEC of a data breach.

As reported in a blog published by Debevoise and Plimpton, dated September 12, 2016, (thank you, thecorporatecounsel.net), a review of Fortune 100 cyber-reporting practices revealed that most disclosures are contained in the risk-factor section of regular periodic reports such as Forms 10-Q and 10-K as opposed to interim disclosures in a Form 8-K. Moreover, only 20 incidents were reported at all in the period from January 2013 through the third quarter of 2015.

My opinion (which was also Mr. LaCroix’s opinion and that of most of the industry) is that companies are relying on the materiality standard to avoid disclosure of cyber-incidents. Most public-company hacking involves large organizations that can reasonably make the judgment call that the incident and its effects are not material to investment decisions. See HERE for a discussion on materiality.

Additional Information

In 2011, at the time of the SEC release, there was a noticeable increase in reliance on technology by all businesses resulting in the issuance of the guidance. Today, the prevalence of technological reliance and cyber-incidents has increased dramatically and as such, it is my view that it is time for the SEC to review and update their guidance.

The SEC focuses time and financial resources on the use of technology by the SEC itself and market participants. In November 2015, the SEC adopted Regulation Systems Compliance and Integrity, which requires key market participants to have comprehensive written policies and procedures to ensure the security and resilience of their technological systems, to ensure that systems operate in compliance with federal securities laws and to provide for maintenance and testing of such systems. For more information see my blog HERE.

Recap on Disclosure Effectiveness Initiative

The disclosure of cybersecurity risks, attacks or other incidents is ultimately just a disclosure. As I’ve been writing about often recently, disclosure has been and continues to be a topic of examination and regulatory change.

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.

« SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A SEC Cracks Down On Failure To File 8-K For Financing Activities; An Overview Of Form 8-K »

SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

Posted by Securities Attorney Laura Anthony | November 29, 2016 Tags: SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amend Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). In addition, the SEC has created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC has amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC has repealed the rarely used and now redundant Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A will take effect on April 20, 2017. Amended Rule 504 will take effect on January 20, 2017, and the repeal of Rule 505 will be effective May 20, 2017. The rule changes had initially been proposed in October 2015. My two-part blog on the proposed amendments can be read HERE and HERE.

Background on Rule 147 and Rationale for Amendments

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption.

Rule 147 was adopted as a safe harbor under Section 3(a)(11) to provide further details on the application of the Intrastate Exemption. Rule 147 was adopted in 1974 and until now had not been updated since that time. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.

Section 3(a)(11) and Rule 147 has limitations that simply do not comport to today’s world. For example, the Rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and, if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.

Also, Rule 147 required that an issuer be incorporated in the state in which the offering occurs. In today’s world many company’s incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be overly burdensome.

The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 made it difficult for issuers to take advantage of these new state crowdfunding provisions.

At the same time, many current state intrastate exemptions are modeled after the language in Section 3(a)(11) and the existing Rule 147. As a result, simply amending Rule 147 to allow changes to the manner of offering to include advertising through Internet, television, radio and other forms of media that could be seen by out-of-state residents, would have left a disparity between state and federal rules. Accordingly, the SEC determined to amend Rule 147 within the statutory constraints of Section 3(a)(11) and add new Rule 147 without such constraints.

Summary of the New Rules

Amended Rule 147 remains a safe harbor under Section 3(a)(11) of the Securities Act allowing companies to continue to rely on the rule for current state law exemptions. New Rule 147A is a stand-alone rule not attached to Section 3(a)(11) and therefore not constrained by the specific language in that Section. New Rule 147A is substantially similar to amended Rule 147 but eliminates the restrictions on offers such that the Internet and websites can be used for such offers, and eliminates the requirement that a company be incorporated in the state in which it is conducting the offering as long as certain conditions are met. Sales will still be limited to residents of the company’s state.

Other than provisions allowing out-of-state offers (such as by use of a website) and offerings by states incorporated out of state, amended Rule 147 and new Rule 147A are substantially the same.

Both amended Rule 147 and new Rule 147A include the following: (i) a requirement that the issuer has its “principal place of business” in-state and satisfy at least one in-state “doing business” requirement; (ii) a new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser; (iii) a requirement that issuers obtain a written representation regarding residency from each purchaser; (iv) determining residency of an entity purchaser using the “principal place of business” standard; (v) limiting resales to persons within the same state for a period of six months; (vi) an integration safe harbor for any other prior offering and some subsequent offerings; and (vii) legend requirements for offerees and purchasers related to resale limitations.

Both amended Rule 147 and new Rule 147A remain intrastate exemptions and must comply with all state laws regarding any offerings. States are free to impose additional disclosure requirements, bad-actor prohibitions and other state-specific investor protections. No notice or Form D filing is required to be made to the SEC.

Rule 504 of Regulation D is a registration exemption for small offerings available to companies that are not Exchange Act reporting, investment companies or blank-check companies. Generally Rule 504 requires that the issuing company comply with state law as to the particular offer and exemption requirements, including, where required, a state level registration. The new rule maintains the structure, and bows to state law requirements but increases the aggregate offering amount from $1 million to $5 million and adds bad-actor disqualifications from reliance on the rule.

The SEC has repealed Rule 505 of Regulation D.

Amended Rule 147 and New Rule 147A – Specifics

Manner of Offering

New Rule 147A will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon.

Amended Rule 147 will continue to prohibit offers to out-of-state residents. Both Rules 147 and 147A will require that all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state. To accommodate space-constrained social media, such as Twitter, the SEC will allow the use of hyperlinks. In particular, where offering materials or information is distributed through a medium with limitations on the number of characters or text that may be included, and the information with disclaimers would exceed such limitations, the company can satisfy its disclosure obligation by including an active hyperlink to the required disclosures. The communication must prominently indicate that the required language is provided through the hyperlink. Where an electronic communication is capable of including the required statements, along with the other information, without exceeding the applicable limit on number of characters or amount of text, a hyperlink should not be used.

Determining Whether an Issuer is a “Resident” of a Particular State

Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual. Amended Rule 147 maintains this basic requirement, but supplants “principal office” with “principal place of business,” a term that is also used in new Rule 147A. Under amended Rule 147 a company will be deemed a “resident” of a particular state in which it is both incorporated and has its principal place of business.

An issuer’s “principal place of business” is defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” The concept of principal office has been eliminated.

Under new Rule 147A residence will be determined solely using the “principal place of business” test without regard to state of incorporation. Under both amended Rule 147 and new Rule 147A, companies may only sell securities to purchasers in the same state in which such company has its principal place of residence. As noted above, Rule 147A does not so limit “offers.”

Where a company changes state of residence, under both rules, it will not be able to conduct another offering until the securities sold in the first offering have “come to rest.” That is, both rules provide that where an issuer completes an offering in one state, it would not be able to conduct an offering in another state until six months after the last sale in the prior state. This six-month period is also used for the resale limitation in both rules, which is an amendment from the prior nine-month rule under old Rule 147.

Other than the above manner of offering and determination of residence provisions, amended Rule 147 and new Rule 147A are identical. Accordingly, each of the following discussed provisions apply equally to both Rule 147 and new Rule 147A.

Determining Whether an Issuer is “Doing Business” in a Particular State

In addition to issuer residency, a company must satisfy at least one test establishing that such company is “doing business” in the state of the offering. Old Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Amended Rule 147 and new Rule 147A add a fourth test based on majority of employees, and only require that a company satisfy one of the four test to qualify for the use of the offering within that state.

In particular, an issuer shall be deemed to be doing business within a state if the issuer meets one of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state; or (iv) a majority of the issuer’s employees are located within the state.

Presumably a majority is satisfied by a greater than 50% determination. An employee would be located in a state if he or she is based in an office located in the state. A particular example provided in the rule release is one where an employee services the Virginia, Maryland and Washington, D.C., area for a company with an office in Maryland. In such case, the employee would be deemed based in Maryland.

Amended Rule 147 eliminates an exception from the 80% rule previously in place for companies with $5,000 or less in revenues.

As with all provisions of amended Rule 147 and new Rule 147A, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

Amended Rule 147 and new Rule 147A define the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. Again, “principal place of business” is defined as the location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.

Amended Rule 147 and new Rule 147A add a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state at the time of the purchase of securities, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. As with 506(c), the SEC is reluctant to provide a firm list of requirements that satisfy the reasonable belief standard but rather urges a company to consider all facts and circumstances. However, the rule release does contain some example considerations, including (i) a pre-existing relationship between the company and prospective purchaser that includes knowledge of residency; (ii) evidence such as the address on utility and house bills; (iii) pay stubs; (iv) tax returns; (v) documents issued by a federal or state governmental authority including a driver’s license; and (vi) public records.

In addition to the reasonable belief requirements, a company must obtain a written representation of residency from the investor. The representation of the investor can serve as evidence of residency but is not dispositive. A self-attestation from an investor, without more, is not enough to create a reasonable belief.

The SEC provides examples of proof of residency. For individuals proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the intrastate offering. Amended Rule 147 and new Rule 147A shorten this holding period to six months from the date of the sale. Market makers or dealers desiring to quote such securities after the six-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information.

Bona fide gifts are specifically not subject to the resale limitations. However, the donee would still be bound by the same limitation. Accordingly, if an issuer conducted an intrastate offering in Florida, for example, and a purchaser than made a bona fide gift to a charity in California, that charity would be limited to resales to purchasers in Florida until the six-month period had expired. In this case, the charity could tack onto the holding period of the original purchaser.

The resale limitation is confined to the state in which the issuer conducts the offering. If an issuer changes its principal place of business following an offering, the resale limitations would stay in the state where the offering had been conducted.

Moreover, Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. In the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence. Finally, persons reselling will need to consider whether they could be considered an underwriter if they purchase with a view to distribution. For purposes of determining underwriter status, a purchaser can rely on the guidance in Rule 144.

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Current Rule 147(b)(2) provides an integration safe harbor based on a hard six-month rule. Amended Rule 147 and new Rule 147A amend the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, offers and sales under Rule 147 and Rule 147A will not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering.

The Rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test. As part of an integration analysis, an issuer will need to consider the particular offering exemptions and requirements, including the use of general solicitation and advertising. For instance, a regulation crowdfunding, which by its nature solicits residents in all states, would not be consistent with a Rule 147 offering, but may work with a Rule 147A offering.

Moreover, an issuer will need to be mindful of gun-jumping issues where a registered offering is begun immediately after the conclusion of a Rule 147 or 147A offering that involved solicitation and advertising. In such cases, like testing the waters under Rule 105(c) of the JOBS Act, solicitations will need to be limited to qualified institutional buyers and institutional accredited investors for the 30 days prior to filing the registration statement. In practice, I suspect most issuers will simply wait for a 30-day period after completing an intrastate offering, prior to filing a registration statement.

Disclosure/Legend Requirements

Under amended Rule 147 and new Rule 147A, a disclosure about the limitations on resale needs to be given to each offeree and purchaser at the time of any offer or sale. The disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser. In addition, a written disclosure must be provided to all purchasers a reasonable period of time before the date of the sale.

Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Such legend must also identify the state in which the intrastate offering was completed for purposes of the resale restrictions.

State Law Requirements

Although the SEC had initial proposed limitations as to the availability of the offering to states that, in turn, had registration or exemptions with particular specified provisions including limits on investment amounts, the final rules do not contain such provisions. The SEC believes the states can regulate such offerings without particular federal requirements. The SEC notes that most state crowdfunding or intrastate offering protections already contain total offering limits and per-investor investment limitations.

Intrastate Broker-dealer Exemption

Section 15 of the Exchange Act exempts any broker whose business is exclusively intrastate and who does not use any facility for a national securities exchange, from broker-dealer registration requirements (the “intrastate broker-dealer exemption”). At the request of commenters, the SEC clarifies that a broker will not lose its ability to rely on the intrastate broker-dealer exemption merely because it maintains a website that can be viewed by out-of-state persons so long as such broker takes reasonable steps to ensure that its business remains exclusively intrastate. Such reasonable measures can include disclosures and disclaimers and taking measures to determine the state of residency of a potential client or lead.

Section 12(g) Registration

Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors to register such class of securities with the SEC. After consideration, including the fact that intrastate offerings do not impose any ongoing reporting requirements, the SEC determined not to exempt securities sold in Rule 147 and 147A offerings from the Section 12(g) registration requirements.

Exclusion of Investment Companies

Under Section 24(d) of the Investment Company Act of 1940, Section 3(a)(11) is not available to investment companies registered or required to be registered under the Investment Company Act. Accordingly, investment companies will remain excluded from Section 3(a)(11) and amended Rule 147. For consistency, the SEC specifically excludes investments companies from the use of new Rule 147A.

Amendments To Rules 504 And 505

Overview of Current Rule

Currently Rule 504 of Regulation D provides an exemption from registration for offers and sales up to $1 million in securities in any twelve-month period. Current Rule 504, like Regulation A/A+, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Moreover, current rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

Rules 504, 505 and 506 together comprise Regulation D. Rule 506 is promulgated under Section 4(a)(2) of the Securities Act and preempts state law. Rules 505 and 506 are promulgated under Section 3(b) of the Securities Act and do not preempt state law. Currently Rules 505 and 506 have bad-actor disqualification provisions but Rule 504 does not.

The vast majority of states require the registration of Rule 504 offerings. Rule 504 is similar to the offering exemption found in Section 3(a)(11) in that on the federal level it defers to state legislation and oversight. In fact, of the 34 states that have recently passed state-based crowdfunding exemptions, Maine specifically allows an issuer to rely on Rule 504 in utilizing its crowdfunding provisions.

As Rule 504 is, in essence, a deferral to the states for small offerings, the SEC is of the position that it does not warrant imposing extensive regulation on the federal level. I agree. As stated by the SEC, the purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions and general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Amendments

The SEC has increased the amount of securities that may be offered and sold in reliance on Rule 504 to $5 million in any 12-month period, and has added bad-actor disqualification provisions to the rule. The SEC believes the change will help facilitate capital formation and give states greater flexibility in developing state-coordinated review programs for multi-state registrations. The proposed rule also corrects the technical reference to Section 3(b) of the Securities Act in the Rules 504 to Section 3(b)(1), which change was made by the JOBS Act in 2012.

The proposed bad-actor disqualification provisions are substantially the same as those in place for Rule 506 offerings. For a review of the Rule 506 bad-actor disqualification provisions, see my blog HERE.

Repeal of Rule 505

The SEC has repealed the almost never used Rule 505 in its entirety.

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 Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers” Yahoo Hacking Scandal And Obligations Related To Cybersecurity »

SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | November 22, 2016 Tags: Application; Associated Person Registration; Supervision, CAB, CABs, Conduct Rules for CABs, Description of Capital Acquisition Broker (“CAB”), Financial and Operational Rules for CABs, FINRA Rule 2121, FINRA Rule 3110, FINRA rules, M&A deals

On August 18, 2016, the SEC approved FINRA’s rules implementing a new category of broker-dealer called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. FINRA first published proposed rules on CABs in December 2015. My blog on the proposed rules can be read HERE. In March and again in June 2016, FINRA published amendments to the proposed rules. The final rules enact the December proposed rules as modified by the subsequent amendments.

A CAB will generally be a broker-dealer that engages in M&A transactions, raising funds through private placements and evaluating strategic alternatives and that collects transaction-based compensation for such activities. A CAB will not handle customer funds or securities, manage customer accounts or engage in market making or proprietary trading.

Description of Capital Acquisition Broker (“CAB”)

There are currently FINRA-registered firms which limit their activities to advising on mergers and acquisitions, advising on raising debt and equity capital in private placements or advising on strategic and financial alternatives. Generally these firms register as a broker because they may receive transaction-based compensation as part of their services. However, they do not engage in typical broker-dealer activities, including carrying or acting as an introducing broker for customer accounts, accepting orders to purchase or sell securities either as principal or agent, exercising investment discretion over customer accounts or engaging in proprietary trading or market-making activities.

The proposed new rules will create a new category of broker-dealer called a Capital Acquisition Broker (“CAB”). A CAB will have its own set of FINRA rules but will be subject to the current FINRA bylaws and will be required to be a FINRA member. FINRA estimates that there are approximately 750 current member firms that would qualify as a CAB and that could immediately take advantage of the new rules.

FINRA is also hopeful that current firms that engage in the type of business that a CAB would, but that are not registered as they do not accept transaction-based compensation, would reconsider and register as a CAB with the new rules. In that regard, FINRA’s goal would be to increase its regulatory oversight in the industry as a whole. I think that on the one hand, many in the industry are looking for more precision in their allowable business activities and compensation structures, but on the other hand, the costs, regulatory burden, and a distrust of regulatory organizations will be a deterrent to registration. It is likely that businesses that firmly act within the purview of a CAB but for the transactional compensation and that intend to continue or expand in such business, will consider registration if they believe they are “leaving money on the table” as a result of not being registered. Of course, such a determination would include a cost-benefit analysis, including the application fees and ongoing legal and compliance costs of registration. In that regard, the industry, like all industries, is very small at its core. If firms register as a CAB and find the process and ongoing compliance reasonable, not overly burdensome and ultimately profitable, word will get out and others will follow suit. The contrary will happen as well if the program does not meet these business objectives.

A CAB will be defined as a broker that solely engages in one or more of the following activities:

Advising an issuer on its securities offerings or other capital-raising activities;

Advising a company regarding its purchase or sale of a business or assets or regarding a corporation restructuring, including going private transactions, divestitures and mergers;

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;

Qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in respect to the purchase or sale of newly issued unregistered securities (see below for the FINRA definition of institutional investor, which is much different and has a much higher standard than an accredited investor);

Qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer or control person in connection with a change of control of a privately held company. For purposes of this section, a control person is defined as a person that has the power to direct the management or policies of a company through security ownership or otherwise. A person that has the power to direct the voting or sale of 24% or more of a class of securities is deemed to be a control person; and/or

Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters. For more information on this, see my blog HERE regarding the SEC no-action letter granting a broker registration exemption for certain M&A transactions.

Since placing securities in private offerings is limited to institutional investors, that definition is also very important. Moreover, FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. Under the proposed CAB rules, an institutional investor is defined to include any:

Bank, savings and loan association, insurance company or registered investment company;

Government entity or subdivision thereof;

Employee benefit plan that meets the requirements of Sections 403(b) or 457 of the Internal Revenue Code and that has a minimum of 100 participants;

Qualified employee plans as defined in Section 3(a)(12)(C) of the Exchange Act and that have a minimum of 100 participants;

Any person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million;

Persons acting solely on behalf of any such institutional investor; or

Any person meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (i.e., any natural person that owns at least $5 million in investments; family offices with at least $5 million in investments; trusts with at least $5 million in investments; or any person acting on their own or as a representative with discretionary authority, that owns at least $25 million in investments).

A CAB will not include any broker that does any of the following:

Carries or acts as an introducing broker with respect to customer accounts;

Holds or handles customers’ funds or securities;

Accepts orders from customers to purchase or sell securities either as principal or agent for the customer;

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making; or

Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act (interesting that FINRA would include Regulation A in this, as currently no license is required at all to maintain such a platform – only platforms for Regulation Crowdfunding require such a license).

Application; Associated Person Registration; Supervision

A CAB firm will generally be subject to the current member application rules and will follow the same procedures for membership as any other FINRA applicant, with four main differences. In particular: (i) the application has to state that the applicant will solely operate as a CAB; (ii) the FINRA review will consider whether the proposed activities are limited to CAB activities; (iii) FINRA has set out procedures for an existing member to change to a CAB; and (iv) FINRA has set out procedures for a CAB to change its status to regular full-service FINRA member firm.

The CAB rules also set out registration and qualification of principals and representatives, which incorporate by reference to existing NASD rules, including the registration and examination requirements for principals and registered representatives. CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs will also be subject to current rules regarding Operations Professional registration.

CABs would have a limited set of supervisory rules, although they will need to certify a chief compliance officer and have a written anti-money laundering (AML) program. In particular, the CAB rules model some, but not all, of current FINRA Rule 3110 related to supervision. CABs will be able to create their own supervisory procedures tailored to their business model. CABs will not be required to hold annual compliance meetings with their staff. CABs are also not subject to the Rule 3110 requirements for principals to review all investment banking transactions or prohibiting supervisors from supervising their own activities.

CABs would be subject to FINRA Rule 3220 – Influencing or Rewarding Employees of Others, Rule 3240 – Borrowing form or Lending to Customers, and Rule 3270 – Outside Activities of Registered Persons.

Conduct Rules for CABs

The proposed CAB rules include a streamlined set of conduct rules. This is a brief summary of some of the conduct rules related to CABs. CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Rules 2080 and 2081 regarding expungement of customer disputes; and the FINRA arbitration requirements in Rules 2263 and 2268. CABs will also be subject to know-your-customer and suitability obligations similar to current FINRA rules for full-service member firms, and likewise will be subject to the FINRA exception to that rule for institutional investors. CABs will be subject to abbreviated rules governing communications with the public and, of course, prohibitions against false and misleading statements.

CABs are specifically not subject to FINRA rules related to transactions not within the purview of allowable CAB activities. For example, CABs are not subject to FINRA Rule 2121 related to fair prices and commissions. Rule 2121 requires a fair price for buy or sell transactions where a member firm acts as principal and a fair commission or service charge where a firm acts as an agent in a transaction. Although a CAB could act as an agent in a buy or sell transaction where a counter-party is an institutional investor or where it arranges securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters on such M&A deals, FINRA believes these transactions are outside the standard securities transactions that typically raise issues under Rule 2121.

Financial and Operational Rules for CABs

CABs would be subject to a streamlined set of financial and operational obligations. CABs would be subject to certain existing FINRA rules including, for example, audit requirement, maintenance of books and records, preparation of FOCUS reports and similar matters.

CABs would also have net capital requirements and be subject to suspension for noncompliance. CABs will be subject to the current net capital requirements set out by Exchange Act Rule 15c3-1.

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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« House Passes Accelerated Access To Capital Act SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A »

House Passes Accelerated Access To Capital Act

Posted by Securities Attorney Laura Anthony | November 15, 2016 Tags: Accelerating Access to Capital Act, Access to Capital Act, Micro Offering Safe Harbor Act, Private Placement Improvement Act

On September 8, 2016, the U.S. House of Representatives passed the Accelerating Access to Capital Act. The passage of this Act continues a slew of legislative activity by the House to reduce regulation and facilitate capital formation for small businesses. Unlike many of the House bills that have been passed this year, this one gained national attention, including an article in the Wall Street Journal. Although the bill does not have a Senate sponsor and is not likely to gain one, the Executive Office has indicated it would veto the bill if it made it that far.

Earlier this year I wrote about 3 such bills, including: (i) H.R. 1675 – the Capital Markets Improvement Act of 2016, which has 5 smaller acts imbedded 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.
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, which also contains thoughts and commentary that likewise apply here.

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.

The Accelerating Access to Capital Act

The Accelerating Access to Capital Act would broaden the availability of a Form S-3 short-form registration statement to include:

(i) All companies listed on a national securities exchange (currently the eligibility is based on the size of the company and generally Form S-3 is not available to smaller reporting companies); and
(ii) Remove an instruction limiting the use of Form S-3 to offerings that (a) represent less than 1/3 of the aggregate market value of the non-affiliated common equity; (b) are not conducted by a shell company nor any company that has been a shell company within the last 12 months; and (c) by companies listed on a national exchange.

This Act would, in essence, open up the use of Form S-3 to penny stock issuers. A Form S-3 can be used for shelf offerings. Moreover, shelf takedowns are not subject to separate SEC review or approval.

The Micro Offering Safe Harbor Act

The Micro Offering Safe Harbor Act would add a new Section 4(f) to the Securities Act of 1933, as amended (“Securities Act”). Section 4 exempts certain transactions from the registration requirements of the Securities Act. The new Section 4(f) would exempt transactions by an issuer, including all entities controlled by or under common control with the issuer, that meet the following:

(i) Pre-existing relationship – each purchaser must have a substantive pre-existing relationship with an officer, director or 10% or greater shareholder of the issuer;
(ii) 35 or fewer purchaser – there are no more than 35 purchasers of securities sold in reliance on the exemption during the 12-month period preceding the transaction;
(iii) Small offering amount – the aggregate offering amount of securities sold by the company, including any amount sold under this exemption, during the 12 months preceding the transaction, does not exceed $500,000;
(iv) Bad Actor Disqualification – the exemption would not be available to any issuer that would be disqualified under the Rule 506 bad actor rules (see HERE) for a refresher); and
(v) State law pre-emption – securities sold under the exemption would be included as federally covered securities.

The Micro Offering Safe Harbor Act is obviously poorly drafted and raises many questions as to how it could be implemented and utilized within the current regulatory framework.
The Private Placement Improvement Act

The Private Placement Improvement Act requires the SEC to revise Regulation D to simplify the Form D filing requirements and to clarify that the filing of a Form D is not a condition to relying on the exemption. Moreover, it would become the SEC’s responsibility to notify states of the Form D filing. The Act also adds a “knowledgeable employee” of a private fund or the fund’s investment advisor to the definition of an accredited investor.

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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« Changes In India’s Laws Related To Foreign Direct Investments- A U.S. Opportunity; Brief Overview For Foreign Private Issuers SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers” »

Florida Broker-Dealer Registration Exemption For M&A Brokers

Posted by Securities Attorney Laura Anthony | October 25, 2016 Tags: Broker-Dealer Registration Exemption, Florida, Florida Broker-Dealer Registration Exemption, Florida M&A Broker Exemption, M&A Broker, M&A Brokers, M&A offer and sale exemption, M&A Transactions

Following the SEC’s lead, effective July 1, 2016, Florida has passed a statutory exemption from the broker-dealer registration requirements for entities effecting securities transactions in connection with the sale of equity control in private operating businesses (“M&A Broker”). As discussed further below, the new Florida statute, together with the SEC M&A Broker exemption, may have paved the way for Florida residents to act as an M&A broker in reverse or forward merger transactions involving OTCQX-traded public companies without broker-dealer registration.

Florida has historically had stringent broker-dealer registration requirements in connection with the offer and sale of securities. Moreover, Florida does not always mirror the federal registration requirements or exemptions. For example, see my blog HERE detailing some state blue sky concerns when dealing with Florida, including the lack of an issuer exemption from the broker-dealer registration requirements for public offerings.

However, in a move helpful to merger and acquisition (M&A) transactions in the state, Florida has now passed an M&A broker-dealer exemption and concurrent securities registration exemption for M&A transactions. The Florida exemption is similar but not identical to the federal exemption. For a review of the SEC exemption for M&A brokers, see my blog HERE and the summary at the end of this blog. The SEC exemption specifically limited itself to the federal broker-dealer registration requirements. In addition, to Florida, other states have passed similar M&A broker exemptions; however, as of the writing of this blog, I have not conducted a survey on same.

Florida M&A Broker Exemption

The sale of securities in Florida is regulated by the Florida Office of Financial Regulation, Division of Securities and is generally found in Chapter 517 Florida Statutes and corresponding rules adopted under the Florida Administrative Code (F.A.C.), Chapter 517, Florida Statutes – Securities and Investor Protection Act and Chapter 69W-100 through 69W-1000, Florida Administrative Code.

Any offer or sale of securities in Florida, which offer or sale is not pre-empted by federal law, must either be registered or exempted from registration in accordance with the state securities laws. The Florida registration exemptions can be found in Florida Statutes section 517.061. All sales of securities in Florida must be made by a properly registered dealer (Chapter 517.12(1), Florida Statutes) or by someone utilizing an exemption provided by Chapter 517.12, Florida Statutes.

The new M&A offer and sale exemption has been codified by adding a new securities registration exemption to Section 517.061 and a new broker-dealer registration exemption to Section 517.12.

Read More

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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« SEC Announces Enforcement Results For Fiscal Year-End 2016 SEC Issues New C&DI On Rule 701 »

SEC Announces Enforcement Results For Fiscal Year-End 2016

Posted by Securities Attorney Laura Anthony | October 18, 2016 Tags: Fiscal Year-End 2016, SEC, SEC Announces Enforcement Results For Fiscal Year-End 2016

On October 11, 2016, the SEC announced its enforcement results for fiscal year-end September 30, 2016 (FYE 2016). In FYE 2016 the SEC filed a record 868 enforcement actions, including against companies and executives for reporting violations, misconduct by companies and gatekeepers, fraud actions and more resulting in judgments and orders totaling more than $4 billion in disgorgement and penalties.

The actions also included a record number of enforcement proceedings against investment advisors and investment companies, a trend I expect to continue in the coming year as the SEC continues to crack down on the failure to adequately disclose all fees associated with investments into and operations of funds, as well as related party transactions.

Consistent with prior speeches and messaging, SEC Chair Mary Jo White made the following quote in the release announcing the enforcement results: “By every measure the enforcement program continues to be a resounding success holding executives, companies and market participants accountable for their illegal actions. Over the last three years, we have changed the way we do business on the enforcement front by using new data analytics to uncover fraud, enhancing our ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.”

In a speech in February of this year, Chair White focused on enforcement, stating that the SEC “needs to go beyond disclosure” in carrying out its mission. That mission, as articulated by Chair White, is the protection of investors, maintaining fair, orderly and efficient markets, and facilitating capital formation. In 2015 the SEC brought a record number of enforcement proceedings and secured an all-time high for penalty and disgorgement orders, which record has been bested in FYE 2016. The primary areas of focus included cybersecurity, market structure requirements, dark pools, micro-cap fraud, financial reporting failures, insider trading, disclosure deficiencies in municipal offerings and protection of retail investors and retiree savings.

The SEC Division of Enforcement likewise is pleased with their results. Andrew J. Ceresney, Director of the Division of Enforcement, stated, “Through their hard work and steadfast dedication to our mission, the Division’s committed staff have helped protect investors and made our markets fairer and more reliable.”

Highlights of FYE 2016 SEC Enforcement

The SEC notes that in FYE 2016 it brought several first-of-its-kind actions, including: (i) against a firm solely for failing to file Suspicious Activity Reports (SARs) (see my blogs HERE and HERE for more on SARs); (ii) against an audit firm for auditor independence failures based on personal relationships with audit clients; (iii) municipal advisors for violations of fiduciary and antifraud provisions created by Dodd-Frank; (iv) against a private equity advisor for acting as an unlicensed broker-dealer; (v) against an issuer for misstatements and omissions related to the issuance of structured notes.

In addition, in FYE 2016 the SEC won a jury trial against a municipality and one of its officers for violations of the federal securities laws. The SEC also continued its use of data and analytics to uncover market manipulation and insider trading violations. In FYE 2016, the SEC brought 78 insider trading cases.

Moreover, the SEC continues to crack down on attorneys, accountants and other gatekeepers. This is an extremely important aspect of the enforcement ecosystem, especially in the small- and micro-cap space. Attorneys, accountants, transfer agents, and broker-dealers that are active in the OTC Markets environment play an important role in improving and protecting the OTC Marketplace to the extent that they are reasonably capable in any given fact situation. In December 2015 the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents. The proposal would add significant obligations on transfer agents, some of which I agreed with and others I did not. See my blogHERE on the subject. The SEC has not taken further action on this notice as of yet.

In its publication on FYE 2016 enforcement results, the SEC noted that it brought actions against gatekeepers for “failures to comply with professional standards.” A common theme in these actions is missing or ignoring clear indications of fraud or red flags. Examples of such actions include: (i) against auditors for ignoring red flags and fraud risks in conducting audits for annual reports to be filed with the SEC; (ii) violations of auditor independence rules; (iii) against a private fund administrator who missed or ignored clear indications of fraud in preparing and maintaining fund accounting records; (iv) against a consultant for improperly evaluating internal control deficiencies (this was a first-of-its-kind action as well); and (v) against EB-5 lawyers for acting as unregistered brokers.

In addition to enforcement matters I have written about such as HERE, micro-cap fraud and market manipulation continued to be a significant area of enforcement, as it always will. The SEC suspended tradingin 199 micro-cap issuers in FYE 2016. The SEC’s use of technology and data also helped uncover elaborate foreign market manipulation and trading schemes, including such as against a United Kingdom resident for intruding into online brokerage accounts of U.S. investors and making unauthorized trades.

Private offering fraud matters were also the target of multiple enforcement actions. Multiple private offering fraud actions were brought by the SEC in FYE 2016, including actions targeting certain population sectors such as seniors.

The SEC also brought action and collected record fines against market participants, including a $35 million penalty against Barclay’s and a $54 million penalty against Credit Suisse for violations in the operations of each of their alternative trading systems (ATSs). Merrill Lynch faced a $12.5 million fine for failure to have adequate risk controls in place before providing customers with access to the market, and Morgan Stanley was charged $1 million for inadequate written policies and procedures related to the protection of customer records and information.

Investment advisers and investment companies faced an unprecedented level of scrutiny in FYE 2016. In addition to many highly publicized cases related to hidden fees and undisclosed related party transactions, the SEC brought actions for fraud, such as against Aequitas Management for hiding its rapidly deteriorating financing condition after raising $350 million from investors. Thirteen investment advisory firms were charged with repeating false claims made by an investment manager firm highlighting the importance of independent due diligence and responsibilities. Investment funds also faced violations related to improper trading activity, including prearranged trades favoring certain clients.

Other areas that the SEC specifically continued to target for enforcement proceedings include Whistleblower protections (see HERE) and Foreign Corrupt Practices Act violations.

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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« NASDAQ Requires Disclosure Of Third-Party Director Compensation Florida Broker-Dealer Registration Exemption For M&A Brokers »

SEC Whistleblower Awards Pass $100 Million As It Continues To Crack Down On Confidentiality Provisions In Employment Agreements

Posted by Securities Attorney Laura Anthony | September 27, 2016 Tags: Rule 21F-2, Rules 21F-1, SEC Enforcement Proceedings, Section 21F, The Dodd-Frank Act Whistleblower Statute, whistleblower regulations, whistleblower statute

The SEC has proudly announced that including a $22 million award on August 30, 2016, its whistleblower awards have surpassed $100 million. The news comes in the wake of two recent SEC enforcement proceedings against companies based on confidentiality and waiver language in employee severance agreements. Like two prior similar actions, the SEC has taken the position that restrictive language in confidentiality, waiver or settlement agreements with employees violates the anti-whistleblower rules adopted under Dodd-Frank.

Background – The Dodd-Frank Act Whistleblower Statute

The Dodd-Frank Act, enacted in July 2010, added Section 21F, “Whistleblower Incentives and Protection,” to the Securities Exchange Act of 1934 (“Exchange Act”). As stated in the original rule release, the purpose of the rule was “to encourage whistleblowers to report possible violations of the securities laws by providing financial incentives, prohibiting employment related retaliation, and providing various confidentiality guarantees.” Upon enactment of Section 21F, the SEC established the Office of the Whistleblower and created the SEC Whistleblower Program (“Whistleblower Program”).

The whistleblower regulations are comprised of Section 21F of the Exchange Act and Rules 21F-1 through 21F-17 promulgated thereunder. The bulk of the whistleblower regulations relate to the submission of original information leading to successful enforcement actions, and the eligibility, calculation and payment of awards to the whistleblower. The regulations also implement measures to protect the whistleblower from retaliatory actions.

Rule 21F-2, “Whistleblower status and retaliation protection,” defines a whistleblower as follows:

(a)(1) “You are a whistleblower if, alone or jointly with others, you provide the Commission with information pursuant to the procedures set forth in § 240.21F-9(a) of this chapter, and the information relates to a possible violation of the Federal securities laws (including any rules or regulations thereunder) that has occurred, is ongoing, or is about to occur. A whistleblower must be an individual. A company or another entity is not eligible to be a whistleblower.”

(b) Prohibition against retaliation. (1) “[F]or purposes of the anti-retaliation protections…, you are a whistleblower if: (i) you possess a reasonable belief that the information you are providing relates to a possible securities law violation… that has occurred, is ongoing, or is about to occur, and; (ii) you provide that information in a manner described in Section 21F(h)(1)(A); (iii) The anti-retaliation protections apply whether or not you satisfy the requirements, procedures and conditions to qualify for an award.”

Rule 21F-17, “Staff communications with individuals reporting possible securities law violations,” which is the subject of the enforcement actions, provides:

(a) “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement… with respect to such communications.”

Enforcement Proceedings

The SEC brought two enforcement proceedings against companies during the month of August based on restrictive language in confidentiality and waiver provisions in employee severance agreements. The two new proceedings are similar to two prior proceedings based on the same issue. The SEC enforcement proceedings claim that the restrictive language acts as a method to stifle or retaliate against whistleblowers.

In early 2016, the SEC began issuing requests to companies for copies of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and settlement agreements entered into with employees and former employees of the companies. The initiative specifically requested copies of documents since the enactment of the Dodd-Frank provisions that grant awards and protections for whistleblowers. The SEC was also asking for copies of company human resource policies, employee memos, training guides and any and all documents that discuss “whistleblowers” either directly or indirectly.

The SEC’s concern is that corporations are retaliating against potential whistleblowers and attempting to curb the whistleblowing incentives in the Dodd-Frank Act by providing detriments to employment in contracts and policies veiled as confidentiality protections. The Dodd-Frank Act directly prohibits retaliatory conduct by companies.

In the action filed on April 1, the SEC charged KBR, Inc., with violating Rule 21F-17 under the Dodd-Frank Act. In this case, KBR required employees participating in internal investigations related to potential securities law violations, to sign confidentiality agreements that prohibited the employee from discussing the matter with outside parties without KBR approval with a consequence of discipline or termination in the event of a violation of such confidentiality agreement. As the investigations included allegations of securities law violations, the terms in the agreement were found to violate Rule 21F-17 of the Dodd-Frank Act, which specifically prohibits companies from taking any action to impede whistleblowers from reporting possible securities law violations to the SEC. KBR agreed to pay a penalty of $130,000 and to amend its confidentiality statement to make it clear that employees are free to report possible violations to the SEC and other federal agencies without KBR approval or fear of retaliation.

In its press release on the matter, Andrew J. Ceresney, SEC Director of the Division of Enforcement, was quoted as saying, “By requiring its employees and former employees to sign confidentiality agreements imposing pre-notification requirements before contacting the SEC, KBR potentially discouraged employees from reporting securities violations to us. SEC rules prohibit employers from taking measures through confidentiality, employment, severance, or other type of agreements that may silence potential whistleblowers before they can reach out to the SEC. We will vigorously enforce this provision.”

The SEC enforcement action came despite the factual conclusion that no employee had actually been prevented from reporting a violation to the SEC or had sought to do so.

On August 10, 2016, the SEC brought a settled administrative proceeding against BlueLinx Holdings, Inc., ordering a $265,000 penalty for a violation of Rule 21F-17 by illegally using severance agreements requiring outgoing employees to waive their rights to seek monetary compensation under the SEC Whistleblower Program. A violation of the agreement would result in a loss of severance payments and other post-employment benefits. Similarly, in a settled administrative proceeding on August 16, 2016, the SEC ordered Health Net, Inc., to pay a $340,000 penalty for violating Rule 21F-17 with a similar provision.

In both cases, the agreements specifically did not preclude a former employee from participating in an investigation, communicating with or cooperating with investigators or reporting wrongdoing, but it did prevent the employee from seeking monetary compensation for doing so. Like the earlier KBT case, there was no evidence that an employee had actually been deterred from taking action as a result of the provision in the severance agreements. However, the SEC notes that the financial incentive portion of the Whistleblower Program is “a critical component of the Whistleblower Program… that any individual could look towards in determining whether to take the enormous risk of blowing the whistle in calling attention to fraud.”

The SEC is sending a clear message that any efforts to chill whistleblowers will be considered a violation of the rules.

Success of Whistleblower Program

As indicated, the Whistleblower Program has been a resounding success since its inception, resulting in over $500 million in financial remedies against wrongdoers and the payout of $111 million in awards to 34 whistleblowers. On August 30, 2016, the second-largest award, at $22 million, was granted to a whistleblower. On September 20, 2016 a $4 million dollar award was announced. The funds to pay out the awards come from an investor protection fund entirely financed through monetary sanctions paid to the SEC from securities law violators.

Whistleblowers may be eligible to receive an award when they voluntarily provide unique and useful information to the SEC that results in an enforcement action and monetary penalty against a wrongdoer. The awards range from 10% to 30% of the amount collected when sanctions ordered are in excess of $1 million.

In an August 30, 2016 press release, SEC Chair Mary Jo White stated, “[T]he SEC’s whistleblower program has proven to be a game changer for the agency in its short time of existence, providing a source of valuable information to the SEC to further its mission of protecting investors while providing whistleblowers with protections and financial rewards.”

The same press release contains some interesting facts, including that the Whistleblower Office has received more than 14,000 tips. Moreover, to help ensure that employees continue to utilize the statute without fear of repercussions, the SEC has now brought a total of 5 enforcement actions against companies related to retaliation. One of these actions was for actual retaliatory conduct, and the other 4 related to confidentiality and severance agreements as discussed herein.

Conclusion

The SEC has found the whistleblower statute to be extremely beneficial in uncovering and prosecuting large-scale securities fraud. In essence, the whistleblower statute, and potential monetary awards for successful prosecutions, provides the SEC with an army of investigators well beyond what the agency could afford using its own resources. Several states have taken notice of the success of the program and enacted their own version of the . Recently the State of Indiana awarded $95,000 to a whistleblower for helping bring an enforcement action against JP Morgan Chase for failing to disclose certain conflicts of interest to RIA clients.

When the SEC filed its first action back in April 2016, this firm made particular modifications to its forms of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and employee settlement agreements. We urge all companies to seek the advice of competent counsel prior to entering into any such contracts, and of course, when conducting internal investigations which include allegations of potential securities law violations. Additional enforcement actions are expected as the SEC continues to review documents requested and provided by various employer companies.

The Author

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

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