SEC - Reverse-Merger.com

SEC Issues Proposed Amendments To Item 601 Of Regulation S-K Related To Exhibits

Posted by Securities Attorney Laura Anthony | September 20, 2016 Tags: Item 601 Of Regulation S-K, Regulation S-K, SEC

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.

This newest proposed rule change to Regulation S-K is part of the SEC Division of Corporation Finance’s Disclosure Effectiveness Initiative. At the end of this blog, I include an up-to-date summary of the proposals and request for comment related to the ongoing Disclosure Effectiveness Initiative.

Background

On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). The S-K Concept Release contained a discussion and request for comment on exhibit filing requirements. Item 601 of Regulation S-K specifies the exhibits that must be filed with registration statements and SEC reports. Item 601 requires the filing of certain material contracts, corporate documents, and other information as exhibits to registration statements and reports.

A particular area of discussion recently has been the need to file schedules to contracts. These schedules can be lengthy and lack materiality. Likewise, a recent area of discussion has been the necessity of filing an immaterial amendment to a material exhibit. The S-K Concept Release contains a lengthy discussion on exhibits, including drilling down on specific filing requirements. Many of the exhibit filing requirements are principle-based, including, for example, quantitative thresholds for contracts. Consistent with the rest of the S-K Concept Release, the SEC discusses whether these standards should be changed to a straight materiality approach. The SEC also discusses eliminating some exhibit filing requirements altogether, such as where the information is otherwise fleshed out in financial statements or other disclosures (for example, a list of subsidiaries).

Companies are allowed to reference exhibits filed in prior filings as opposed to refiling the exhibit with the SEC. The current proposed rule amendment is limited to the presentation of such information and, in particular, including a hyperlink to the actual filed exhibit. I suspect the SEC shall issue further amendments related to exhibits as it continues its initiative and rule changes related to Regulation S-K.

Proposed Amendments

In addition to the filing of exhibits and schedules, Item 601 of Regulation S-K requires each company to include an exhibit index list that lists each exhibit included as part of the filing. Once an exhibit has been filed once, the company can incorporate by reference by including a footnote as to which filing the original exhibit can be found in. Unfortunately, I find that companies often will indicate that an exhibit has been previously filed, without giving a specific reference as to which filing or when, leaving an investor or reviewer to go fish. The SEC rightfully asserts that requiring companies to include hyperlinks from the exhibit index to the actual exhibits filed would allow much easier access to these filings.

The proposed rule change would require companies to include a hyperlink to each filed exhibit on the exhibit index for virtually all filings made with the SEC, including XBRL exhibits. An active hyperlink would be required in all filings made under the Securities Act or Exchange Act, provided however, that if the filing is a registration statement, the active hyperlinks need only be included in the version that becomes effective.

Currently exhibits may be filed in the EDGAR system in either ASCII or HTML format. HTML format allows for hyperlinks to another place within the same document or to a separate document. ASCII does not support such hyperlinks. Over the years HTML has become the standard used for EDGAR filings, with 99% of filings in 2015 using HTML. The current proposed rule would prohibit the use of ASCII for exhibits and require onlyHTML with the newly required hyperlinks.

In addition, the proposed rule changes would include conforming changes to Rule 105 of Regulation S-T. Rule 105 sets forth the limitations and liabilities for the use of hyperlinks. Rule 105 allows hyperlinks to other documents within the same filing or previously filed documents on EDGAR but prohibits hyperlinks to sites, locations, or documents outside the EDGAR system.

Further Background

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 changes 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

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.

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

Download our mobile app at iTunes.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

« SEC Requests Comment On Changes To Subpart 400 To Regulation S-K SEC Whistleblower Awards Pass $100 Million As It Continues To Crack Down On Confidentiality Provisions In Employment Agreements »

SEC Requests Comment On Changes To Subpart 400 To Regulation S-K

Posted by Securities Attorney Laura Anthony | September 13, 2016 Tags: Fast Act, Regulation S-K, Regulation S-X, SEC, Smaller Reporting Company, Subpart 400, The Fast Act

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. The request for comment is part of the ongoing SEC Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72003 of the FAST Act.

Background

The topic of disclosure requirements under Regulations S-K and S-X as pertains to financial statements and disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has come to the forefront over the past couple of years. The purpose of the Disclosure Effectiveness Initiative is to assess whether the business and financial disclosure requirements continue to provide the information investors need to make informed investment and voting decisions.

Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act. Regulation S-X contains specific financial statement preparation and disclosure requirements.

In addition to affecting companies filing registration statements (including on Form 1-A in a Regulation A/A+ offering) and those filing reports with the SEC, any changes to Regulations S-K or S-X will affect acquired entities, acquirees, investment advisers, investment companies, broker-dealers and nationally recognized statistical rating organizations.

In accordance with its mandate under Section 72003 of the FAST Act, the SEC is studying and seeking comment to:

Determine how to modernize and simplify disclosure requirements to reduce the costs and burdens to the company while still providing all material and necessary information to investors;

Further a principles-based approach whereby companies and their management can determine the relevancy and materiality of information provided instead of just including boilerplate language or filling space to meet a static requirement. Of course, this needs to be balanced with the need to ensure completeness and comparability of information among different companies; and

Evaluate information delivery methods and explore ways to eliminate repetition and the disclosure of immaterial information.

Request for Comment

Subpart 400 of Regulation S-K, including Items 401 through 407, require disclosures on directors, executive officers, control persons and promoters; executive compensation; security ownership of certain beneficial owners and management; transactions with related persons, promoters and control persons; ethics and corporate governance.

The SEC’s request for comment does not provide any commentary about particular concerns, thoughts, or questions by the SEC, but is a short general request on “existing requirements in these rules as well as on potential disclosure issues that commenters believe the rules should address.”

Overview of Subpart 400

Item 401 – Directors, Executive Officers, Promoters and Control Persons

Item 401 of Regulation S-K requires the disclosure of the identity and ages of all directors and persons nominated to become a director. In addition, Item 401 requires disclosure of all positions held at the company by that director or nominee, their term of office, and any arrangement or understanding between that person and another person “pursuant to which he was or is to be selected as a director or nominee.” The instructions provide some clarity. Compensation for service as a director is not included in arrangements with other persons. A person must consent to being included as a nominee. No information need be provided on an outgoing director.

Item 401 requires the disclosure of the identity and ages of all executive officers. In addition, Item 401 requires disclosure of all positions held at the company by that executive officer, their term of office, and any arrangement or understanding between that person and another person pursuant to which he was or is to be selected as an officer. A person must consent to being included as an executive officer.

For a first-time registration statement or a registration statement by a company not subject to the reporting requirements under the Securities Exchange Act, Item 401 requires the identification of certain significant employees – in particular, where a person is not an executive officer but otherwise makes a significant contribution to the company’s business. The same information required for executive officers is required for significant employees. Similarly, for a first-time registration statement or registration statement by a company that has not been subject to the reporting requirements for at least 12 months, the same information must be provided for promoters and control persons.

In addition, family relationships, business experience for the past five years, and disclosures of certain legal proceedings must be made for each director and executive officer. The legal proceeding disclosure is a scaled-down version of the bad-actor requirements found elsewhere in the rules, such as Rule 506 and Regulation A. Also, Item 401 requires disclosure of bankruptcy proceedings involving the person or a company for which they were an executive officer during the past five years.

Item 402 – Executive Compensation

An entire treatise could be written on Item 402. From a high level, Item 402 requires disclosure of all compensation awarded to, earned by, or paid to a company’s executive officers and directors. Item 402 also requires disclosures related to pay ratio and require “say on pay” advisory votes. See my blog HERE.

Compensation must be disclosed in tabular form and is meant to encompass any and all benefits received by an executive officer or director, including salary, bonuses, stock awards (including under a plan or not, qualified or non-qualified), option awards, non-equity incentive plans, pension value, benefits, perquisites and all other forms of compensation. Moreover, Item 402 requires a compensation discussion and analysis explaining the presented information.

Item 402 requires details of outstanding stock awards and options, including exercise dates and prices, the market value of underlying securities and vesting schedules. Detailed information is also required regarding pension benefits.

Emerging-growth and smaller reporting companies provide a scaled-down disclosure under Item 402. For details on the Item 402 scaled-down requirements related to emerging growth and smaller reporting companies, see my blog HERE.

Item 403 – Security Ownership of Certain Beneficial Owners and Management

Item 403 requires disclosure of the security ownership of officers, directors and 5% or greater shareholders, including the beneficial owner or natural person behind any entity ownership. Ownership is disclosed in tabular form and includes name, address, number of securities owned and percentage owned of that class. Item 403 requires disclosure of all classes of outstanding equity regardless of whether such class is registered or publicly trades.

Item 404 – Transactions with Related Persons, Promoters, and Certain Control Persons

Item 404 requires the disclosure of material related party transactions. For purposes of Item 404, related parties include officers or officer nominees, directors or director nominees, a family member of a director or executive office, 5% or greater shareholders, or any person that has a direct or indirect material interest in the company. Companies other than emerging-growth or smaller reporting companies must also disclose the company’s policy for the review, approval or ratification of related party transactions. Item 404 also requires the disclosure of compensations, assets or benefits to be received by promoters where the company is filing an S-1 or Form 10 registration statement.

A “promoter” has a specific definition in the securities laws and is not tied to stock promotion in the sense that many may think. A “promoter” is defined in Rule 405 of the Securities Act as including:

(1) Any person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer; or

(2) Any person who, in connection with the founding and organizing of the business or enterprise of an issuer, directly or indirectly receives in consideration of services or property, or both services and property, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of such securities. However, a person who receives such securities or proceeds either solely as underwriting commissions or solely in consideration of property shall not be deemed a promoter within the meaning of this paragraph if such person does not otherwise take part in founding and organizing the enterprise.

(3) All persons coming within the definition of promoter in paragraph (1) of this definition may be referred to as founders or organizers or by another term provided that such term is reasonably descriptive of those persons’ activities with respect to the issuer.

Item 404 expands the definition of promoter to include “any person who acquired control of a registrant that is a shell company, or any person that is part of a group, consisting of two or more persons that agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of a registrant, that acquired control of a registrant that is a shell company.”

Item 405 – Compliance with Section 16(a) of the Exchange Act

Section 16(a) of the Exchange Act requires the filing of Forms 3 and 4 by officers, directors or 10%-or-greater shareholders. For a review of the Section 16 filing requirements, see my blog HERE. Item 405 requires a company to disclose failures to meet these filing requirements.

Item 406 – Code of Ethics

Item 406 requires a company to disclose whether it has adopted a code of ethics for the executive officers and accounting controller. A copy of the code of ethics must also be filed with the SEC and included on the company’s website.

Item 407 – Corporate Governance

Item 407 requires disclosure of corporate governance standards, including those related to director independence; board committees, including audit compensation, and nominating committees; and annual meeting attendance. Item 407 requires detailed information for each category of corporate governance as well as the policies and procedures of each board committee.

Further Background

The request for comment follows the July 13, 2016 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 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 ReleaseHERE 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 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.

Prior to the S-K Concept Release and current Regulation S-K and S-X proposed amendments, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

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

The Author

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

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

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

Download our mobile app at iTunes.

« FinCEN Updates Due Diligence Rules SEC Issues Proposed Amendments To Item 601 Of Regulation S-K Related To Exhibits »

SEC Continues Efforts To Prevent Microcap Fraud

Posted by Securities Attorney Laura Anthony | August 16, 2016 Tags: Finra, Micro-Cap Fraud, Microcap Fraud, SEC

As I’ve written about numerous times in the past, a primary agenda of the SEC and FINRA is to prevent small- and micro-cap fraud. On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC complaint, as well as numerous industry articles and a blog by Mr. Gentile himself, reveal in-depth efforts by the SEC together with FINRA and the FBI and DOJ to remove recidivist and bad actors from the micro-cap system. While the methods used by the regulators have been the subject of heated debates and articles, the message and result remain that the SEC is committed to its efforts to deter securities law violations.

Although small- and micro-cap fraud has always been an important area of concern and enforcement by the SEC since the financial crisis of 2008, it has increasingly been a focus. Regulators have amplified their efforts through regulations and stronger enforcement, including the SEC Broken Windows policy, increased Dodd-Frank whistleblower activity and reward payments, CEO and CFO liability for SEC reports under the Sarbanes-Oxley Act and increased bad actor prohibitions. See my blog HERE related to the SEC Broken Windows policy and CEO/CFO liability (as an aside, I note that the proposed Stronger Enforcement of Civil Penalties Act never made it past its introduction in July 2015) and HERE related to Rule 506 and Regulation A bad actor prohibitions.

The fight against small- and micro-cap fraud is an industry positive overall. While not a regulator, OTC Markets itself has taken great strides in improving the quality of and information available related to OTC Markets-traded companies, including through qualitative and quantitative standards for quotation on both the OTCQB (see my blog HERE) and OTCQX (see my blog HERE).

The Guy Gentile Case

On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC litigation release alleges that Gentile, who owned and operated Sure Trader, a registered broker-dealer, engaged in manipulative trading, provided illegal kickbacks, illegally issued unregistered stock and distributed promotional mailings of glossy newsletters using fake publication names to pump the stocks of at least two penny stocks (KYUS and RVNG). The SEC continues that Gentile misled investors with positive but fake price and volume trends while concealing the control persons’ identities and compensation. Apparently, Gentile, together with attorney Adam Gottbetter and a few stock promoters, controlled large blocks of the companies’ stock, which control was not disclosed in company filings or the promotional activities.

The SEC complaint, filed in March 2016, details Gentile’s actions involving KYUS and RVNG, which actions occurred in 2007 and 2008. As alleged by the SEC, the entire history of RVNG and KYUS was a fraud, from its creation using a sham registration (see my blog HERE for more on this) to its issuances of freely tradable securities to insiders, manipulative trades and promotional activities.

The SEC complaint does not address the fact that a period of 8-9 years went by between the illegal activities and the filing of the complaint. Guy Gentile has written a detailed blog explaining his version of events, or more precisely, what happened in the missing years. In particular, Gentile claims that he was arrested in 2012 and that from that time until the complaint against him in March 2016, he acted as a cooperating witness and SEC and FBI informant, assisting in the indictment of over a dozen individuals related to hundreds of millions of dollars in pump-and-dump and other illegal activities and resulting in over $12 million in fines and disgorgements with the potential of tens of millions more to come.

Gentile details his involvement in elaborate, and sometimes dangerous, undercover operations. The complaint, together with Gentile’s blog and numerous industry articles on the events, reads like a movie. It is undisputed that Gentile’s brokerage firm, Sure Trader, which was based in the Bahamas, remained in business and continued to market to U.S.-based retail customers after Gentile’s arrest in 2012 and through at least July 2015. It appears that the entire firm was wired up and all happenings were being recorded by the FBI.

Guy Gentile’s biggest defense is the statute of limitations, which is five years. However, apparently he signed a waiver of the statute of limitations while acting as an informant.

The prevention of fraud has been on the SEC agenda since the commission was founded in 1933, with efforts intensifying as the sophistication of the marketplace has grown. On November 17, 2009, President Obama established, by executive order, an Interagency Financial Fraud Enforcement Task Force to strengthen efforts to combat financial crime. To start, the Department of Justice led the task force and the Department of Treasury, HUD and the SEC served on the steering committee. The task force’s leadership, along with representatives from federal agencies and regulatory authorities, continue to work with state and local partners to investigate and prosecute significant financial crimes, address discrimination in the lending and financial markets, and recover proceeds for victims.

Putting aside the entertainment value of the entire case, it does fully illustrate the commitment by regulators to attack small- and micro-cap fraud. Clearly, the more of these egregious activities that are uncovered and prosecuted, the more success legitimate small businesses will have raising capital, growing, and supporting the U.S. economy including through job creation.

Conclusion

It is undisputed that emerging companies play a critical role in the U.S. economy, supporting growth, innovation and job creation. The JOBS Act made dramatic changes to the landscape for the marketing and selling of both private and public securities. These significant changes include: (i) the creation of Rule 506(c), which came into effect on September 23, 2013, and allows for general solicitation and advertising in private offerings where the purchasers are limited to accredited investors; (ii) the overhaul of Regulation A creating two tiers of offerings, which came into effect on June 19, 2015, and allows for both pre-filing and post-filing marketing of an offering, called “testing the waters”; (iii) the addition of Section 5(d) of the Securities Act, which came into effect in April 2012, permitting emerging-growth companies to test the waters by engaging in pre- and post-filing communications with qualified institutional buyers or institutions that are accredited investors; and (iv) Title III crowdfunding, which came into effect on May 19, 2016, and allows for the use of Internet-based marketing and sales of securities offerings.

Furthermore, the OTC Markets has proven itself as a small-cap venture exchange, supporting the secondary trading of small and emerging growth companies and providing a respected trading platform for companies prior to moving on to an exchange such as NASDAQ or the NYSE MKT.

The other side of these initiatives is the real concern of fraud. I’m not expressing an opinion on the methods used by the regulators in this case, but I do support the efforts. I also believe in the basic principle that it is better for the industry that investors believe egregious fraudulent activities will be prosecuted.

This firm does not participate in SEC enforcement proceedings or related litigation matters; however, as with any good securities attorney, we keep our clients informed of the law so that they can avoid participation in these proceedings.

The Author

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

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

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

Download our mobile app at iTunes.

« SEC Issues Proposed Regulation S-K and S-X Amendments Smaller Reporting Companies vs. Emerging Growth Companies »

SEC Issues Concept Release On Regulation S-K; Part 2

Posted by Securities Attorney Laura Anthony | May 17, 2016 Tags: Form 8-K, MD&A, Regulation S-K, Regulation S-X, S-K Concept Release, SEC

On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). This blog is the second part discussing that concept release. In Part I, which can be read HERE, I discussed the background and general concepts for which the SEC provides discussion and seeks comment. In this Part II, I will discuss the rules and recommendations made by the SEC and, in particular, those related to the 100, 200, 300, 500 and 700 series of Regulation S-K.

Background

The fundamental tenet of the federal securities laws is defined by one word: disclosure. In fact, the SEC neither reviews nor opines on the merits of any company or transaction, but only upon the appropriate disclosure, including risks, made by that company. However, excessive rote immaterial disclosure can dilute the material important information regarding that particular company and have the unintended consequence of weakening necessary disclosure to potential investors and the public trading markets.

The SEC non-financial disclosure requirements for both registration statements and reports under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are found in Regulation S-K.

At the highest level, the purpose of disclosure is to provide investors and the marketplace with information needed to make informed investment and voting decisions. As discussed in the S-K Concept Release, proper disclosure “may lead to more accurate share prices, discourage fraud, heighten monitoring of the managers of companies, and increase liquidity.” Further, effective disclosure should “increase the integrity of securities markets, build investor confidence, and support the provision of capital to the market.”

The SEC seeks comment on hundreds of questions from broad conceptual points to specific rule changes. In many cases the SEC indicates that additional disclosure might be necessary on a particular topic. Although disclosure improvement is the goal, that does not necessarily mean less information and, in many cases, may actually mean more information.

Description of Business and Properties

The SEC believes that the information elicited under Item 101 regarding a description of the company’s business and Item 102 related to the company’s materially important physical properties, provides the necessary foundation needed by investors to make investing and voting decisions. This basic information assists in putting other disclosure items into context. The SEC seeks comment on whether Items 101 and 102 should be eliminated or modified and whether new or different disclosure requirements should be added to these Items.

The Concept Release contains detailed discussion of each of the requirements under Items 101 and 102, including prior comments received from the public and SEC views. Currently Item 101 requires a description of the general development of the company’s business over the past 3 years for smaller reporting companies and 5 years for other classes of company, or such shorter period as the company has been in business. Item 102 requires disclosure of the location and general character of plants, mines and other materially important physical properties.

Examples of information required include disclosure of the basic background of the business such as: (i) the year of formation; (ii) type of entity; (iii) nature and results of any bankruptcy, receivership or similar; (iv) nature and result of any material reclassification, merger or consolidation; (v) the acquisition or disposition of any material assets outside the ordinary course of business; and (vi) material changes to the business operations. In addition, Item 101 requires a narrative description of a company’s business, including 13 specific areas as follows: (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of business; (vi) working capital practices; (vii) dependence on certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) company sponsored research and development activities; (xii) compliance with environmental laws; and (xiii) number of employees.

Smaller reporting companies benefit from several other scaled disclosures from the standard requirements, including: (i) elimination of the requirement to discuss seasonality, working capital practices, backlog or government contracts; (ii) names of principal suppliers; (iii) royalty agreements or labor contracts; (iv) need for government approval for products or services; and (v) effects of existing or probable government regulations.

Emerging growth companies must meet all of the standard requirements. Moreover, keeping in line with the concept of materiality, where a smaller reporting company is in a business that makes any of the standard disclosures material to its business, it must include those discussions, even if not technically required. Accordingly, for example, a smaller reporting company in a cannabis-related industry would need to include a discussion on the need for government approval for products and services, and the effects of existing or probable government regulations on its business, even though the scaled disclosure requirements would not otherwise require such discussion.

As with other areas of discussion, the SEC requests comments on the scaled disclosure requirements and whether the current disparities between requirements related to smaller reporting companies and emerging growth companies should be eliminated.

The SEC discusses eliminating redundancies in the 101 and 102 disclosure requirements. In particular there are several categories in Form 8-K that request the same information elicited in Items 101 and 102 and included in all 10-Q’s and 10-K’s. Information on business background is included in the MD&A discussion and in footnotes to financial statements. Redundancies could be eliminated by allowing cross-referencing, including internal hyperlinks. Moreover, the SEC could, and should, distinguish between new registrants disclosing their business background for the first time, and those that are established reporting companies repeating information again and again.

Many of the detailed requirements may not be relevant in today’s business environment, which differs greatly from even twenty years ago. For instance, many businesses no longer have physical locations or corporate headquarters but rather run through virtual offices. For those businesses, providing a detailed discussion of each location (home office…) would not be relevant and rather could diminish the value of the business discussion. Likewise, businesses in today’s world often outsource or hire independent contractors. Consideration should be given to expanding the requirements to include such independent contractors, or eliminate this requirement altogether where it does not add value to the particular business. For example, it may be important to know that certain companies are scaling back on their workforce, while for others, the information is not relevant.

Likewise, Regulation S-K does not currently address the current reliance on web-based and intellectual property-based assets and as such, additional disclosure items may need to be included. Another area that may need increased disclosure relates to international business operations and reliance on non-U.S.-based assets.

Management Discussion and Analysis

Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis (“MD&A”) not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.

MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity for MD&A to use a principles/materiality approach and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.

In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. There has been a rise in recent controversy over the use of these non-GAAP numbers, an in-depth discussion of which will be the topic of a future blog.

However, the short version is that 90% of companies use non-GAAP numbers to explain their financial operations and the SEC is pushing back, making a review of the rules related to non-GAAP use a priority. There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves needs some adjustment.

Risk Factors

Risk-related disclosures need a thorough review and potential overhaul. Although the SEC has long stated that risk factors should not be boilerplate repetition of items applicable to the market as a whole and not necessarily applicable to a particular company, most companies use boilerplate language. I note that Item 503 contains examples of risks that a company can make related to its offerings, and so, of course, those risks, in boilerplate format, are always included in registration statements and reports.

Currently, risk-related disclosures are currently included in multiple items under Regulation S-K, including Item 503 related to investment risk and Item 305 related to market risk. The focus of the SEC discussion is on aggregating risk information in a more central readable format and improving the content to enhance investors’ ability to evaluate the particular risk factors.

Securities of the Company

Several Items in Regulation S-K address the securities of a company. For example, Item 202 requires a description of the terms and conditions of securities being registered; Item 201 requires disclosure of the number of holders of common securities; Item 701 requires disclosure of sales of unregistered securities and use of proceeds from offerings, and Item 703 requires disclosure of securities re-purchased by a company and its affiliates.

As with other areas, the SEC focuses on whether these disclosures should be modified, increased or eliminated and on the presentation of the information.

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 ofLawCast.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.

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

Download our mobile app at iTunes.

« SEC Issues Final Rules Implementing The JOBS ACT And Rules On The FAST ACT SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1 »

The U.S. Capital Markets Clearance And Settlement Process

Posted by Securities Attorney Laura Anthony | April 19, 2016 Tags: Clearance And Settlement Process, DTC Eligibility, The U.S. Capital Markets Clearance And Settlement Process

Within the world of securities there are many sectors and facets to explore and understand. To be successful, a public company must have an active, liquid trading market. Accordingly, the trading markets themselves, including the settlement and clearing process in the US markets, is an important fundamental area of knowledge that every public company, potential public company, and advisor needs to comprehend. A basic understanding of the trading markets will help drive relationships with transfer agents, market makers, broker-dealers and financial public relations firms as well as provide the knowledge to improve relationships with shareholders. In addition, small pooled funds such as venture and hedge funds and family offices that invest in public markets will benefit from an understanding of the process.

This blog provides a historical foundation and summary of the clearance and settlement processes for US equities markets. In a future blog, I will drill down into specific trading, including short selling.

History and Background

The Paperwork Crisis

Prior to the advent of modern technology, securities were literally cleared and transferred by providing paper certificates to a company’s transfer agent, who would record the transfer on their books and records and issue new securities to the new holders. A transfer agent would receive a bundle of documents from a broker-dealer and physically process all of the paperwork and then send it to a separate registrar to record each of the transfers. In order to reduce time, most brokers, transfer agents and registrars were located in New York City in the Wall Street district. The broker would courier the documents to the transfer agent each day, who would process the paperwork and courier them to the registrar to process the transfers each after following a series of document checks, balances and audits, and then deliver the new certificates to the designated parties using a messenger or courier.

As the volume of transactions increased, numerous clearing brokers and clearing agencies emerged to help with the processing. However, the system was disjointed and as the physical certificate process remained the same, each of these clearing brokers and agencies maintained offices physically near each other to messenger paper back and forth. By the 1960s and early 1970s the sheer volume of paperwork crushed the system and caused what came to be known as the Paperwork Crisis.

At the time the Paperwork Crisis was the biggest crisis to face the securities industry since the Great Depression and to this day remains one of the most difficult and largest challenges the markets have faced. As a result of the Paperwork Crisis, the entire industry, including Congress, state and federal regulators, brokers, banks and security exchanges, all participated in a complete overhaul of the markets’ operational systems, which ultimately resulted in the current national clearing and settlement system. Years of expensive studies all came to the same basic conclusion regarding the Paperwork Crisis, which is that the securities industry needed a uniform, coordinated nationwide system for the clearance and settlement of securities transactions.

The birth of DTC

The current system did not pop up overnight, but rather took years and a series of changes and adjustments and then more changes and adjustments. In 1968 the NYSE created the Central Certificate Service as a division of the Stock Clearing Corporation to act as a clearing agency and depository service. In 1973, the Central Certificate Service (“CCS”) changed its name to the Depository Trust Company (DTC).

A clearing agency or depository typically compares member transactions, clears, nets and settles trades, and provides risk management services, such as trade guarantees. Depositories centralize securities by holding them on deposit for their participants and effect transfers of interests in those securities through book-entry credits and debits of participants’ accounts. Currently DTC, through its subsidiaries, is both the only central depository in the United States and the only one registered with the SEC as a clearing agency, but it wasn’t always. In the beginning CCS was only used by the NYSE and soon after by the American Stock Exchange.

In its early years, broker-dealers and banks would deposit their certificated securities with CCS, which would transfer them into the name of the CCS nominee and physically hold them in custody. That nominee account came to be referred to as “street name” and the nominee as CEDE. CCS maintained book accounts for all its members. When a member transferred securities, the transfer was recorded by book entry with a debit and credit between accounts rather than a physical transfer of securities. The securities themselves remained registered to CCS’s nominee account (today CEDE). Today DTC continues to hold physical custody of certificated securities held in street name. As an aside, the flooding from Hurricane Sandy destroyed massive amounts of paper certificates and records held by DTC in its New York storage, taking years to sort out and causing huge delays in the processing of transactions.

Around the same time that the NYSE created the CCS, the NASD formed the National Clearing Corporation (NCC) in an effort to develop and implement a nationwide system of interconnected regional clearinghouses for the clearance of all OTC and NASDAQ securities. In 1977 the NCC merged with CCS and formed the National Securities Clearing Corporation (“NSCC”). The NSCC in turn later merged with DTC. The NSCC net settles securities amongst all the participating broker participants, who in turn maintain records for each client account.

SEC gains regulatory power

It was quickly apparent to the thought leaders of the time that it was imperative to give the SEC the power to regulate the clearance and settlement process, including requiring clearing agencies to register with the SEC and to give the SEC the power to implement rules and regulations related to both the system and its participants. In 1975 Congress enacted the Securities Act Amendments of 1975, making sweeping changes to the federal laws and creating what is today the national market system and national clearance and settlement system.

The 1975 Amendments directed the SEC to “(i) facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities; (ii) end the physical movement of securities certificates in connection with the settlement among brokers and dealers of transactions in securities; and (iii) establish a system for reporting missing, lost, counterfeit, and stolen securities.” In addition, related to the national market system, the SEC was directed to establish a national market system to link together the multiple individual markets that trade securities to achieve the business objective of efficient, competitive, fair and orderly markets.

In the early ’70s the CCS and NCC were not the only clearing agencies; several others had popped up as well. However, using the power of the 1975 Amendments, the SEC required registration of and imposed regulations and compliance on these clearing agencies. In 1982 and 1983 the NASD (now FINRA) and the five major stock exchanges all amended their rules to require members to use an SEC registered clearing firm and depository. By the late ’90s DTC was the largest depository and NSCC was the largest clearing firm. In 1999 the two merged and DTC remained the only SEC registered clearing agency and depository.

DTC introduces FAST

By the mid to late ’70s, technological advancements were assisting in overall system advancements. In 1975 DTC created the Fast Automated Securities Transfer Program (“FAST”), which was approved by the SEC in 1976. Also, in 1977 Article 8 of the Uniform Commercial Code (UCC) was amended to allow for uncertificated book entry records of security ownership.

Prior to FAST, and today for those securities not eligible for the FAST program, when a security is being deposited into DTC, a broker-dealer physically sends the certificate to DTC, who in turn sends it to the transfer agent to register in CEDE. Again, CEDE is DTC’s nominee name for holding legal title to securities in the DTC system. Likewise for the withdrawal of these securities from the DTC system, DTC physically sends the certificate back to the transfer agent, who re-registers it and sends it back to DTC, who then sends it to the participating broker. If the participating broker is a clearing broker, that clearing broker then sends the certificate to the introducing broker, who then sends it to the account holder!

The FAST system allows transfer agents to act as custodians for all shares in the CEDE account. Each individual brokerage firm DTC participant maintains corresponding books representing their customers shareholder accounts for securities held in street name. When securities are deposited into or withdrawn from DTC, the FAST transfer agent makes an electronic adjustment which is electronically confirmed and balanced between DTC and the participating brokers on a daily basis.

Improving matters further, in 1996 the Direct Registration System (“DRS”) was implemented, which allowed investors to hold uncertificated securities in registered form directly on the books of the transfer agent. FAST eligibility is a prerequisite to using DRS. Using DRS and FAST together, a shareholder can electronically transfer shares to and from a brokerage account to facilitate their sale or transfer.

To become FAST, and therefore DRS eligible, a FAST approved transfer agent must apply to DTC on behalf of an issuer. The approval is not automatic. All FAST applications undergo a DTC review process. At a minimum, in order to be FAST eligible, an issuer must be eligible for DTC’s book-entry-only services, which requires a Blanket Letter of Representation (BLOR) in a form subscribed by DTC. DTC can ask for opinion letters to accompany an application. Beyond the BLOR and standard published DTC eligibility criteria, I was unable to find published criteria by DTC as to exactly what review requirements are included in a FAST application review process. I also spoke to several transfer agents that submit FAST issuer applications on a regular basis, and they likewise were unsure as to the review criteria used by DTC. However, it seems generally agreed that DTC conducts an issuer quality review looking at similar issues that would result in chills and locks, compliance with SEC reporting requirements, trading market price, volume and liquidity, and possibly bad actor reviews.

For further reading on DTC eligibility and chills and locks, see HERE; HERE; HERE; and HERE (Please note that DTC never implemented the rules discussed in that particular blog; however, the proposed process became a sort of industry practice. Also, note that the advent of chills and locks has dramatically decreased in recent years.)

Many OTC traded securities remain ineligible for the FAST program and DRS services today. The entire process of depositing securities into and removing securities from DTC is time-consuming for these non-FAST securities. The DTC, brokerage firms and transfer agents all charge for their part in the process—thus the current approximate $1,000 fee to deposit paper securities into DTC. This process, together with heightened regulatory scrutiny related to the deposit of all OTC traded securities and especially penny stocks, adds to the overall difficulty for OTC traded companies and the flow of their securities. See my blogHERE for a discussion on issues related to depositing penny stocks in today’s regulatory environment.

The Current Clearance and Settlement System

Today, 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.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name (i.e., legally titled in the name of DTC’s nominee, CEDE) which have been deposited with a brokerage firm and are in the DTC system. As discussed, these securities show up on the shareholder list in the CEDE account. Each brokerage firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Where securities are held at DTC, the member brokerage firm will be identified on the books and records of DTC as having the entitlement to their pro rata share of all of the securities of that issuer held by DTC. The individual investor will then be identified on the books and records of the DTC member—i.e., the brokerage firm where the investors maintains an account and has deposited the securities. The specific rights of the individual investor are determined by rules and regulations, as well as by contract between the investor/shareholder and the particular brokerage firm.

Also, 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.

Only a limited number of clearing brokers will clear penny stocks and accordingly, only introducing brokers with clearing arrangements through those specific clearing brokers will, in turn, accept and clear penny stocks. COR Clearing, Alpine Securities and Wilson-Davis & Co. are the most widely known DTC member clearing brokers that will process penny stocks. Management of companies that issue penny stocks should communicate to their shareholders as to firms that will or will not clear their securities.

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 the US equities markets, settlement usually occurs three business days after the trade date, commonly referred to as “T+3.” As discussed, 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.

DTC’s clearing arm generally nets all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. This process is continuous. Moreover, brokerage 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.

The SEC concept release on transfer agent rules contained a good summary of this process. In particular, “…final settlement of the securities leg of the transaction will involve the following sequential steps: (i) the DTC securities account of the seller’s clearing broker will be debited with the securities being purchased; (ii) NSCC’s securities account at DTC will be credited with the securities purchased; (iii) the DTC securities account of the buyer’s clearing broker will also be credited; and (iv) each broker will credit or debit their respective customers’ securities accounts held with the broker. On the cash side, final settlement will involve the following sequential steps: (i) the Federal Reserve bank account of the buyer’s clearing broker will be debited for the sale price of the securities; (ii) DTC’s Federal Reserve bank account will credited for the sale price of the securities; (iii) DTC will transfer this cash to the Federal Reserve bank account of the seller’s Clearing Broker; and (iv) each broker will credit or debit its respective customers’ cash accounts held with the broker.”

This process is the same for all buy and sell transactions, whether the transaction involves a long or short sale. However, where the transaction involves a short sale, there are added “locate” and “close-out” requirements, generally governed by Regulation SHO. In a future blog, I will drill down on the short selling process and Regulation SHO.

Although the order flow is all electronic, certain fundamentals cannot be bypassed. For instance, for every sell order there must be a matching buyer, and for every buy order a matching seller. The ability to match a buyer and seller is often referred to as the liquidity of a company’s trading market.

Conclusion

It is important for high-level securities attorneys to go beyond the technical ability to draft a contract, 10-K or registration statement, but to also understand how trading markets work and thus be able to provide guidance and advice as to relationships with transfer agents, market makers and financial public relations firms.

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.

« Regulation SCI NASDAQ Listing Requirements »

Responding To SEC Comments

Posted by Securities Attorney Laura Anthony | March 29, 2016 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities, responding to sec comments, SEC, sec comment process

Background

The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). 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 anti-fraud 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.

CorpFin’s review and responsibilities can be described with one word: disclosure!

CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed. Forms 8-K reporting a change of auditor, a material acquisition, or a change in financial statements are almost always reviewed. Moreover, the Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

CorpFin does not publicly disclose the criteria it uses to identify companies and filings for review. Essentially, a publicly reporting company’s filings may be reviewed at any time and periodic comment letters are a standard part of being a public company.

There are three basic levels of review. A review by CorpFin can be a “full review” in which CorpFin will review a filing from cover to cover, including both legal and accounting aspects and basic form for compliance with the federal securities laws. A partial review may include either legal or accounting, but generally a partial review is related to financial statements and related disclosures, including Management Discussion and Analysis of Financial Condition and Results of Operations, and is completed by CorpFin accounting staff. A review may also be a targeted review in which CorpFin will examine the filing for one or more specific items of disclosure. Moreover, although not a designated level of review, CorpFin sometimes “monitors” a filing, which is a term used for a light review.

Reviewers are appointed files based on industry sectors. CorpFin has broken down its reviewers into the following eleven broad industry sectors: healthcare and insurance; consumer products; information technologies and services; natural resources; transportation and leisure; manufacturing and construction; financial services; real estate and commodities; beverages, apparel and mining; electronics and machinery and telecommunications. Each industry office is staffed with an assistant director and approximately 25 to 35 professionals, primarily accountants and lawyers. Each filing has more than one reviewer with a frontline contact person and supervisor. A full review file will have an accounting and legal reviewer as well as a supervisor.

Neither the SEC nor the 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.

Comment Letters and Responses

Comment letters are based on a company’s filings and other public information about the company. For instance, CorpFin will review press releases and a company’s website, management communications and speeches, and conference presentations in addition to the company’s filings with the SEC. In comment letters, CorpFin may ask that a company provide additional supplemental information to the staff (such as backup materials to justify factual information such as reference to reports, statistics, market or industry size, etc.), revise disclosure in the document, provide additional disclosure in the reviewed filing or provide additional or different disclosure in future filings. Where a change is requested in future filings, intended disclosures may be provided in the comment letter response for SEC advance approval.

A company generally responds to the particular comment letter with a responsive letter that addresses each comment and where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure. CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses. The company should carefully consider its responses to comments that could open the door to additional review and comments. Comments related to accounting treatment and the flow-through to MD&A can be especially tricky and open the door to further review and changes.

Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, explain how the company is burdened and how the alternative provided by the company will provide adequate disclosure for investors. The argument that technical compliance is overly burdensome rarely succeeds with CorpFin, but at times a middle ground can be reached if the company is convincing enough in its analysis.

The comment and response process continues until the staff has resolved all comments. CorpFin may request that the reasoning behind a disclosure be added to the SEC report itself, and so the company should consider whether it wants particular language included in public filings when drafting a response letter to a comment.

Although the basic process involves letters and responses, the CorpFin staff is available to discuss comments with a company and its legal, accounting and other advisors. The process can and often does involve such conversations. CorpFin will not give legal or accounting advice, but it will talk through comments and responses and discuss the analysis and adequacy related to disclosures. The initial comment letter received from CorpFin will have the reviewer’s direct contact information. The back-and-forth process does not require a formal protocol other than the required written response letter. That is, a company or its advisors may engage in conversations regarding comments, or request the staff to reconsider certain comments prior to putting pen to paper.

Moreover, CorpFin encourages this type of conversation, especially where the company or its advisors do not understand a particular comment. The staff would rather discuss it than have the company guess and proceed in the wrong direction. Where the staff suggests that a company should revise its disclosure or its financial statements, the company may, and should as appropriate, provide the staff with a written explanation of why it provided the disclosure it did. This explanation may resolve the comment without the need for the requested amendment. A CorpFin review is not an attack and should not be approached as such. My experience with CorpFin has always been pleasant and involves a type of collaboration to improve company disclosures.

A company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director. Matters of legal disclosure or application of GAAP accounting principles are not an exact science, and discussions are encouraged such that the end result is an enhanced disclosure by the company and consistent disclosures across different companies. The SEC provides all of these individuals contact information on its website and will willingly engage in productive conversations with a company.

When responding to comment letters and communicating with SEC staff, it is important that a person who understands the process, such as SEC counsel, take the lead in communication. Responses should be consistent, both related to a particular comment letter and over time. A company that flip-flops on accounting treatment or disclosures will lose credibility with the SEC and invoke further review and comments.

CorpFin is also willing to provide a reasonable amount of extra time to respond to comment letters when requested. Most comment letters request a response within 10 days. CorpFin is usually willing to give an extra 10 days but will balk at much longer than that without a very good reason by the company for the delay.

If the reviewed filing is a Securities Act registration statement, such as an S-1, the CorpFin staff will verbally inform the company that it has cleared comments and the company may request that the SEC declare the registration statement effective. Where the reviewed filing is an Exchange Act filing that does not need to be declared effective, CorpFin will provide the company with a letter stating that it has resolved all of its comments.

Comment letters and responses are posted on the EDGAR database by CorpFin no earlier than 20 days after it has finished the review process.

The SEC generally requires 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. This language is referred to as a “Tandy” letter. The Tandy portion of a response must be agreed to by the company itself, so if the response letter is on attorney letterhead, a signature line must be provided for the company or the company can submit a separate letter. The Tandy language for an Exchange Act filing is generally 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 is generally 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 delegated authority, in declaring the filing effective does not relieve the company from its full responsibility for the 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 initated by the Commission or any person under the federal securities laws of the United States.

A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting. The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included. As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports. As CorpFin is only reviewing information provided by, or publicly available related to, a company, the completion of a review is not a guarantee as to the accuracy or adequacy of the information in the filing and cannot be used as a defense to claims of fraud or misrepresentations.

Although a full discussion of confidential treatment and requests are beyond the scope of this blog, a company may seek confidential treatment of materials and responses to comments under Rule 83. Rule 83 requires the company to respond to comments with two separate letters – one containing the confidential information and the other not. Unlike confidential treatment requests under Rule 406 and 24b-2, a confidential treatment request for a comment response letter does not require that the company provide a justification for such confidential treatment. However, if a Freedom of Information Act (FOIA) request is submitted by a third party related to such comment letter response, the SEC will inform the company and request justification for continued confidential treatment. Confidential treatment under Rule 83 expires after 10 years unless a renewal is requested. Both Rule 83 and other confidential treatment rules require very specific transmittal procedures, and the documents must all clearly indicate that confidential treatment is requested. In a future blog I will discuss confidential treatment requests and SEC review policies.

Conclusion

The very best way to handle comments and responses is to have a competent team in place that submits high-quality SEC reports in the first place and that is able to communicate with the SEC and understand the legal disclosure and accounting requirements, including interpretative changes over time. The topic of disclosures and disclosure requirements is in the forefront these days, and changes are being reviewed and considered by the SEC (see, HERE for example). Understanding the disclosure requirements for your particular company and industry will save substantial time and effort for a public company.

For a review of basic public company disclosures, see my blog HERE. For more information regarding officer and director liability associated with signing SEC reports, 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 Advisory Committee On Small And Emerging Companies Reviews Capital Formation Mergers And Acquisitions: Types Of Transactions »

House Passes More Securities Legislation

Posted by Securities Attorney Laura Anthony | March 15, 2016 Tags: House Passes More Securities Legislation

In what must be the most active period of securities legislation in recent history, the US House of Representatives has passed three more bills that would make changes to the federal securities laws. The three bills, which have not been passed into law as of yet, come in the wake of the Fixing American’s Surface Transportation Act (the “FAST Act”), which was signed into law on December 4, 2015.

The 3 bills include: (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. None of the bills have been passed by the Senate as of yet.

Meanwhile, the SEC continues to finalize rulemaking under both the JOBS Act, which was passed into law on April 5, 2012, and the Dodd-Frank Act, which was passed into law on July 21, 2010. The SEC provides comprehensive information on its progress under each of the Acts on its website. For Dodd-Frank see HERE and for the JOBS Act see HERE.

H.R. 1675 – Capital Markets Improvement Act of 2016

On February 3, 2016, the House passed H.R. 1675, the Capital Markets Improvement Act of 2016, comprising 5 titles including (i) Title I – Encouraging Employee Ownership Act of 2015; (ii) Title II – Fair Access to Investment Research; (iii) Title III – Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification; (iv) Title IV – Small Company Disclosure Simplification; and (v) Title V – Streamlining Excessive and Costly Regulations Review.

The Executive Office strongly opposes H.R. 1675 and has issued a Statement of Administration Policy voicing its objections. The Executive Office points out that the bill has many flaws, imposes risks to investors, is overly broad, allows financial institutions to avoid appropriate oversight and is duplicative of existing administration authorities. I will continue to monitor progress and provide updates.

Title I – Encouraging Employee Ownership Act of 2015

The bill requires the SEC to amend Securities Act Rule 701 to require an issuer to provide certain delineated disclosures to employee investors regarding compensatory benefit plans if the aggregate sales price or aggregate amount of securities sold in any 12-month period exceeds $10 million, indexed for inflation every 5 years. The current regulations have a threshold of $5 million.

The Executive Branch strongly opposes the bill and even issued an official Statement of Administration Policy expressing its opposition.

Brief Summary of Rule 701

Rule 701 provides an exemption from the registration requirements under Section 5 of the Securities Act for offers and sales of securities pursuant to certain compensatory benefit plans and contracts related to compensation. The exemption only applies to issuers that are not subject to the reporting requirements of the Securities Exchange Act and is generally used by private companies.

The aggregate amount of sales under Rule 701 is limited to the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer (or of the parent if the parent is a co-issuer or guarantor); or (iii) 15% of the total outstanding of the class of securities being offered. Rule 701 currently requires the delivery of the compensatory benefit plan or contract as applicable and additional disclosure if the aggregate sales exceed $5 million. Those additional disclosure include risk factors, a summary of the plan and financial statements prepared in accordance with U.S. GAAP.

Although securities issued under Rule 701 are restricted under Rule 144, they become freely tradable 90 days after the issuer becomes subject to the reporting requirements of the Securities Exchange Act without regard to the current information and holding period requirements under Rule 144 for non-affiliates and without regard to the holding period requirements for affiliates.

Like other exemptions, Rule 701 transactions are still subject to the anti-fraud provisions of the federal securities laws. Rule 701 does not pre-empt state law and accordingly, state securities laws must be complied with in any issuance under the Rule.

Title II – Fair Access to Investment Research

Title II requires the SEC to adopt rules providing that research issued by investment funds will not be deemed to be an offer for the sale of securities regardless of whether the report covers an issuer that is going to or has embarked on a registered offering and regardless of whether a broker-dealer associated with the fund will participate in the offering. The Act contains strong language, including prohibiting an SRO (FINRA) from maintaining or enforcing any rules conditioning the ability of a member to publish or distribute research on whether the member is participating in a registered offering.

Title III – Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification

Title III attempts to codify a broker-dealer registration exemption for mergers and acquisition brokers. The Executive Office Statement of Administration Policy points out that Title III as written is overly broad and would eliminate the registration requirements for M&A brokers engaged in a transaction for any privately held company with gross revenues up to $250 million. The Executive Office thinks this exemption amount is too high, among other issues. Moreover, the Executive Office notes that the SEC has already recognized an exemption for M&A brokers though a no action letter (see my blog HERE).

Title IV – Small Company Disclosure Simplification

Title IV creates an exemption from the XBRL requirements for small and emerging growth companies. The Executive Office also opposes this change on the grounds that “[o]pen data disclosure systems benefit investors, issuers, and the public, increasing transparency of publicly traded companies by making their filings more easily accessible. Impeding regulators’ ability to use 21^st century technological tools to regulate markets and protect investors is contrary to the SEC’s mission.”

I support Title IV and the exemption from the XBRL requirements.

Title V – Streamlining Excessive and Costly Regulations Review

Title V may be herculean in nature. Title V requires the SEC to review each significant regulation issued by the SEC to determine by vote of the SEC if such regulation is (i) outmoded, ineffective, insufficient or excessively burdensome; or (ii) is no longer necessary in the public interest or consistent with the SEC’s mandate to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. Title V requires the immediate review and a 10-year periodic review. The Executive Office statement of opposition states that “[T]hese requirements are unnecessarily duplicative, wasteful and costly. The SEC already complies with the Regulatory Flexibility Act and is encouraged, under Executive Order 13579, to review rules to assess whether they are outdated or excessively burdensome. Requiring a review and full Commission vote on every major rule every 10 years under full Administrative Procedure Act-style requirements would severely hinder the SEC’s ability to monitor markets and protect investors.”

H.R. 3784 – Establishing Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee

On February 1, 2016, the House passed H.R. 3784, the SEC Small Business Advocate Act. The Act proposes to amend the Securities Exchange Act to establish the Advocate for Small Business Capital Formation within the SEC. The office would be charged with (i) assisting small businesses and their investors in resolving significant problems with the SEC and other SROs; (ii) identifying areas where small businesses and their investors would benefit from changes in SEC and other SRO regulation; (iii) identifying problems small businesses have with security access to capital; (iv) analyzing the potential impact of proposed rules and regulations on small businesses; (v) conduct outreach programs with small businesses and their investors; and (vi) work to propose these changes to the SEC and Congress.

In addition, the Act would create the Small Business Capital Formation Advisory Committee. The committee would provide the SEC with advice on SEC rules, regulations, and policies relating to (i) capital raising by emerging, privately held small businesses and publicly traded companies with less than $250 million in public market capitalization through securities offerings; (i) trading in the securities of such businesses and companies; and (3) public reporting and corporate governance requirements of such businesses and companies.

The new proposed committee seems duplicative of the existing SEC Advisory Committee on Small and Emerging Companies, which was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to (i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.

H.R. 2187 – Amendment to the Definition of Accredited Investor

Also on February 1, 2016, the House passed H.R. 2187, the Fair Investment Opportunities for Professional Experts Act, proposing an amendment to the definition of accredited investor as to natural persons. In particular, the bill proposes to add provisions to the definition of accredited investor to include (i) any natural person who is currently licensed or registered as a broker or investment adviser by the SEC, FINRA or a state securities regulator and (ii) any natural person the SEC determines by regulation to have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA.

In addition, the bill tweaks other aspects of the definition related to natural persons. The bill proposes to adjust the current $1,000,000 net worth accredited investor eligibility standard every 5 years for inflation. The bill tweaks the exclusion of a person’s primary residence from the calculation such that any indebtedness secured by the residence (i.e., a mortgage) that is in excess of the fair market value of the home, will be included as a liability in determining net worth. I think this creates ongoing calculation issues as the value of homes can vary widely in a short period of time.

I doubt the bill in its current form will gain any traction or ultimately become law, but we will, no doubt, see changes to the accredited investor definition in the near future. For further discussion, 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 Gives Insight On 2016 Initiatives SEC Advisory Committee On Small And Emerging Companies Reviews Capital Formation »

SEC Gives Insight On 2016 Initiatives

Posted by Securities Attorney Laura Anthony | March 8, 2016 Tags: dodd-frank act, mary jo white, SEC, The Fast Act, the jobs act

SEC Chair Mary Jo White gave a speech at the annual mid-February SEC Speaks program and, as usual, gave some insight into the SEC’s focus in the coming year. This blog summarized Chair White’s speech and provides further insight and information on the topics she addresses.

Consistent with her prior messages, Chair White focuses 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. The primary areas of focus included cybersecurity, market structure requirements, dark pools, microcap fraud, financial reporting failures, insider trading, disclosure deficiencies in municipal offerings and protection of retail investors and retiree savings. In 2016 the SEC intends to focus enforcement on financial reporting, market structure, and the structuring, disclosure and sales of complex financial instruments.

2016 Disclosure Agenda

Chair White hit on the tremendous volume of regulatory changes and congressional mandates. Since 2010 Congress has given the SEC nearly 100 statutory mandates covering a multitude of complex rule requirements, with the FAST Act, JOBS Act, and the Dodd-Frank Act just being 3 examples. White confirms that the amount of recent rulemaking is of historic proportions, completing or overhauling many regulatory areas and providing dramatic changes to others. Again, 3 small examples are the FAST Act, JOBS Act and the Dodd-Frank Act, with the multitude of regulatory changes flowing from these 3 statutory directives.

In 2016 the SEC will continue implementing rules as directed by Congress. In addition to finalizing the remaining security swap and security-based swap dealer requirements under the Dodd-Frank Act, the SEC hopes to continue rulemaking related to the asset management industry, the structure of the equity markets and disclosure requirements (under Regulation S-K and Regulation S-X).

Related to the asset management industry, in May 2015 the SEC proposed increased reporting for investment advisers and mutual funds, including a requirement that funds report risk metrics, the use of derivatives, securities lending and liquidity of holdings.

Related to the structure of equity markets, the SEC has increased oversight over proprietary traders (see my blog HERE) and has proposed major revisions to regulations for alternative trading systems (this will be the subject of a future blog). Also related to equity markets, Chair White referenced the recent ANPR on new transfer agent rules (see my blog HERE) and the Tick Size Pilot program (see my blog HERE). Moreover, Chair White revealed that the SEC intends to shorten the clearing settlement life cycle from T+3 to T+2.

Disclosure effectiveness has been an ongoing central topic since the JOBS Act required the SEC to launch its Disclosure Effectiveness Initiative. The SEC intends to continue its focus in this arena and expects both additional rulemaking and industry guidance in 2016.

I have written several times on the SEC initiative and the subject of improving the disclosure requirements for reporting companies. Recently the SEC sought comment on financial disclosure requirements for subsidiaries and affiliate entities (see my blog HERE). Moreover, several of the provisions in the recent FAST Act were related to these initiatives. In particular, The FAST Act adopted many of the provisions of a bill titled the Disclosure Modernization and Simplification Act, including rules to: (i) allow issuers to include a summary page to Form 10-K (Section 72001); and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for EGCs, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K (Section 72002). In addition, the SEC is required to conduct yet another study 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 (Section 72003). See my blog on the FAST Act and these provisions HERE.

In September 2015, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. My blog on these recommendations can be read HERE.

Prior to that, in March 2015, the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For a review of these recommendations, see my blog HERE.

Mission and Philosophy

Chair White made a point of conveying the message that the SEC is not just about disclosure. They have broad regulatory authority over trading markets, broker-dealers, SRO’s, the settlement and clearing process and the PCAOB. The SEC intends to continue to work in each of these areas, including additional regulations on the swaps markets, clearing agencies, transfer agents, and technology systems. In addition, the SEC has and will continue to seek public comment on proposed rules, ideas related to proposed rules, and concepts in general. As Chair White states, “[W]e are therefore increasingly considering using measures beyond disclosure to fulfill our mission of providing strong investor protection, safeguarding market integrity, and achieving other regulatory objectives.”

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.

« State Blue Sky Concerns; Florida and New York House Passes More Securities Legislation »

State Blue Sky Concerns; Florida and New York

Posted by Securities Attorney Laura Anthony | March 2, 2016 Tags: Blue Sky Laws, Florida Corporate Statutes

I have often written about state blue sky compliance and issues in completing offerings that do not pre-empt state law, including Tier 1 of Regulation A+ and initial or direct public offerings on Form S-1. I’ve also often expressed my opinion that the SEC, together with FINRA, is best suited to govern most securities-related registrations and exemptions, including both for offerings and broker-dealer matters, and that the states should be more focused on state-specific registrations and exemptions (such as intrastate offerings) and investigation and enforcement with respect to fraud or deceit, or unlawful conduct.

Despite the SEC support for the NASAA-coordinated review program to simplify the state blue sky process for securities offerings, such as under Tier 1 of Regulation A+, only 43 states participate. I say “only” in this context because the holdouts – including, for example, Florida, New York, Arizona and Georgia – are extremely active states for small business development and private capital formation. Moreover, even using the coordinated review program, the states have vastly different rules and interpretations of the same rules.

Blue sky compliance is tricky at best. In this blog I am discussing particular difficulties with the blue sky legislation in Florida and New York as an example of the types of traps an issuer can face without proper planning and, of course, competent legal counsel.

For a review of federal pre-emption of state securities laws, see my two-part blog on the National Markets Improvement Act of 1996 (NSMIA) HERE and HERE. For further information on the NASAA-coordinated review program, see my blog HERE for further discussion.

Florida

Florida does not have an issuer exemption from broker-dealer registration for public offerings, including offerings made under Regulation A/A+ or self-underwritten public offerings made using Form S-1. Put another way, an issuer must register as a broker-dealer with the state of Florida (the state has an issuer registration process) in order to complete a Regulation A or direct public offering, and sell securities to investors within the state of Florida. Tier 2 of Regulation A+ pre-empts state law and accordingly, Florida cannot impose issuer broker-dealer registration.

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.

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(3), Florida Statutes. However, the broker-dealer registration exemptions, including the issuer exemption, only apply to exempt offerings. Neither a Regulation A nor a direct public offering are exempt offerings. Accordingly, persons who sell securities in a Tier 1 Regulation A offering or direct public offerings, including issuers and their officers, directors and employees, must register as a broker-dealer in the state of Florida to sell to investors within the state of Florida.

In addition, Florida law has another trap where an issuer or finder could inadvertently violate the law. Florida Statute §475.41 specifically states that a contract by an unlicensed broker to sell or to negotiate the purchase or sale of a business for compensation is invalid and in particular:

No contract for a commission or compensation for any act or service enumerated in §475.01(3) is valid unless the broker or sales associate has complied with this chapter in regards to issuance and renewal of the license at the time the act or service was performed.

Fla. Stat. §475.01(3) defines “operating” as a broker as meaning “the commission of one or more acts described in this chapter as operating as a broker.” “Broker” is defined broadly in Fla. Stat. §475.01(1)(a) and includes, among other things:

… a person who, for another, and for compensation or valuable consideration directly or indirectly paid or promised, expressly or impliedly, or with an intent to collect or receive compensation or valuable consideration therefore… sells… or negotiate[s] the sale, exchange, purchase, or rental of business enterprises or business opportunities… or who advertises or holds out to the public by any oral or printed solicitation or representation that she or he is engaged in the business of appraising, auctioning, buying, selling, exchanging, leasing or renting business enterprises or business opportunities… or who directs or assists in the procuring of prospects or negotiation or closing of any transaction which does, or is calculated to, result in a sale, exchange, or leasing thereof, and who receives, expects, or is promised any compensation or valuable consideration, directly or indirectly… (emphasis added)

Relying on these provisions, Florida courts and arbitration panels have found consulting and finder arrangements related to mergers and acquisitions and other corporate finance transactions that would otherwise not require federal broker-dealer registration, to be unlawful.

In addition to the conflict with federal law, the Florida statute is particularly troubling for practitioners as it is not included in the Florida Securities and Investor Protection Act found in chapter 517 of Florida Statutes. Florida Statute §517.12 is the state equivalent to Section 15(a)(1) of the Exchange Act requiring broker-dealer registration. Like the Exchange Act, §517.12 requires registration as a broker or dealer for the sale or offer of any securities.

Section 475, on the other hand, is the Florida statute governing “Real Estate Brokers, Sales Associates, Schools and Appraisers.” Section 517 gives no reference to Section 475 and vice versa. Other than through research of case law, a practitioner would have no reason to research laws governing real estate transactions in association with business mergers and acquisitions and the payment of related finders’ fees.

Selling securities without a license can be a criminal matter under §517.302. Violation of §517.302 is a third-degree felony, punishable by up to five years in prison and is a strict liability offense. A separate violation of §517.12 occurs every time the defendant sells a security without the proper license. Thus, a defendant who sells a security to eight different victims would commit eight separate violations of §517.12. Neither ignorance of the license requirement nor the defendant’s good faith reliance on the advice of counsel is a recognized defense.

The Florida provisions remind us of the complexities associated with state blue sky compliance.

New York

New York State’s securities statute, Articles 23-A of the General Business Law, known as the Martin Act, is unique among state securities laws in two important respects. First, the Martin Act does not require the registration of securities, other than securities sold in real estate offerings, theatrical syndications or intra-state offerings. Instead, it requires that issuers register as dealers in their own securities. New York exempts issuers from registering as dealers when they complete a firm commitment underwritten offering but not in other circumstances, including a best efforts underwritten offering or where no underwriter or placement agent is utilized.

Second, the Martin Act does not differentiate between registered or exempt offerings or provide for exemptions for federally covered (state pre-empted) offerings. The Martin Act requires that any person “engaged in the business of buying and selling securities from or to the public” to register as a broker-dealer. Although the Martin Act does not offer any guidance, case law has interpreted the words “to the public” to exclude private offerings under Section 4(a)(2). However, despite requests, New York has failed to amend the Martin Act to make any differentiation, leaving practitioners not knowing what, if any, notice filings would be required for private offerings.

As a result of the controversy surrounding New York’s blue sky compliance, many practitioners simply do not file any notice documents or pay any fees where the offering pre-empts state law under the NSMIA. As a reminder, securities subject to the NSMIA are called “covered securities.”

Covered securities may still be, and generally are, subject to notice filing requirements by the individual states. The NSMIA specifically allows the states to require a copy of any document filed with the SEC, together with annual or periodic reports of the value of securities sold or offered to be sold to persons located in the state (if not already included in the SEC filing) as long as such filing is solely for notice purposes and for the assessment or calculation of a fee. States may also require the filing of consent to service of process.

States may also require the payment of a fee in connection with a notice filing except that fees are specifically prohibited in connection with securities that are listed or authorized for listing on a national securities exchange such as the NYSE or NASDAQ and securities in Title III crowdfunding transactions except where 50% or greater of the securities are sold in a single state. Although a state may not condition the federal pre-emption granted by the NSMIA upon the payment of a fee, it can suspend an otherwise covered offering in its state for the failure to file a notice filing and pay the fee.

The Committee on Securities Regulation of the New York State Bar Association submitted a position paper to the Office of the New York State Attorney General in August 2002 related to New York’s overreaching blue sky laws with respect to private offerings; however, the state of New York did not respond.

The Committee concluded that all offerings exempt under Section 4(a)(2) of the Securities Act and Rule 506 of Regulation D are exempt from the Martin Act and that New York cannot require issuers to register as broker-dealers for such federally pre-empted private offerings. The Committee goes further by stating that “[I]f New York State wishes to receive a notice and fee for Section 4(a)(2) and Rule 506 offerings, it must amend the Martin Act to require (or to permit the Attorney General to require) notice filings in non-public offerings.” Many practitioners rely on this position paper in support of the position that no filings must be made with New York when relying on Section 4(a)(2) of the Securities Act.

Conclusion

My consistent view is that the SEC, together with FINRA, is best suited to govern most securities-related registrations and exemptions, including both for offerings and broker-dealer matters, and that the states should be more focused on state-specific registrations and exemptions (such as intrastate offerings) and investigation and enforcement with respect to fraud or deceit, or unlawful conduct.

I am thrilled with the opportunity that Tier 2 of Regulation A+ offers for issuers in completing going public transactions that pre-empt state blue sky law and would like to see an expansion of the NSMIA for direct and initial public offerings using form S-1.

The Author

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

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

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

Download our mobile app at iTunes.

« SEC Proposes Transfer Agent Rules SEC Gives Insight On 2016 Initiatives »

SEC Proposes Transfer Agent Rules

Posted by Securities Attorney Laura Anthony | February 23, 2016 Tags: DTC Eligibility, SEC, Transfer Agent Rules

On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. The transfer agent rules were adopted in 1977 and have remained essentially unchanged since that time. An advance notice of proposed rulemaking (ANPR) describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. The SEC indicates that following the comment process associated with this ANPR, it intends to propose actual new rules as soon as practicable.

To invoke thoughtful comment and response, the SEC summarized the history of the role of transfer agents within the securities clearing system as well as the current rules and proposed new rules. In addition, the SEC discusses and seeks comments on broader topics that may affect transfer agents and the securities system as a whole. This blog gives a high level review of the whole APNR and concept release with a more detailed focus on the proposed rules and discussions that will directly impact the transfer and deposit of restricted securities in the small-cap industry.

Introduction

As set out by the SEC, among other functions, transfer agents (i) track, record and maintain the official shareholders registrar and ownership records; (ii) cancel, issue and transfer securities, both in certificate and book entry form; (iii) communicate with shareholders on behalf of issuers; and (iv) process dividends and corporate actions such as reverse splits. In addition, from my own experience, transfer agents will act as mailing agent for proxy and other communications from the issuer, sometimes offer EDGAR agent services, and facilitate DTC eligibility applications with DTC member firms, obtain DWAC/FAST DTC eligibility for issuers and act as a front line where shareholders are attempting to remove a restrictive legend and deposit securities with brokerage firms.

Transfer agents are also seen as a gatekeeper in the prevention of fraud, and compliance with the registration and exemption provisions of the federal securities laws. In that regard, the SEC intends to impose obligations on a transfer agent in the processing and transfer of restricted securities. A major focus of the rulemaking is related to combatting microcap fraud. This is consistent with the recent SEC approach of increasing obligations and pressure on the gatekeepers, including brokerage firms related to the deposit of securities (see my blog HERE), attorneys and auditors, and transfer agents.

For the discussion of the proposed new rules related to the transfers of restricted securities, see the discussion below under the subheading “Restricted Securities and Compliance with Federal Securities Laws.”

History and Background

The SEC ANPR is lengthy and provides an in-depth discussion of the history of the clearing and settlement process and role of transfer agents in the process. Briefly, the ownership of securities represents certain property rights and the securities themselves are a negotiable instrument under state law allowing the owner to transfer such property to a third party. Where federal securities laws govern the registration and exemption provisions, the individual state’s Uniform Commercial Code (UCC) governs the transfer of certificates and securities as property. Accordingly, in addition to compliance with federal law, the daily activities of a transfer agent require knowledge of and compliance with the UCC.

Under the UCC, in order to obtain valid title to a security, the seller must voluntarily transfer possession of the security and the buyer must give value, not have notice of any adverse claim to the security and actually obtain control over the security. It is compliance with the UCC that requires that a certificate be endorsed, the signature guaranteed, instructions and authority from the seller, proof of payment/consideration from the buyer, proper cancellation of certificates and the proper registration and recording on the shareholder list. Moreover, it is the UCC that governs the process for replacing lost or stolen certificates and for an issuer or security holder to impose stop transfer restrictions.

Technology has helped streamline some of this process and for traded securities in DTC eliminated paper certificates altogether, but as all in the industry know, the paperwork is still extensive. Article 8 of the UCC governs the transfer of electronic or uncertificated securities. The SEC gives an interesting background discussion of the Paperwork Crisis beginning in the 1960s resulting from the massive volumes of paper needed to transfer securities associated with the growing and active trading markets. As a result of the Paperwork Crisis, the Depository Trust Company (DTC) and its securities holding arm, CEDE, were formed.

Moreover, for those interested, the APNR and concept release provides a thorough history of the creation and amendments to the national market system, national clearing and settlement system, SIPC, DTC the FAST program, and development of laws allowing for the holding and trading of book entry and electronic securities. Although this history is well beyond the scope of this blog, what I found particularly interesting is how recent many of these developments have been. For instance, it was only in 1996 that the Direct Registration System (DRS) was implemented that allowed investors to hold uncertificated securities in registered form on the books of the transfer agent and to utilize the FAST system to transfer shares to and from and brokerage account. It was during the late 1990s that DTC really flourished to become the largest depository and clearing house in the US. Today DTC provides the depository and book entry services for virtually all securities available for trading in the US.

Transfer Agent Role in Clearance and Settlement Processes

A transfer agent is an integral part of the National C&S System. The clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved. I will detail the clearing and settlement process in a future blog.

Security ownership can be either registered or beneficial. State corporate law conveys certain rights to registered owners that beneficial owners may not receive. For example, the right to examine a stockholder list at a meeting is limited to registered and not beneficial owners. Registered owners are listed on the stockholder list by name and are sometimes referred to as “holders of record.” In addition to state law rights, the holders of record is an important concept throughout the securities laws. For example, Section 12(g) of the Securities Exchange Act requires a company to register when it has 2,000 or more holders of record. Likewise, deregistration eligibility is determined in part by the number of holders of record.

A transfer agent often deals directly with a holder of record, including in the provision of transfer services, dividend payments and communications, such as the delivery of proxy forms. Record holders may hold their securities in either certificate or book entry form.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name which have been deposited with a brokerage firm and are in the DTC system. These securities usually show up on the shareholder list in the Cede account and sometimes in the name of the particular brokerage firm. Each brokerage and clearing firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Current Transfer Agent Regulations

Transfer agents have been regulated by federal securities laws since 1975. A “transfer agent” is defined as any person who engages in the following activities on behalf of an issuer: (i) countersigning securities upon issuance; (ii) monitoring issuances and preventing unauthorized issuances; (iii) registering the transfer of securities; (iv) exchanging or converting securities; or (v) processing transfer and maintaining book entry ownership records. Public company transfer agents are required to be registered with the SEC.

The SEC currently regulates (i) registration and annual reporting requirements; (ii) timing and certain notice and reporting requirements (the “turnaround rules”); and (iii) recordkeeping and record retention rules and safeguarding requirements for securities and funds. The current transfer agent rules are extensive, and below is just a very high-level brief overview.

Current Registration and Annual Reporting Requirements

The current registration and annual reporting requirements are found in Exchange Act Rules 17Ac2-1 through 17Ac3-1. All transfer agents must register with the SEC on Form TA-1. The rules include eligibility prohibitions against certain “bad actors” similar to other bad actor rules within the securities laws. All transfer agents must file an annual report on Form TA-2, including information on compliance with turnaround rules, number of accounts, items received, funds distributed and lost securities. Both the application and the annual report can be viewed by the public on EDGAR. In addition to reviewing these forms, the SEC performs site visits and examinations of transfer agents.

Current Processing, Reporting, Recordkeeping and Exemptions

Exchange Act Rules 17Ad-1 through 17Ad-7 set forth performance standards for transfer agents. In relation to these rules, transfer agents must have written internal controls and procedures. The rules focus on establishing minimum performance and recordkeeping standards for routine transfers, cancellations and issuances. Routine items must be processed within 3 business days of receipt and non-routine items must receive “diligent and continuous attention” and be “turned around as soon as possible.” Routine items are defined in the negative such that all items are routine except items (i) requiring the issuance of a new certificate that the transfer agent does not have; (ii) subject to stop order, adverse claim or other restriction; (iii) requiring additional documentation to review and complete; (iv) are part of a corporate action (such as split or dividend); (v) are part of a public or private offering; or (vi) certain warrants, options or other convertible securities. The performance rules contain certain exemptions, such as for the processing of limited partnerships and redemptions for registered investment companies and for certain very small transfer agents.

The performance rules also require a transfer agent to respond to certain written inquiries within prescribed time periods and, in particular, within 5, 10 or 20 days depending on the person making the inquiry and the subject of the inquiry.

Transfer agents are required to keep detailed, defined records including minimum delineated information that allows for the prompt delivery of information related to shareholders, ownership positions and historical records related to same. Records, funds and securities in a transfer agent’s custody must be safeguarded to prevent theft, loss, destruction or misuse.

Transfer agents are required to notify DTC when terminating or assuming transfer agent services for an issuer.

SRO Rules and Requirements

In addition to federal securities laws, transfer agents are regulated by SRO’s including, for example, the NYSE and DTC. The NYSE requirements include further regulation on turnaround times and recordkeeping as well as capitalization and insurance requirements.

All transfer agents that include electronic or book entry services (which is really all of them) must comply with DTC rules including (i) being “Limited Participants” in DTC; (ii) participate in the FAST program and agree to DTC’s Operational Arrangements; (iii) link with DTC’s electronic communication system; and (iv) participate in DTC’s Profile Surety Program.

State Law

As briefly discussed above, transfer agents must comply with state corporate statutes related to recordkeeping and notice requirements as well as each state’s Uniform Commercial Code.

Proposed New Rules

The SEC has issued an advance notice of proposed rulemaking (ANPR) which describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. Following the receipt of public comment on the ANPR, the SEC will publish proposed rules. The ANPR reveals a thorough revamping of the transfer agent rules.

The ANPR proposes rules to (i) increase the scope of information on the registration application (Form TA-1) and annual report (Form TA-2) for transfer agents; (ii) require all contracts between a transfer agent and issuer to be in writing, which includes a fee schedule and termination provisions, including provisions for handing over information to a new transfer agent; (iii) enhance transfer agent requirements for the safeguarding of funds and securities; (iv) apply anti-fraud provisions to specific transfer agent activities; (v) require transfer agents to establish business continuity and disaster recovery plans; (vi) require transfer agents to establish basic procedures regarding the use of information, including safeguarding personal information; (vii) revise recordkeeping requirements; and (viii) conform and update various terms and definitions and eliminate those that are obsolete.

Restricted Securities and Compliance with Federal Securities Laws

All sales of securities, including the re-sale of restricted securities held by a current shareholder, must either be registered under the Securities Act or there must be an available exemption. The most common exemption for the resale of restricted securities is Section 4(a)(1) of the Securities Act and Rule 144, which is a safe harbor under Section 4(a)(1). Since transfer agents are responsible for affixing a restrictive legend on stock certificates or making a restrictive notation on book entry securities and for processing the transfer and legend removal from such securities, they are an important gatekeeper in the prevention of fraud and unregistered distributions.

Transfer agents are subject to aiding and abetting liability for violations of the registration requirements under Section 5 of the Securities Act. In addition, like any market participant, a transfer agent could be charged with fraud violations under Section 10(b) and Rule 10b-5 under the Exchange Act and Section 17(a) of the Securities Act.

Currently a transfer agent must determine whether any particular request is routine and thus requires a 3-day turnaround, and whether the state UCC requires the processing of a request. Neither federal nor state UCC regulations require the processing of a request that does not comply with the federal securities laws. Accordingly, the transfer agent must determine whether a particular request complies with federal (or state) securities laws and thus what their particular processing requirements are. It is this determination that has made it an industry practice to require an opinion letter from counsel with each request to transfer or remove a legend from restricted securities. The SEC is concerned that reliance on opinion letters from a shareholder’s or issuer’s counsel does not offer enough protection against improper transfers or fraud.

Accordingly, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from directly or indirectly taking any action to facilitate a transfer of securities if such person knows or has reason to know that an illegal distribution of securities would occur in connection with the transfer. Such knowledge qualifier carries a duty to make reasonable inquiry.

Moreover, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from making any materially false statements or omissions or engaging in any other fraudulent activity in connection with the performance of their duties.

In addition, the SEC proposes new rules requiring each transfer agent to adopt internal controls, policies and procedures reasonably designed to ensure compliance with securities laws and requiring that each transfer agent designate a chief compliance officer.

There is no proposal to adopt rules that would provide specificity to a transfer agent related to the removal of a restrictive legend or transfer of restricted securities. However, the SEC does seek comment on same and, in particular, whether there should be requirements related to (i) obtaining an attorney opinion letter; (ii) obtaining issuer approval; (iii) requiring evidence of a registration statement or available exemption; (iv) requiring evidence of beneficial ownership; (v) requiring representations related to affiliation; and/or (vi) conducting some level of due diligence. I would advocate for such guidelines.

As the SEC notes, there is a potential conflict between a transfer agent’s duties to process a transfer and to ensure compliance with federal securities laws. However, in my opinion, from a transfer agent’s perspective, there are certain rules (turnaround rules and the UCC) requiring processing and only a vague fear of being charged with aiding and abetting related to ensuring compliance with federal securities laws. The proposed new rule generally increasing the potential liability on the transfer agent is likewise vague in the APNR. Without specific guidelines and standards, transfer agents will have a hard time navigating the new regulatory environment and all market participants will pay the price.

In fact, fear of regulatory retribution has already created a very challenging environment in the small-and mid-cap marketplace. The deposit of penny stock securities has become extremely difficult and expensive, but the flow of information to the market participants as to what is and is not acceptable has been slow and disjointed. At the same time that the OTC Markets has created self-imposed quantitative and qualitative standards to improve the marketplace and has been attempting to support small and emerging growth business capital formation, the secondary trading becomes increasingly difficult.

Moreover, there is a contrarian reality among the legislature, the SEC’s public position, and again, the actual small-cap secondary trading market, including the ability to deposit securities. The JOBS Act, including Regulation Crowdfunding, and the FAST Act are designed to improve capital formation in the small and emerging growth sectors, including a specific focus on allowing companies easier access to public markets and facilitating going public transactions. The advent of Regulation A+ and 506(c), the creation of the emerging growth company category, the various provisions of the FAST Act including improvements to the Form S-1 filing process and the SEC initiatives to modernize and update disclosure obligations are all meant to ease capital formation and public filings for micro- and small-cap companies.

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

The contrary side to all of this is the extreme difficulty in depositing securities for small- and micro-cap public companies and in creating a vibrant trading market. Although not comprehensive on the issues, see my blogs HERE regarding broker duties in depositing stocks and HERE regarding the need for a venture exchange.

The small- and micro-cap marketplace needs more definitive standards that companies and practitioners can rely upon. The fact is, it is relatively easy for a company to pass a footnote 32 type vehicle through the SEC and obtain a ticker symbol from FINRA and then extremely difficult to do anything with it. See my blog HERE. The fact that it is easy to create the vehicles in the first place creates a sort of confusion and disconnect in the marketplace. I’d rather see the SEC and FINRA be more stringent in their review process on these obvious vehicles and require that they label themselves a shell such that brokers and transfer agents have some comfort that when a company has cleared the SEC and FINRA, it is as labeled, subject of course to post effectiveness changes.

Of course, brokers and transfer agents still need to be gatekeepers, but the standards they are relying upon and the issues they are facing in their own SEC investigations and reviews need to be articulated and communicated to the marketplace. New proposed transfer agent rules is a step in the right direction and a very good start, but if those rules include a vague requirement that the transfer agent follow the law, we will not have made the type of headway that is badly needed to support real and viable small businesses and their capital formation.

I note that as part of the SEC request for comment there are some extreme thoughts. For instance, the SEC requests comment on whether a transfer agent should be required to (i) confirm the existence and legitimacy of an issuer’s business by reviewing contracts and corporate records; (ii) conduct credit and criminal background checks for issuers and their officers and directors; (iii) obtain information on shareholders before processing requests for legend removal; and (iv) review public news and information on issuers and principals. My view is that this level of review by a transfer agent is too extreme. I strongly oppose giving a transfer agent that level of independent power over an issuer and its shareholders. In addition to the shutdown in the small and micro-cap markets that would entail, the re-tooling of current transfer agents to adequately be able to satisfy this level of responsibility would be cost-prohibitive both to the transfer agents and their clientele.

Some of the other comment requests of interest (and my view in parentheses) include: (i) should the SEC enumerate red flags that would trigger a duty of further inquiry by a transfer agent (yes); (ii) should there be a heightened review for securities of non-reporting issuers (yes, if no current information); (iii) should a transfer agent be required to deliver securities only to the registered shareholder and not third parties (yes, unless the third party is an attorney or other proper representative of the shareholder); and (iv) should transfer agents be prohibited from accepting stock as compensation (no).

Registration and Annual Reporting

The purpose of the registration and annual reporting requirements is to assist the regulators, issuers and investors in determining whether a transfer agent is performing its functions properly, determining the nature of a particular transfer agent’s business, assisting the SEC in making examination and investigation decisions, including areas of concern, monitoring the transfer agents activities and ensuring compliance with rules and regulations.

The SEC proposes to add information to the registration and annual reporting requirements, including financial information, potential conflicts of interest and details about the types of services being provided and the transfer agent’s clientele. For example, it is proposed that a transfer agent disclose any past or present affiliations with or ownership of issuers or broker-dealers serviced by or affiliated with a transfer agent. I note that several small-cap broker-dealers have sister transfer agencies and do not believe such vertical business investment is problematic nor should it be construed as nefarious. However, I do see benefit in the disclosure of same.

The SEC also proposed to require a transfer agent to designate a chief compliance officer with responsibilities to ensure compliance with written internal controls and procedures.

Written Agreements Between Transfer Agents and Issuers

The APNR proposed to require written agreements between transfer agents and issuers. Although it is not now a legal requirement, I think most transfer agents do have such agreements. I am hard-pressed to think of any issuer clients that do not have a written contract with their transfer agent, and most are quick to require the signing of an addendum or updated contract where there is a change of management or control of the issuer.

However, the SEC rightfully points out that where there is either no written agreement or the agreement does not cover certain questions, there is an increase of disputes with respect to (i) the duration of the arrangement; (ii) termination rights; (iii) the disposition of records and transfer of records to a new transfer agent; and (iv) fees. These issues are most prevalent in the small-cap world, especially where a transfer agent “holds records hostage” in exchange for a large termination fee. The APNR does not suggest that the transfer agent be limited in allowable termination fees, nor that a transfer agent be required to turn over records regardless of sums owed or the payment of a termination fee, though it does seek comment on such issues.

Safeguarding Funds and Securities

Transfer agents often provide administrative and processing services in relation to dividends, payouts associated with splits (paying agent services) and other transactional escrow services. The APNR proposes a more robust set of standards for transfer agents acting as a paying agent or providing escrow services. The APNR indicates the SEC will provide new rules such as (i) maintaining secure vaults; (ii) installing theft and fire alarms; (iii) having written procedures related to access and control over accounts and information; (iv) greater bookkeeping requirements; (v) and specific unclaimed property procedures. In addition, the SEC intends to impose rules similar to those for broker-dealers, requiring internal controls, annual reporting and independent audits related to these services.

Cybersecurity, Information Technology and Related Issues

Cybersecurity is a big concern for the SEC. In 2014 the SEC adopted Regulation Systems, Compliance and Integrity requiring covered entities to test their automated systems for vulnerabilities, test their business continuity and disaster recovery plans and notify the SEC of intrusions. In particular, the SEC intends to propose new or amended rules requiring registered transfer agents to, among other things: (i) create and maintain a written business continuity plan; (ii) create and maintain basic procedures and guidelines governing the transfer agent’s use of information technology, including methods of safeguarding data and personally identifiable information; and (iii) create and maintain appropriate procedures and guidelines related to a transfer agent’s operational capacity, such as IT governance and management.

Concept Release and Request for Additional Comment

The SEC concept release contains discussion and seeks comment from the public on issues outside of and in addition to the APNR. The SEC highlights different questions and issues such as whether brokerage firms should also be required to be registered as transfer agents when they hold securities in nominee accounts; specific issues affecting transfer agents for mutual funds and transfer agents that serve as administrators for employee stock option and similar plans. The concept release also seeks comment on a transfer agent’s role in a Regulation Crowdfunding offering (Title III Crowdfunding).

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’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies State Blue Sky Concerns; Florida and New York »