SEC Modernizes Auditor Independence Rules
On October 16, 2020, the SEC adopted amendments to codify and modernize certain aspects of the auditor independence framework. The rule proposal was published in December 2019 (see HERE).
The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time. The regulatory structure lays out governing principles and describes certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent. Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances. Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties. Rule 2-01(c) provides a non-exclusive list of circumstances which the SEC would consider inconsistent with independence.
The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company. The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets. Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.” However, under the old rules, technical violations that would not result in a lack of integrity were swept into the regulatory structure, causing unnecessary burdens and expenses associated with the client-auditor relationship.
The final amendments reflect updates based on recurring fact patterns that the SEC staff observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality. Accordingly, the new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time-consuming audit committee review of non-substantive matters.
The SEC adopting release provides examples of the types of concerns the new rules are designed to address, including one related to student loans and one related to a portfolio company. The student loan example is very straightforward, involving the technical independence violation where an auditor in an audit firm is still paying student loans to a large student loan lender and the audit firm audits the lender. Under the new rules, this would no longer create an independence violation.
The second example is more complicated but, in essence, involves a fund with multiple (could be hundreds) of portfolio companies and an audit firm with multiple global network affiliates. Under the prior rules, it was very complicated to sort out to make sure that the audit firm was not providing audit services to more than one portfolio company even though the only relationship between the companies was a common investor. Furthermore, a scenario could result where no qualified large audit firm could be independent due to the widespread investing activing of the fund.
Although the SEC doesn’t name names, this scenario could be fairly common. The three largest asset management firms, BlackRock, Vanguard and State Street, manage over $15 trillion in combined global assets, which is equivalent to more than three-quarters of the U.S. gross domestic product. Under the current rules, if one of their portfolio companies wanted to complete an IPO, it is very likely that the best audit firms would fail an independence test. The result would be that the company would be required to either: (i) replace their audit firm with another audit firm if one could be found; (ii) to wait to register with the SEC for up to three years after termination of the services provided to another portfolio company; or (iii) to make a determination, likely in consultation with SEC staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality. The amended rules would eliminate the need for a company’s audit committee and their auditors to seek SEC staff guidance in these scenarios.
The amendments will be effective 180 days after publication in the Federal Register, but voluntary compliance is permitted for new relationships once published in the Federal Register. However, auditors cannot retroactively apply the final amendments to relationships in existence prior to the effective date.
Amendments
Definitions of Affiliate of the Audit Client and Investment Company Complex
The SEC has amended the definitions of an “affiliate of the audit client” and “investment company complex” with a focus on decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited. Currently an audit client includes not only the entity being audited but also affiliates of the audit client. Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities. Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also any investment company advised by a sister investment adviser or which has a sister sponsor.
The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies. In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.
Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality. In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.
The SEC has amended the definition of affiliate and ICC as relates to an audit client to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor. In reviewing materiality, the audit firm will need to consider both whether the sister entity and/or the audit client is material to the controlling entity. The amendment to the definition does not alter the general requirement that an auditor review all facts and circumstances to confirm independence. The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.
Audit and Professional Engagement Period
Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies. For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC. For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC. That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.
The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI. The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO. Accordingly, the SEC has amended the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.
Loans and Debtor-Creditor Relationships
Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client. The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.
The SEC has amended the rule to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions. In addition, the SEC has added language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.
The SEC has also revised the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.
Business Relationship Rule
The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders. The SEC has replaced the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”
As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.
Inadvertent Violations for Mergers and Acquisitions
An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction. The SEC has added a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner. Under the new rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances. Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.
« SEC Proposes Amendments To Rule 144 Finders – Part 2 »
SEC Adopts Amendments To Management Discussion And Analysis
It has been a very busy year for SEC rule making, guidance, executive actions and all matters capital markets. Continuing its ongoing disclosure effectiveness initiative on November 19, 2020, the SEC adopted amendments to the disclosures in Item 303 of Regulation S-K – Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A). The proposed rule had been released on January 30, 2020 (see HERE). Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles-based approach to disclosure requirements. In addition, the rule changes are intended to reduce repetition and disclosure of information that is not material.
The new rules eliminate Item 301 – Selected Financial Data – and amend Items 302(a) – Supplementary Financial Information and Item 303 – MD&A. In particular, the final rules revise Item 302(a) to replace the current tabular disclosure with a principles-based approach and revise MD&A to: (i) to state the principal objectives of the disclosure; (ii) update liquidity and capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion; (vi) eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements; and (vii) add a requirement to discuss critical accounting estimates and (viii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The new rules also apply to foreign private issuers (FPIs). Finally, the amendments will make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.
Below the discussion of the rule changes is a chart of each of the amendments and its principal objective. The amendments take effect thirty days after publication in the federal register.
Detail on Final Rules
Elimination of Item 301 – Selected Financial Data
Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years. Smaller reporting companies (SRCs) are not required to provide this information, and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.
When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL. Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends. Accordingly, Item 301 is not useful and the SEC has eliminated it.
Amendment to Item 302 – Supplementary Financial Information
Item 302 requires selected disclosures of quarterly results and variances in operating results including the effects of any discontinued operations and unusual or infrequently occurring items. SRCs and FPIs are not required to provide the information (note that FPIs are not required to report quarterly results or file quarterly reports at all). Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).
The SEC had originally proposed eliminating this item altogether like Item 301. However, the SEC recognized that while most quarterly financial information could be found in prior filings, certain fourth quarter information was only captured in Item 302. Accordingly, the final rule release did not eliminate Item 302 but amended it such that it now only requires disclosure when there are one or more material changes for any of the quarters in the last two fiscal years for which financial statements are provided. Duplicative disclosures are not required.
Elimination of Item 303(a)(5) – Contractual Obligations Table
Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format. There is no materiality threshold for the disclosure. The SEC has eliminated the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy. Likewise, current Items 303(c) and (d) have been eliminated as these items have been picked up in amended 303(b).
Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
Currently MD&A is broken down into 5 parts. Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations. Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information. Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures. Item 303(d) provides scaled-back disclosure accommodations for SRCs. The amended rule substantially changes this structure.
The new Item 303 (i) adds a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods and to provide instructions to guide the rest of the rule; (ii) eliminates unnecessary cross-references, clarifies and removes outdated and duplicative language; (iii) updates capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) updates the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) updates the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (vi) eliminates the requirement to discuss the impact of inflation; (vii) replaces the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) adds a requirement to discuss critical accounting estimates, and (ix) adds the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The new Item 303(a) instruction paragraph has been revised to set forth the principal objectives of MD&A. The instructions codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.” The SEC stresses that MD&A should provide an analysis that encompasses short-term results as well as future prospects. The SEC does not want companies to merely recite the amounts of changes from year to year that are readily calculated from the financial statements, but rather to provide greater analysis as to the reasons for changes.
Also, the instructions emphasize providing disclosure on:
(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;
(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and
(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.
Chart on Rule Changes
The following chart, copied from the SEC’s rule release, summarized the new rules.
| Current Item or Issue | Summary Description of Amended Rules | Principal Objective(s) | |
| Item 301, Selected financial data | Registrants will no longer be required to provide 5 years of selected financial data. | Modernize disclosure requirement in light of technological developments and simplify disclosure requirements. | |
| Item 302(a), Supplementary financial information | Registrants will no longer be required to provide 2 years of tabular selected quarterly financial data. The item will be replaced with a principles-basedrequirement for material retrospective changes. | Reduce repetition and focus disclosure on material information. Modernize disclosure requirement in light of technological developments. | |
| Item 303(a), MD&A | Clarify the objective of MD&A and streamline the fourteen instructions. | Simplify and enhance the purpose of MD&A. | |
|
Item 303(a)(2), Capital resources |
Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cashrequirements, and the general purpose of such requirements. | Modernize and enhance disclosure requirements to account for capital expenditures that are not necessarily capital investments. | |
| Item 303(a)(3)(iii),Results of operations | Clarify that a discussion of material changes in net sales or revenue is required (rather than only material increases). | Clarify MD&A disclosure requirements by codifying existing Commission guidance. | |
| Item 303(a)(3)(iv),
Results of operations
Instructions 8 and 9 (Inflation and price changes) |
The item and instructions will be eliminated. Registrants will still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations. |
Encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, and circumstances. |
|
|
Item 303(a)(4), Off- balance sheet arrangements |
The item will be replaced by a new instruction to Item 303. Under the new instruction, registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidatedbalance sheets. |
Prompt registrants to consider and integrate disclosure of off-balance sheet arrangements within the context of their MD&A. |
|
| Item 303(a)(5),Contractual obligations | Registrants will no longer be required to provide a contractual obligations table. A discussion of material contractual obligations will remain required through an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cashrequirements from known contractual and other obligations. | Promote the principles-based nature of MD&A and simplify disclosures. | |
|
Instruction 4 to Item 303(a) (Material changes in line items) |
Incorporate a portion of the instruction into amended Item 303(b). Clarify in amended Item 303(b) that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms isrequired. | Enhance analysis in MD&A. Clarify MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A. | |
|
Item 303(b), Interim periods |
Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter. Registrants subject to Rule 3-03(b) of Regulation S-X will be afforded the same flexibility.
|
Allow for flexibility in comparison of interim periods to help registrants provide a more tailored and meaningful analysis relevant to their business cycles. | |
| Critical Accounting Estimates | Registrants will be explicitly required to disclose critical accounting estimates. | Facilitate compliance and improve resulting disclosure. Eliminate disclosure that duplicates the financial statement discussion of significantpolicies. Promote meaningful analysis of measurement uncertainties. | |
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
On November 19, 2020, as discussed in this blog, the SEC adopted amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also eliminated Item 301 – Selected Financial Data and revised Item 302 – Supplementary Financial Information. For my blog on the rules January 30, 2020 proposal, see HERE.
On August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K. See HERE.
In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. My blog on the final amendments will be published after this blog.
In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls. See HERE.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE, and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments 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 amendment also requires that all exhibits be filed in HTML format. The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.
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. Final amendments were approved on August 17, 2018 – see HERE
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment 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. In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
In early December 2015, the FAST Act was passed into law. The FAST Act required 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. See my blog HERE.
« Updated Guidance On Confidential Treatment In SEC filings OTCQB And OTCQX Rule Changes »
Updated Guidance On Confidential Treatment In SEC filings
In March 2019, the SEC adopted amendments to Regulation S-K as required by the Fixing America’s Surface Transportation Act (“FAST Act”) (see HERE). Among other changes, the amendments allow companies to redact confidential information from most exhibits without filing a confidential treatment request (“CTR”), including omitting schedules and exhibits to exhibits. Likewise, the amendments allow a company to redact information that is both (i) not material, and (ii) competitively harmful if disclosed without the need for a confidential treatment request. The enacted amendment only applies to material agreement exhibits under Item 601(b)(10) and not to other categories of exhibits, which would rarely contain competitively harmful information.
After the rule change, the SEC streamlined its procedures for granting CTR’s and for applying for extended confidential treatment on previously granted orders. The amendments to the CTR process became effective April 2, 2019. See HERE for a summary of confidential treatment requests. In December 2019, the SEC issued new guidance on confidential treatment applications submitted pursuant to Rules 406 and 24b-2.
Confidential Treatment Requests Under Rule 406 or 24b-2
Rule 406 of the Securities Act of 1933 (“Securities Act”) and Rule 24b-2 of the Securities Exchange Act of 1934 (“Exchange Act”) set forth the exclusive procedures for seeking confidential treatment for any information that may be required to be publicly filed under either Act and for which the streamlined procedures for confidential treatment of material contracts and their exhibits is not available. Furthermore, a company may voluntarily seek approval under Rules 406 and 24b-2 even if the self-executing procedure for omitting information is available. Later in this blog, I include a refresher on the streamlined, self-executing rules for omitting confidential information from material contract exhibits to SEC filings.
Like all CTR’s, requests under these rules must be made in paper format and not electronic. Also, like all CTR’s, if a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.
To make a CTR under Rule 406 or 24b-2, a person must omit the confidential information from the relevant EDGAR filing, noting that information has been omitted based on a CTR, and concurrently file the CTR with the SEC using the specific fax number and designated person for receiving such information. All documents and information must be marked “Confidential Treatment.”
The CTR must include one unredacted copy of the entire document for which confidential treatment is sought and a cover letter or memo containing (i) identification of the information sought to be kept confidential; (ii) a statement of the grounds for keeping the information confidential, including reference to particular provisions under FOIA and other SEC rules and regulations; (iii) the specific time period for which confidentiality is sought (year, month and date) and a justification for such period; (iv) a detailed explanation of why, based on the facts and circumstances of the particular case, disclosure of the information is unnecessary for the protection of investors; (v) a written consent to the furnishing of the confidential information to other government agencies, offices, or bodies and to the Congress; and (vi) the name, address and telephone number of the person to whom all notices and orders should be directed.
For an Exchange Act Rule 24b-2 CTR, the name of each exchange upon which the materials would be filed (or omitted) must also be included. Furthermore, the submission must include a statement that: (i) none of the confidential information has been disclosed to the public; (ii) disclosure of the information will cause substantial competitive harm to the company; and (iii) disclosure of the confidential information is not necessary for protection of investors.
As discussed below, the SEC will not grant confidential treatment to information that is material. Moreover, if information is omitted beyond what is customarily treated as private or confidential, the SEC will ask that an amendment be filed with fewer omissions and a new CTR filed.
If confidential treatment is granted, an order will be entered and filed on EDGAR. If confidential treatment is denied, the company will have an opportunity to withdraw the filing with the confidential information if withdrawal is otherwise allowable (such as a voluntary S-1 filing or Exchange Act report by a voluntary filer). A denial may also be appealed.
Application for Extension of Confidential Treatment
Companies that have previously obtained a confidential treatment order for a material contract must continue to file extension applications under Rules 406 or 24b-2 if they want to protect the confidential information from public release pursuant to a Freedom of Information Act request after the original order expires. The SEC has created a simple one-page form to apply for an extension of time for which a confidential treatment order had previously been granted. Rather than submitting a whole new application, with the confidential information included, a company seeking to extend a confidential treatment order previously granted can simply affirm that the facts and circumstances that supported the prior application continue to be true, complete and accurate.
The short-form application allows for an extension of confidential treatment for a period of three, five or ten years and requires a brief explanation to support the request. The request for extension must be filed prior to the original order’s expiration. If the applicant reduces the redactions from the previous version, the revised redacted version of the contract must be publicly filed when the short-form extension application is submitted. The short-form application cannot be used to add new exhibits to the application or make additional redactions. In that case, a full application under Rules 406 or 24b-2 would still be required.
The SEC has provided an email address (CTExtensions@sec.gov) for submittal of the new short-form application. The email address is exclusive to these short-form applications and, as such, should not be used in connection with any other type of confidential treatment or extension request. Upon approval, the SEC will post the order granting CTR on the applicant’s EDGAR page.
Confidential Treatment Requests for Material Contracts
Effective March 2019, Item 601(b)(10) of Regulation S-K allows a company to file redacted material contracts without applying for confidential treatment of the redacted information provided the redacted information (i) is not material and (ii) would be competitively harmful if publicly disclosed. If it does so, the company should mark the exhibit index to indicate that portions of the exhibit or exhibits have been omitted and include a prominent statement on the first page of the redacted exhibit that certain identified information has been excluded from the exhibit because it is both not material and would likely cause competitive harm to the registrant if publicly disclosed. The company also must indicate by brackets where the information is omitted from the filed version of the exhibit.
If requested by the SEC, the company must promptly provide an un-redacted copy of the exhibit on a supplemental basis. The SEC also may request the company to provide its materiality and competitive harm analyses on a supplemental basis. Any requested supplemental information must be provided in paper format and only to the designated email address provided by the SEC to protect and preserve its confidential nature. If the SEC does not agree with the analysis, it could request that the company amend its filing to include any previously redacted information. If a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.
The company may request confidential treatment of the supplemental material submitted to the SEC pursuant to Rule 83 while it is in the possession of the SEC. After completing its review of the supplemental information, the SEC will return or destroy the information at the request of the company if the company complies with the procedures outlined in Rules 418 or 12b-4. Rules 418 or 12b-4 require that a company request that the SEC either return or destroy the supplemental information, at the same time as it is first furnished to the SEC and that returning or destroying the information (i) is consistent with the protection of investors and (ii) is consistent with the Freedom of Information Act. Also, if information is electronically provided to the SEC, the SEC has no obligation to return or destroy same.
Although the letter requesting additional information, and the closing of the review letter, will both be made public on the EDGAR system, the SEC will not make public its comments regarding redacted exhibits, nor the company’s responses thereto.
The amendments are not meant to alter what information is deemed confidential or can be omitted, but rather to streamline the process by allowing a company to redact without the confidentiality treatment process. The w may still randomly review company filings and “scrutinize the appropriateness of a registrant’s omissions of information from its exhibits.”
What Information Qualifies for Confidential Treatment
Generally speaking, a company can seek confidential treatment for information which could adversely affect the company’s business and financial condition, usually because of competitive harm, if disclosed, as long as the information is not material to investors.
A CTR must include specific citations to an exemption from disclosure under FOIA. The FOIA specifies nine categories of information that may be exempted from the FOIA’s broad requirement to make information available to the general public. The most commonly used exemption for public companies allows for confidential treatment for “trade secrets and commercial or financial information obtained from a person and privileged or confidential.” The U.S. Supreme Court’s case Food Marketing Institute v. Argus Leader Media (October 2018) held that where commercial or financial information is both customarily and actually treated as private by its owner and provided to the government under an assurance of privacy, the information is “confidential” within the meaning of FOIA and that it is not necessary to show substantial competitive harm. The SEC’s new guidance refers CTA applicants to the Supreme Court case for assistance in crafting arguments for the CTA application.
Although FOIA may generally exempt trade secrets, not all trade secrets may be kept confidential by public companies. In essence, when a company determines to go public and files a registration statement under either the Securities Act or Exchange Act, and thus agrees to file reports with the SEC, the company is agreeing to make public the information required by Regulation S-K and S-X. A company cannot avoid these specific requirements by claiming confidentiality. Examples of information that a private company may deem confidential, but for which a public company will need to disclose, include: (i) the identity of 10% or greater customers; (ii) the identity of 5% or greater shareholders; (iii) the dollar amount of firm backlog orders; (iv) the duration and effect of all patents, trademarks, licenses and concessions held; (v) related party transactions; and (vi) executive compensation.
Assuming that information is not specifically required to be disclosed under the Securities Act or Exchange Act, a “trade secret” is “a secret, commercially valuable plan, formula, process or device that is used for the making, preparing, compounding or processing of trade commodities and that can be said to be the end product of either innovation or substantial effort.” Examples of information that a public company could successfully complete a CTR for include (i) pricing terms; (ii) technical specifications; (iii) payment terms; (iv) sensitive information regarding business strategy, or timing of research, development and commercialization efforts; (v) details of intellectual property (that isn’t already public, such as in a filed patent); (vi) details of cybersecurity procedures; and (vii) customer databases.
A company can never obtain confidential treatment for information that is already in the public domain or has been publicly disclosed, even if inadvertently. Accordingly, it is important that a company be very careful to ensure that any information for which it seeks confidential treatment is kept strictly confidential, including by third parties. For example, care should be given that a counterparty to a contract does not issue a press release or otherwise make provisions public.
Confidential Treatment Requests Under Rule 83
Rule 83 provides a procedure for requesting that information be kept confidential from Freedom of Information Act (“FOIA”) requests where no other procedure, such as Rules 406 or 24b-2, are available. Generally, Rule 83 is used in the context of requests for supplemental information, examinations, inspections and investigations. Under Rule 83, the submitter of information must mark each page with “Confidential Treatment Requested by [name]” and an identifying number and code, such as a Bates-stamped number. Also, the words “FOIA Confidential Treatment Request” must appear on the top of the first page of the request. Like all other CTR’s, the request must be via paper and not electronically. The SEC has provided a specific fax line and office (the FOIA Office) to receive Rule 83 CTR’s to maintain their confidentiality, even among SEC staff. A confidential treatment request will expire 10 years from the date the FOIA Office receives it unless that office receives a renewal request before it expires.
The requester may claim personal or business confidentiality, but need not substantiate his or her request until the FOIA Office notifies him or her of a FOIA request for the records. If a FOIA request is received for the records, the person that requested confidential treatment will be notified and given an opportunity to provide a legal and factual analysis supporting confidential treatment. A substantiation submittal must include: (i) the reasons that the information can be withheld under FOIA and referring to the specific provisions of FOIA supporting same; (ii) any other statutes or regulatory provisions that may govern the information; (iii) the existence and applicability of any prior determinations by the SEC, other federal agency or court relating to the confidential treatment of the information; (iv) the adverse consequences to a business enterprise, financial or otherwise, that would result from disclosure of confidential commercial or financial information, including any adverse effect on the business’ competitive position; (v) the measures taken to protect the confidentiality prior to and after submission to the SEC; (vi) the ease or difficulty of a competitor’s obtaining or compiling the commercial or financial information; (vii) whether the information was voluntarily submitted to the SEC; (viii) if the substantiation argument document itself should be kept confidential; and (ix) such additional facts and legal analysis as appropriate to support the request.
Where a Rule 83 CTR is being made in the course of live testimony or oral discussions, the request for confidential treatment must be made contemporaneously with providing the information and followed with a written request no later than 30 days later.
Rule 83 provides for an appeal process where an initial determination that confidential treatment is not warranted. Rule 83 appeals are reviewed and decided by the SEC’s Office of General Counsel. If the General Counsel decides the information does not need to be kept confidential, it will give the person 10 days’ notice during which time a person could file an action in federal court to continue to fight to maintain the confidentiality of the information. Likewise, if the SEC determines that information should be kept confidential, the person seeking the information can appeal by filing suit in federal court.
Rule 83 cannot be relied upon to request confidential treatment for information that would otherwise be required to be disclosed in SEC registration statements or reports. In that case, the person making the CTR would have to rely on the new procedures for redacting information in material contracts or make a CTR under Rules 406 or 24b-2.
« SEC Issues Transitional FAQ On Regulation S-K Amendments SEC Adopts Amendments To Management Discussion And Analysis »
SEC Issues Transitional FAQ On Regulation S-K Amendments
The recent amendments to Items 101, 103 and 105 of Regulation S-K (see HERE) went into effect on November 9, 2020, raising many questions as to the transition to the new requirements. In response to what I am sure were many inquiries to the Division of Corporation Finance, the SEC has issued three transitional FAQs.
The amendments made changes to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.
FAQ – Form S-3 Prospectus Supplement
The first question relates to the impact on Form S-3 and in particular the current use of prospectus supplements for an S-3 that went into effect prior to November 9, 2020. In general, a Form S-3 is used as a shelf registration statement and a company files a prospectus supplement each time it takes shares down off that shelf (see HERE).
The prospectus supplement must meet the requirements of Securities Act Rule 424 and includes specific information that was omitted from the base S-3 shelf registration. That information generally includes facts about a particular offering or shelf take-down such as the public offering price, description of securities or similar matters, and facts and events that constitute a substantive change from or addition to the information included in the base S-3.
The specific FAQ is “[A] registrant has a Registration Statement on Form S-3 that became effective before November 9, 2020. If the registrant files a prospectus supplement to the Form S-3 on or after November 9, 2020, must the prospectus supplement comply with the new rules?”
The SEC confirms that a prospectus supplement does not need to comply with new Items 101 and 103 because Form S-3 does not expressly require Item 101 or Item 103 disclosure but rather requires the incorporation by reference from Exchange Act reports containing that information. Further, the SEC confirms that a company does not need to amend its Form 10-K that is incorporated by reference into the Form S-3 to update for the new rules. For more on incorporation by reference including with respect to a Form S-3, see HERE.
On the other hand, Item 105 – risk factor disclosures – are required to be included in a prospectus supplement. In particular, Securities Act Rule 401(a) requires that the form and contents of a prospectus supplement conform to the applicable rules and forms as in effect on the initial filing date of the prospectus supplement. The SEC, however, has stated it will allow a company to continue to comply with the old Item 105 rules for prospectus supplements filed until the next update to the Registration Statement on Form S-3 for Section 10(a)(3) purposes.
A Form S-3 is updated for Section 10(a)(3) purposes each year when it files its Form 10-K, which is automatically incorporated by reference into the S-3. A company may also file a post-effective amendment to the Form S-3 as a result of fundamental changes, which post-effective amendment would act as a Section 10(a)(3) update.
FAQ – Form 10-K
Quickly following the passage of the new rules, practitioners noticed a disconnect between the new Item 101 requirements and the instructions on Form 10-K. In particular, Item 1 of Form 10-K requires the company to “[F]urnish the information required by Item 101 of Regulation S-K (§ 229.101 of this chapter) except that the discussion of the development of the registrant’s business need only include developments since the beginning of the fiscal year for which this report is filed.”
Amended Item 101(a) replaces the former prescriptive requirement to provide information related to the development of the company for the last 5 years (or 3 years for a smaller reporting company) with a principles-based materiality approach. Now, a company must provide information that is material to an understanding of the development of its business, irrespective of a specific time frame. The adopting rule release did not discuss the applicability to Form 10-K.
To clarify any confusion, the SEC issued an FAQ confirming that the new rules do not change Item 1 of Form 10-K, which only requires disclosures regarding the development of the registrant’s business for the fiscal year covered by the 10-K.
FAQ – Item 101 in Reports and Registration Statements
The third FAQ asks whether a company must always provide a full discussion of general development of its business pursuant to new Item 101(a) (or new Item 101(h) for a smaller reporting company) in an annual report or registration statement that requires Item 101 disclosure. The SEC’s response is “not necessarily.”
In particular, except in an initial registration statement, new Item 101 will permit a company to omit the full discussion of the general development of its business if the company: (1) provides an update to the general development of its business, disclosing all material developments that have occurred since the most recent registration statement or report that includes the full discussion; (2) includes one active hyperlink to the registration statement or report that includes the full discussion; and (3) incorporates the full discussion by reference to the registration statement or report. However, a company is not required to use this updating method. The SEC anticipates that the updating method will apply mainly to registration statements.
« SEC Proposed Conditional Exemption For Finders Updated Guidance On Confidential Treatment In SEC filings »
SEC Proposed Conditional Exemption For Finders
Over the years I have written many times about exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services (see, for example: HERE). Finally, after years of advocating for SEC guidance on the topic, the SEC has proposed a conditional exemption for finders assisting small businesses in capital raising. The proposed exemption will allow for the use of finders to assist small businesses in raising capital from accredited investors.
In its press release announcing the proposal, SEC Chair Clayton acknowledged the need for guidance, stating, “[T]here has been significant uncertainty for years, however, about finders’ regulatory status, leading to many calls for Commission action, including from small business advocates, SEC advisory committees and the Department of the Treasury. If adopted, the proposed relief will bring clarity to finders’ regulatory status in a tailored manner that addresses the capital formation needs of certain smaller issuers while preserving investor protections.”
Separately, New York has recently proposed a new finder’s exemption, joining California and Texas, who were early in creating exemptions for intra-state offerings. Also, I have received several inquiries lately on the topic of non-U.S. finders in the Regulation S context. This seems a good time to address it all. In Part I of this blog, I will review the new SEC proposal and in Part II the state law exemptions and Regulation S framework.
Introduction
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders.
In its proposal the SEC recognizes this cottage industry, stating finders “often play an important and discrete role in bridging the gap between small businesses that need capital and investors who are interested in supporting emerging enterprises.” The SEC goes further recognizing that the lack of regulation makes it very difficult, noting that “companies that want to play by the rules struggle to know in what circumstances they can engage a ‘finder’ or a platform that is not registered as a broker-dealer.” The SEC gives a nod to the numerous calls for action over the years, including the ABA’s 2005 report, the SEC Advisory Committee on Small and Emerging Companies and the U.S. Treasury report (see links to discussions under Additional Reading on Finders).
I have advocated in the past for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. Although the exemptive order does have bad actor prohibitions it does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Although I think the proposal is a much needed step towards regulating finders, there are two aspects of the exemption that I have trouble with. The first is limiting the exemption to natural persons. Many natural persons operate through personal business entities such as an LLC or S corporation for valid business reasons including tax and estate planning.
The second is making the exemption unavailable for companies that are subject to the Exchange Act reporting requirements. The SEC reasons that once a company is able to file reports under the Exchange Act it is more likely able to attract a licensed broker dealer and would not need an unlicensed finder. The SEC indicates that non-reporting companies are more likely to experience difficulty obtaining the assistance of a broker-dealer, and are therefore most likely to need the assistance of a finder. I completely disagree with this reasoning as a basis for limiting the exemption.
Certainly the SEC reasoning may be true in some cases, but many broker-dealers will not work with small public companies, and many are simply prohibited from doing so. For instance Bank of America, and their brokerage, Merrill Lynch, will not transact business in the securities of companies with less than a $300 million market cap and less than a $5.00-per-share stock price (see HERE). Even many of the smaller tier brokerage firms that I deal with on a daily basis will not assist with a capital raise for an OTC Markets traded security unless the raise is a public offering in conjunction with an up-listing to a national exchange. Many of these brokerage firms clear through a clearing firm who in turn will not allow them to transact business with an OTC Markets issuer. Even those that will work with these smaller public companies, generally will not do so for a private capital raise, but rather will only work on public registered offerings.
If the SEC’s argument is based on need, then there is a large group of small public companies that have a palpable need for assistance with exempt offering capital raising efforts that will be left unfulfilled. Exempt offerings are smaller than registered offerings. Even if a small company can attract a broker-dealer for a private capital raise, the commissions, expense reimbursement and fees are generally extremely high and the agreements generally include strong rights of first refusal (ROFR rights) and other provisions that can make the cost of capital unfeasible. Further, knowing that by becoming subject to the SEC reporting requirements, the ability to use finder’s will be foreclosed, many of these companies may delay a going public transaction, which in and of itself is contrary to the SEC’s stated policies of encouraging public offerings and access to U.S. capital markets (see for example HERE).
Furthermore, one of the SEC’s core missions is the protection of investors. Companies that are subject to the Exchange Act reporting requirements are audited by independent auditors and required to comply with Sarbanes Oxley Act Rule 404(a) requiring the company to establish and maintain internal controls over financial reporting and disclosure control and procedures and have their management assess the effectiveness of each. These companies are subject to robust disclosure requirements delineated by Regulation S-K and financial disclosure requirements under Regulation S-X. Clearly, investors have much greater protections with the use of finders on behalf of a reporting company than a small private company.
Proposed Federal Finder’s Exemption
Background
Registered broker-dealers are subject to comprehensive regulation under the Exchange Act and under the rules of each self-regulatory organization (“SRO”) of which the broker-dealer is a member, such as FINRA, the NYSE and Nasdaq. Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 15(a)(1) of the Exchange Act, in turn, makes it unlawful for any broker to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker is registered with the SEC. Accordingly, absent an available exception or exemption, a person engaged in the business of effecting transactions in securities is a broker required to register with the SEC.
Periodically the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. The Guide clearly includes “finders” and in particular:
Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):
- “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
- Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
- Finding investment banking clients for registered broker-dealers;
- Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
- Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
- Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flesh out, with inconsistent and uncertain results. Despite the inconsistent results, key considerations have included: (i) actively soliciting or recruiting investors; (ii) participating in negotiations between the issuer and the investor; (iii) advising investors as to the merits of an investment or opining on its merits; (iv) handling customer funds and securities; (v) having a history of selling securities of other issuers; and (vi) receiving commissions, transaction-based compensation or payment other than a salary for selling the investments.
The SEC has now proposed to issue an exemptive order, not a rule change, which would provide exemptive relief to allow a natural person to engage in certain defined activities without registration as a broker dealer. The exemption is in the form of a non-exclusive safe harbor and accordingly even if the parameters of the safe-harbor are not met, the traditional facts and circumstances analysis could still support that a person did not need to register as a broker dealer for specific activities.
Proposed Exemption
The SEC proposal creates two classes of finders, both of which would allow a natural person (not an entity) to accept transaction-based fees for assisting with capital raising. A Tier I finder would be limited to providing contact information for potential investors and, as such, would not be able to have any direct contact with the investor. A Tier I finder could only assist a single company in a 12-month period.
A Tier II finder may (i) identify, screen and contact potential investors; (ii) distribute offering materials to investors; (iii) discuss company information including about the offering but may not provide advice on valuation or the advisability of making an investment; and (iv) arrange or participate in meetings with the company and investor. A Tier II finder is subject to certain disclosure requirements, including as to their role and compensation, and must obtain a written dated disclosure acknowledgement from the investor prior to any investment solicitation.
Regardless of the Tier, a finder could not (i) be involved in structuring the transaction or negotiating the terms of the offering; (ii) handle customer funds or securities or bind the issuer or investor; (iii) participate in the preparation of any sales materials; (iv) perform any independent analysis of the sale; (v) engage in any “due diligence” activities; (vi) assist or provide financing for such purchases; or (vii) provide advice as to the valuation or financial advisability of the investment.
Further, both Tiers of the proposed finder’s exemption are subject to the following conditions:
(i) the issuer cannot be required to file reports under the Exchange Act;
(ii) the issuer must be relying on a valid Securities Act registration exemption (such as Regulation D or Regulation A);
(iii) the finder cannot engage in general solicitation (the exemptive order does not specify if the issuer itself can engage in general solicitation but the finder cannot and in practice it may be difficult to maintain a clear line evidencing that the investors introduced by the finder did not learn of the offering through general solicitation if the issuer is doing so);
(iv) the investor must be accredited;
(v) the finder must have a written agreement with the issuer, including scope of services and compensation;
(vi) the finder cannot be associated with a broker-dealer;
(vii) the finder could not engage in other broker-dealer activities such as facilitating a registered offering or the resale of securities; and
(vii) the finder cannot be a “disqualified person” as defined in Section 3(a)(39) of the Exchange Act.
A “disqualified person” is similar to a bad actor under the exempt offering rules (see HERE) but regulates when a person is disqualified from being a member of FINRA (i.e., a broker-dealer) or associated with a member.
A person is disqualified from being a member or associated with a member of FINRA, and if the proposal is passed, from acting as a finder, if such person:
(a) has been expelled or suspended from membership, association with or participation in FINRA or foreign equivalent (the language is very broad in covering foreign contracts, markets, regulatory organizations and the like);
(b) is subject to an order of the SEC, other appropriate regulatory authority or foreign financial regulator denying, suspending for 12 months or less, revoking or otherwise limiting registration as a broker, dealer, municipal securities dealer, government securities broker, government securities dealer, security-based swap dealer, major security-based swap participant, or foreign equivalent of any of these or being an associated person of same;
(c) is subject to an order of the CFTC denying, suspending or revoking registration;
(d) is subject to an order of a foreign financial regulatory authority denying, suspending, or revoking the ability to engage in commodities, swaps or similar businesses;
(e) by his conduct while associated with a broker, dealer, municipal securities dealer, government securities broker or dealer, security-based swap dealer, or major security-based swap participant, or while associated with an entity or person required to be registered under the Commodity Exchange Act, has been found to be a cause of any effective suspension, expulsion, or order set forth in the above paragraphs, and in entering such a suspension, expulsion, or order, the SEC, an appropriate regulatory agency, or any self-regulatory organization (FINRA) shall have jurisdiction to find whether or not any person was a cause thereof;
(f) has associated (i.e., licensed with) any person that would be disqualified; or
(g) has committed or omitted any act, or is subject to an order or finding, of willful violation of any provision of the Securities Act, the Investment Advisors Act, the Investment Company Act, the Commodity Exchange Act or the rules of the Municipal Securities Rulemaking Board or has willfully aided, abetted, counseled, commanded, induced or procured such violation; is subject to a final order of a state securities or banking commission or similar agency or federal banking agency baring participation in the securities industry or finding a violation of any law or regulation which prohibits fraud, manipulative or deceptive conduct; has been convicted of any offense specified above or any other felony within ten years of the date of the filing of an application for membership or participation in, or to become associated with a member of, a self-regulatory organization; is enjoined from any action, conduct, or practice above; has willfully made or caused to be made in any application for membership or participation in, or to become associated with a member of, a self-regulatory organization, report required to be filed with a self-regulatory organization, proceeding before a self-regulatory organization, or any foreign equivalent any statement which was at the time, and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, or has omitted to state in any such application, report, or proceeding any material fact which is required to be stated therein (this paragraph is very similar to the Regulation D bad actor rules).
Additional Reading on Finders
For a general review on the law surrounding finder’s fees, including my recommendations for changes, see HERE.
For a review of the U.S. Department of the Treasury report recommending a regulatory structure for finder’s fees, see HERE.
For a review of the no-action-letter-based exemption for M&A brokers, see HERE.
For a review of the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer, see HERE.
To read about the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders, see HERE.
To learn about the exemption for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act, see HERE.
« SEC Adopts Amendments To Tighten Shareholder Proposals SEC Issues Transitional FAQ On Regulation S-K Amendments »
SEC Adopts Amendments To Tighten Shareholder Proposals
Following a tense period of debate and comments, on September 23, 2020, the SEC adopted amendments to Rule 14a-8 governing shareholder proposals in the proxy process. The proposed rule was published almost a year before in November 2019 (see HERE). The amendment increases the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954. The new rules represent significant changes to a shareholder’s rights to include matters on a company’s proxy statement.
Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years. The rules have not been amended in decades and during that time, shareholder activism has shifted. Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets. The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements. A study completed in 2018 found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.
The amendment alters the current ownership requirements for the submission of shareholder proposals to: (i) incorporate a tiered approach that provides for three options involving a combination of amount of securities owned and length of time held; (ii) specify documentation that must be provided when submitting a proposal; (iii) require shareholder proponents to specify dates and times they can meet with company management either in person or on the phone to discuss the submission; and (iv) provide that a person may only submit one proposal, either directly or indirectly, for the same shareholders meeting. The amendment also raise the current thresholds for the resubmission of proposals from 3, 6 and 10 percent to 5, 15 and 25 percent.
The final amendments go into effect 60 days after being published in the federal register and will apply to any proposal submitted for an annual or special meeting to be held on or after January 1, 2022.
Background – Current Rule 14a-8
The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.
All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.
Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors. Rule 14a-8 has been the source of considerable contention. Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that subject to substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.
State laws in general allow a shareholder to attend a meeting in person and at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process. By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost to themselves. It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.
The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so. Under the current Rule 14a-8 to qualify to submit a proposal, a shareholder must:
- Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
- If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
- If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
- Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
- Clearly state the proposal and course of action that the shareholder desires the company to follow;
- Submit no more than one proposal for a particular annual meeting;
- Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
- Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
- If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
- The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.
A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.
Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC. If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.
As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion. Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.
Substantive grounds for exclusion include:
- The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
- The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
- The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
- The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
- The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
- The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
- The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
- The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
- The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
- The proposal seeks to remove an existing director whose term is not completed;
- The proposal questions the competence, business judgment or character of one or more director nominees;
- The company has already substantially implemented the requested action;
- The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
- The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
- The proposal seeks to require the payment of a dividend; or
- The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.
Final Amended Rule
The need for a change in the rules has become increasingly apparent in recent years. As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and, as such, is susceptible to abuse. In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules. Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals. The SEC also conducted a Proxy Process Roundtable and invited public comments and input. The SEC continued its research, including reviewing a plethora of comment letters, after the rule proposals.
Submission Eligibility and Process
The final rule changes amend eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal. The amendments:
(i) Update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;
(ii) Investors who currently are eligible to submit proposals under the current $2,000 threshold/one-year minimum holding period, but currently do not satisfy the new requirements, will continue to be eligible to submit proposals through the expiration of the transition period that extends for all annual or special meetings held prior to January 1, 2023, provided they continue to hold at least $2,000 of a company’s securities;
(iii) Eliminate the 1% test as it historically is never used;
(iv) Eliminate the ability to aggregate ownership with other shareholders to meet the threshold for submittal. Shareholders can still co-file or co-sponsor proposals, but each one must meet the eligibility threshold;
(v) Require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal including a signed statement by the shareholder;
(vi) Require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal (regardless of prior communications on the subject), and provide contact information (of the shareholder, not its representative) as well as business days and specific times (i.e., more than one date and time) that the shareholder is available to discuss the proposal with the company.
One Proposal Requirement
The final amendments change the “one proposal” requirements in Rule 14a-8(c) to:
(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.
Resubmission Thresholds
The final amendments also increase the resubmission thresholds. Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.”
The final amendments amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to increase the current resubmission thresholds of 3%, 6% and 10% of shareholder support related to matters voted on once, twice or three or more times in the last five years, respectively, to 5%, 15% and 25%.
The final amendments did not adopt an amendment from the proposed rule release that would have: (i) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote. Commenters strongly objected to this proposals and the SEC agreed with their reasoning.
SEC Process
As discussed above, a company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. In its proposing release, the SEC asked for comments on this process and how it might be improved upon, or whether the SEC should remove itself from the process altogether deferring to state law. After reviewing comments, the SEC declined to implement any changes to the process.
« SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings SEC Proposed Conditional Exemption For Finders »
SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings
Just eight months following the rule proposal (see HERE), on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K. The amendments make a more principles-based approach to business descriptions and risk factors, recognizing the significant changes in business models since the rule was adopted 30 years ago. The amendments to disclosures related to legal proceedings continue the current prescriptive approach. In addition, the rule changes are intended to improve the readability of disclosure documents, as well as discourage repetition and disclosure of information that is not material.
The Item 101 and Item 103 amendments only apply to domestic companies and foreign private issuer that elect to file using domestic company forms. The forms generally used by foreign private issuers (F-1, F-3, 20-F, etc.) do not have references to Items 101 and 103 of Regulation S-K but rather refer to specific disclosure provisions in Form 20-F. However, the Item 105 (Risk Factor) amendments will apply across the board to both domestic and foreign issuers as the foreign issuer forms specifically refer to that section of Regulation S-K.
The effective date of the new rules is November 9, 2020 and as such, compliance with the new rules will need to be included in any filings made after 5:30 EST on Friday, November 6.
Item 101 – Description of Business
Item 101(a) of Regulation S-K requires a description of the general development of the business of the company during the past five years (or three years for smaller reporting companies) and lists five specific categories of information to include in the disclosure, including, for example, the year the company was formed and a description of any acquisitions or dispositions of businesses.
The SEC has amended Item 101(a) related to a company’s description of its business, to:
(i) Make it largely principles-based by providing a non-exclusive list of the types of information that could be disclosed and only requiring that disclosure to the extent it is material to an understanding of the general development of the business. The non-exclusive list includes: (a) material bankruptcy, receivership or similar proceeding; (b) nature and effects of any material reclassifications, merger or consolidation; (c) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (d) material changes to a company’s previously disclosed business strategy (note the proposed rule was more expansive on this topic but was determined to be repetitive to MD&A disclosures);
(ii) Eliminate a prescribed time frame for the disclosure. The SEC would rather require companies to focus on the information material to an understanding of the development of their business, irrespective of a specific time frame; and
(iii) Permit a company, in filings made after a its initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period. A company must incorporate the previous discussion by reference and can only incorporate from a single previously filed document.
Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by the company, focusing on the segments that are reported in the company’s financial statements. Item 101(c) currently includes a list of 12 topics to cover. Like Item 101(a), the amendments make the rule largely principles-based and encourage a company to exercise judgment in evaluating what disclosure to provide. Only material information need be provided. The rule also provides a list of topics for a company to consider, and maintains the focus on providing company segment information.
The new list of topics include: (i) revenue generating activities, products or services, and any dependence on key products, services, product families, or customers, including governmental customers; (ii) status of development efforts for new or enhanced products, trends in market demand and competitive conditions; (iii) resources material to a company’s business, including raw materials; (iv) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held; (v) a description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (vi) the extent to which the business is or may be seasonal; (vii) compliance with material government regulations, including environmental regulations (the prior list only included environmental regulations) to the extent they impact capital expenditures, earnings and competitive position; and (viii) human capital disclosure.
The human capital category is completely new and would include any material human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy). The final rule includes non-exclusive examples of subjects that may be material, depending on the nature of the registrant’s business and workforce. The SEC declined to define “human capital” allowing a company to tailor the concept to its circumstances and objectives.
The human capital category is a win for advocates of environmental, social and governance (ESG) disclosures which have advocated for increased rule requirements related to these disclosure topics. For more on ESG, see HERE). It is unlikely we will see more than minor incremental increases in ESG disclosures beyond human capital under the current SEC regime. The SEC continues to review and study the issue, but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics.
Item 103 – Legal Proceedings
Item 103 of Regulation S-K requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or of which any of their property is the subject. Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, and a description of the factual basis alleged to underlie the proceeding and the relief sought.
The SEC has amended Item 103 to: (i) expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage companies to avoid duplicative disclosure; and (ii) revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Item 105 – Risk Factors
Item 105 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky and specifies that the discussion should be concise and organized logically. The disclosure of risk factors has always been principles-based with the SEC consistently discouraging the use of boilerplate items. However, despite this guidance, most companies include a lengthy laundry list of boilerplate risks.
The SEC has amended Item 105 to: (i) require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.
A company rarely requires more than 15 pages of risk factors, and as such, the new rule should be a good lesson in brevity and pointedness.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
As discussed in this blog, on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.
In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. My blog on the final amendments will be published after this blog.
In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls. See HERE.
On January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information. See HERE.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE .
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments 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 amendment also requires that all exhibits be filed in HTML format. The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog here on the Item 601 rule changes HERE and HERE related to SEC guidance on same.
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. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment 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. In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE
In early December 2015, the FAST Act was passed into law. The FAST Act required 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. See my blog HERE.
« SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses SEC Adopts Amendments To Tighten Shareholder Proposals »
SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses
One year after proposing amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses, in May 2020 the SEC adopted final amendments (see here for my blog on the proposed amendments HERE). The amendments involved a long process; years earlier, in September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates which was the first step culminating in the final rules (see HERE).
The amendments make changes to Rules 3-05 and 3-14, 8-04, 8-05, and 8-06 of Regulation S-x, as well as Article 11. The SEC also amended the significance tests in the “significant subsidiary” definition in Rule 1-02(w), Securities Act Rule 405, and Exchange Act Rule 12b-2. Like all recent disclosure changes, the proposed rules are designed to improve the information for investors while reducing complexity and compliance costs for reporting companies. The amendments also make several related conforming rule and form changes. The new amendments go into effect on January 1, 2021 but voluntary compliance is permitted immediately.
Introduction
When a company acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires the company to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. Similarly, Rule 3-14 requires a company to file financial statements with respect to a significant real estate acquisition. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the company.
Article 11 requires a company to file unaudited pro forma financial information, including a balance sheet and income statements, relating to the acquisition or disposition of businesses. Pro forma financial information is intended to show how the acquisition or disposition might have affected those financial statements.
Form 8-K generally requires that the audited financial statements and pro forma financial information be filed in an amendment to the original transaction closing form 8-K within 71 days of that closing 8-K (i.e., 75 days from the closing). Where an acquisition or disposition is not significant, no separate audits or pro forma’s are required.
The final amendments will:
- update the significance tests under these rules by revising the investment test to compare the company’s investments in and advances to the acquired or disposed of business to the company’s worldwide market value;
- update the significance tests under these rules by revising the income test by adding a revenue component;
- expanding the use of pro forma financial information in measuring significance;
- conforming the significance threshold and tests for a disposed business;
- modify and enhance the required disclosure for the aggregate effects of acquisitions for which financial statements are not required by increasing the pro forma information related to the aggregated businesses and eliminating historical financial information for insignificant businesses;
- reduce the period of the financial statements of the acquired business from three years to the two most recent fiscal years;
- permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
- permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB);
- no longer require separate acquired business financial statements once the business has been included in the company’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;
- align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
- clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
- amend the pro forma financial information requirements to include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; “Autonomous Entity Adjustments,” reflecting the operations and financial position of a company as autonomous where it was previously part of another entity; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects;
- make corresponding changes to the smaller reporting company and Regulation A requirements in Article 8 of Regulation S-X;
- add a definition of significant subsidiary that is tailored for investment companies; and
- add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.
The rules related to disclosures for the acquisitions and dispositions of businesses are complex and involve a significant accounting analysis. I like to leave the accounting to the accountants, but legal advisors need to be able to understand the requirements and assist client companies in making fully informed business decisions regarding the acquisition or disposition of a business. This blog will focus on explaining the rules without diving into the overly labyrinthine accounting technicalities.
Rules 3-05 and 8-04 of Regulation S-X – Financial Statements of Businesses Acquired or to Be Acquired
Summary of Current Rule
Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue-producing assets will likely be treated as the purchase of a business.
In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X. The “investment test” considers the value of investments in and advances to the acquired business relative to the value of the total assets of the company prior to the purchase. The “asset test” considers the total value of the assets of the company pre- and post-acquisition. The “income test” considers the change in income of the company as a result of the acquisition.
Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal years and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.
Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.
Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.
An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.
The Rule 3-05 or Rule 8-04 financial statements are also required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.
In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.
Final Rule Change
The SEC has substantively revised the investment and income tests for non-investment companies and made non-substantive changes to the asset test. All three significance tests have been revised for investment companies. The final amendments also provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the company’s and its subsidiaries’ consolidated total assets when computing the Asset Test.
Investment Test
The investment test compares the company’s and its other subsidiaries’ investments in (i.e., the purchase consideration paid) and advances to the tested subsidiary to the total assets of the company and its subsidiaries consolidated reflected at the end of the most recently completed fiscal year, or in the case of an acquired business, in the company’s most recent annual financial statements required to be filed at or prior to the acquisition date.
The SEC has amended the investment test such that the company’s investments in and advances to the acquired business will be compared to the aggregate worldwide market value of the company’s voting and non-voting common equity when available. If the company does not have a worldwide market value, the existing test would still be used. The SEC believes that market value is a better parameter for determining the economic significance of an acquisition. I agree. Assets generally remain on the books at purchase price valuation, or are reduced for depreciation or amortization. For non-investment companies, assets are never marked up to fair value and, as such, can quickly become a stale indication of a company’s current value.
The amendments specifically address when aggregate market value should be determined, provide instructions for determining investments and advances, including contingent consideration, and clarify the use of the test for related party transactions.
Income Test
The income test compares the company’s equity in the tested subsidiary’s income from continuing operations before income taxes, including only income amounts contributed to the company’s particular equity in the subsidiary (such as when the subsidiary is not wholly owned) to such income of the company for the most recently completed fiscal year.
The SEC has revised the income test by adding a revenue component and by using income or loss from continuing operations after income taxes (as opposed to before income taxes). This change will help account for factors that could distort income in a given year such as non-recurring expense items. In addition, the change will reduce the anomalous result of making an otherwise insignificant acquisition seem significant, where a company has marginal or break-even net income or loss in a year.
Under the amendment, where a company and the target have recurring revenue, both revenue and income should be tested. By revising the income test to require that the company exceed both the revenue and net income components when the revenue component applies, the SEC believes the test will more accurately determine whether a tested subsidiary is significant. If the company or the target does not have recurring revenue, only the net income test would be used.
In addition, the SEC has eliminated the requirement that three years of financial statements be provided for certain significant acquisitions and instead has capped the period at two years. The SEC has also revised Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period.
The final amendments also clarify that where a Form 10-K is filed after an acquisition closes but prior to the filing of the target financial statements, significance can be determined using either the last Form 10-K filed prior to the acquisition closing, or the newest Form 10-K filed after the closing. The final amendments also make various definition and word changes thought to more clearly and accurately reflect the implementation of the rules.
Asset Purchase
Where assets are purchased that constitute a business, but are not all of the assets or products of the seller, it can be difficult to create historical financial statements that only cover the sold assets. Accordingly, the SEC has amended the rules to permit companies to provide abbreviated audited financial statements including a balance sheet consisting of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if: (i) the business constitutes less than 20% all of the assets and revenues of the seller, after eliminating intercompany transactions, as of the most recent fiscal year-end; (ii) the acquired business was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required; (iii) separate financial statements for the business have not previously been prepared; (iv) the seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements; (iv) interest expense may only be excluded if the corresponding debt will not be assumed; (v) the financial statements do not omit selling, distribution, marketing, general and administrative, research and development, or other expenses other than corporate overhead, interest in some cases, and income taxes, incurred by or on behalf of the acquired business during the periods to be presented; and (vi) the notes to financial statements include certain additional disclosures.
Foreign Business Acquisition
The SEC is modified Rule 3-05 to permit financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to permit foreign private issuers that prepare their financial statements using IFRS-IASB to provide Rule 3-05 financial statements prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP.
Smaller Reporting Companies and Regulation A Issuers
As mentioned above, Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the company is a smaller reporting company. Regulation A issuers are permitted to follow Rule 8-04.
The SEC has revised Rule 8-04 such that smaller reporting companies would be directed to Rule 3-05 for the requirement relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Article 8.
Additionally, under the amendments, a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days prior to the date of the relevant final prospectus or prospectus supplement, rather than 74 days prior to the effective date of the registration statement as under the current rules.
Financial Statements in Registration Statements and Proxy Statements
Prior to the amendments, the rules could result in separate historical financial statements of the acquired business required to be included in registration statements and/or proxy statements after the closing of the acquisition and after SEC reports have been filed including the consolidated financial statements of the then combined entities. The amendment rule no longer requires Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition company consolidated financial statements in certain circumstances.
Specifically, where an acquisition exceeds 20% but is less than 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least nine months, separate financial statements will no longer need to be included in proxy or registration statements. Where an acquisition exceeds 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least a complete fiscal year, separate financial statements will no longer need to be included in proxy or registration statements.
Individually Insignificant Acquisitions
If the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses. The rule amendments require disclosure if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the company, exceeds 50%. Pro forma financial information is only required for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.
Use of Pro Forma Financial Information to Measure Significance
A company is generally permitted to use pro forma, rather than historical, financial information to test significance of a subsequently acquired business if the company made a significant acquisition after the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K as required. The amended rules continue to permit a company to use these pro forma financial statements and expands that ability to include pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end as long as such pro forma information has been filed in an 8-K or amended 8-K.
Rule 3-14 of Regulation S-X – Financial Statements of Real Estate Acquired or to Be Acquired
The SEC has historically believed that the real estate industry has distinct considerations. For example, audited financial statements for a real estate operation are rarely available from the seller without additional effort and expense because most real estate managers do not maintain their books on a U.S. GAAP basis or obtain audits. However, in reality the SEC had found that the differences between the financial statement materiality throughout the industries is much less significant than thought. As such, the SEC has amended the rules to more closely align the financial statement requirement of Rule 3-14 with Rule 3-05.
Article 11 – Pro Forma Financial Information
Article 11 of Regulation S-X details the pro forma financial statement requirements that must accompany both Rule 3-05 and 3-14 financial statements. Typically, pro forma financial information includes the most recent balance sheet and most recent annual and interim period income statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05 and Rule 3-14, respectively. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all companies.
The SEC has revised the accounting adjustments made in preparation of the pro forma financial statements with the intent of simplifying the requirements and better reflecting the synergies of the transaction. The SEC amended Article 11, by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.
The SEC also raised the pro forma financial statement requirement for a disposition from 10% to 20% based on significance testing. Rule 8-05 for smaller reporting companies and Regulation A issuers have been amended to align with the pro forma financial statement requirements in Article 11.
« Covid-19 Disclosures – Not Just Speculation Anymore SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings »
SEC Proposed To Modernize Auditor Independence Rules
As is usual, there are times where I find there are fewer current events to write about in the world of capital markets and I go back to the basics of this regulatory regime I find so fascinating, and others where I have 30 current topics in my writing queue and then a global pandemic occurs adding daily new topics to my list and poof! – six months goes by. Although they were bumped down the list, many of the proposed and completed regulatory changes, and other events, that were on the list remain worthy of attention.
In December 2019, the SEC proposed amendments to codify and modernize certain aspects of the auditor independence framework. The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time. The new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time consuming audit committee review of non-substantive matters.
The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company. The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets. Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.”
In 2000, the SEC adopted a comprehensive framework of rules governing auditor independence, laying out governing principles and describing certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent. Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances. Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties. Rule 2-01(c) provides a non-exclusive list of circumstances in which the SEC would consider inconsistent with independence.
However, over the years, based on company and SEC staff review and feedback, it has become apparent that the current rules should be updated to address changing market conditions and eliminate unnecessary burdens and expenses associated with the client-auditor relationship.
Proposed Amendments
Definition of Audit Client
The SEC is proposing to amend the definition of an “audit client” with a focus of decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited. Currently an audit client includes not only the entity being audited but also affiliates of the audit client. Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities. Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also includes any investment company advised by a sister investment adviser or has a sister sponsor.
The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies. In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.
Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality. In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.
The SEC is proposing to amend the definition of affiliate and ICC as relates to an “audit client” to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor. The amendment to the definition would not alter the general requirement that an auditor review all facts and circumstances to confirm independence. The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.
Audit and Professional Engagement Period
Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies. For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC. For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC. That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.
The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI. The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO.
The SEC is proposing to amend the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.
Loans and Debtor-Creditor Relationships
Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client. The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.
The SEC is now proposing to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions. In addition, the SEC is proposing to add language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.
The SEC is also proposing to revise the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.
Business Relationship Rule
The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders. The SEC is proposing to replace the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”
As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.
Inadvertent Violations for Mergers and Acquisitions
An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction. The SEC is proposing a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner. Under the proposed rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances. Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.
« A Covid IPO: The Virtual Roadshow New CDI On Mining Company Disclosures »
A Covid IPO: The Virtual Roadshow
Although many aspects of an IPO are unaffected by a pandemic, assuming the capital markets continue to have an appetite for public offerings, the grueling road show has gone virtual, and it may be here to stay. An old-fashioned road show involved an intense travel schedule and expensive setup. The new virtual road show can be completed in half the time and a fraction of the price, and interestingly, the IPO’s that have been completed since March 2020, have all priced their deals at the midpoint or higher of their ranges. The lack of face-to-face presentations is not hurting the deals.
I tend to believe the world has changed forever. However, fluidity of memory and a capacity to adapt are fundamental human traits and we have and will adapt our business style to adjust to a world where germs are a real enemy and getting sick doesn’t just mean a day or two out of the office. There has been a perfect storm of advanced technology that allows us to see and hear each other in real time, coupled with a need to avoid crowds and close person-to-person contact with people you don’t live with. We are all comfortable with Zoom, and very quickly 3D holographic images, avatars and other AR/VR technologies could become business commonplace.
In addition to the dramatic change of the road show, IPO’s in the Covid world require a more complex carefully crafted registration statement and prospectus. As I’ve discussed in a series of blogs on Covid-related disclosures (see here for the most recent which contains links to prior blogs on the topic HERE), regulators and the marketplace expect in-depth discussions on the current and anticipated effects of the virus on businesses, with updates as those effects and projections evolve. Risk factors are generally much more robust with drill-downs on an array of potential issues from debt management to human resource uncertainties.
The good news is that the markets are booming. Tech and pharma IPO’s continue unabated and even increased compared to other mid-summer years, especially election years. The country is mired in the worst pandemic in a century and suffered its steepest-ever quarterly plunge in economic activity in the second quarter. Yet the equity markets are rallying, and tech and pharma stocks are trading at historical premiums. Some are predicting there will be at least 15 venture-backed tech IPO’s before the end of the year. Also, although analysts and venture firms focus on the big-board IPO’s, the small and lower middle market deals are busier than ever with IPO’s, a record-setting number of SPAC deals, and a non-stop string of follow on offerings.
We are resilient and the success of the virtual road show is just an example of that resilience. In addition, to the decreased time and expense, as explained below, a virtual road show will almost never involve a written offering or free writing prospectus, allowing for widespread use by all levels of companies.
The Road Show
We often hear the words “road show” associated with a securities offering. A road show is simply a series of presentations made by company management to key members of buy-side market participants such as broker-dealers that may participate in the syndication of an offering, and institutional investor groups and money managers that may invest into an offering. A road show is designed to provide these market participants with more information about the issuer and the offering and a chance to meet and assess management, including their presentation skills and competence in a Q&A setting. Investors often place a high level of importance on road show presentations and as such, a well-run road show can make the difference as to the level of success of an offering. In a virtual road show it is extremely important that the best technology be utilized so the audience can clearly see and hear the presenter to be able to make the same type of assessment as they would in person.
A road show historically involved an intensive period of multiple meetings and presentations in a number of different cities over a one-to-two-week period. Although road shows were generally live, even before Covid they were sometimes by teleconference, or electronic using prepared written presentation materials. Road shows are often recorded from a live presentation and made available publicly for a period of time. The meetings and presentations can vary in length and depth depending on the size and importance of the particular audience. During the road show, the underwriters are building a book of interest which will help determine the pricing for the offering.
A company can also conduct a “non-deal road show” for the purpose of driving interest in the company and its stock, where no particular offering is planned.
Unless it is a non-deal road show, the road show involves an offer of securities. “Offers” of securities are very broadly defined. Section 2(a)(3) of the Securities Act defines “offer to sell,” “offer for sale,” or “offer” to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”
The timing and manner of all offers of securities are regulated, and especially so in registered offerings. All issuers that have filed a registration statement are permitted to make oral offers of their securities, but only certain types of written offers are allowed. Written offers must comply with Section 10 of the Securities Act, including a requirement that a prospectus meeting the information requirements in Section 10(a) be delivered at the time of or prior to the offer. Delivery can be accomplished through the filing of a preliminary prospectus with the SEC, which is publicly available on the EDGAR system.
In addition, certain eligible issuers may provide supplemental written information and graphic communications not otherwise included in the prospectus that is filed with the SEC (i.e., a free writing prospectus) as part of an offer of securities. All of these oral and written communication rules are implicated in the road show process and must be considered when planning and completing the road show whether it is live or virtual.
A road show is generally timed to be completed in the last few weeks before a registration statement goes effective or a Regulation A offering circular becomes qualified. In a registered offering, Section 5(c) prohibits offers prior to the filing of the registration statement and as such, the road show would never commence pre-filing. Regulation A is not a registered offering for purposes of Section 5(c), but for practical purposes, a Regulation A road show also commences right before SEC qualification.
Securities Act Rule 163 provides an exception to the pre-filing offer rules only available to well-known seasoned issuers. A well-known seasoned issuer is generally one with a non-affiliate public float of more than $700 million or has issued at least $1 billion in non-convertible securities in primary offerings for cash in the last 3 years, is S-3 eligible (see HERE), is not an ineligible issuer (described below), is not an asset-backed issuer and is not an investment company.
For a private offering, the road show occurs once the offering documents are completed. A company that has filed its registration statement on a confidential basis must make the initial filing and all confidentially submitted amendments public a minimum of 15 days prior to starting the road show. For more information on confidential filings, and when a company is eligible to do so, see HERE.
A road show is subject to the test-the-waters and pre-effective communication rules. For a review of testing the waters in a registered offering, see HERE and HERE and for Regulation A offerings, see HERE.
A road show is specifically regulated under Rule 433 of the Securities Act and the free writing prospectus rules. Securities Act Rule 433(h)(4) defines a road show as an offer, other than a statutory prospectus, that “contains a presentation regarding an offering by one or more of the members of the issuer’s management ….. and includes discussion of one or more of the issuer, such management, and the securities being offered.”
The SEC definition of road show includes the language “other than a statutory prospectus.” The statutory prospectus is one that meets the requirements of Section 10(a) of the Securities Act and is generally the filed prospectus that contains the disclosures outlined in the particular offering form being used (for example, Form S-1 or 1-A) and including disclosures delineated in Regulations S-K and S-X. To meet the requirements of Section 10(a), the prospectus must include a price range and estimate of volume of shares to be registered.
In general, if the information being presented in a road show is nothing more than what is already included in the prospectus filed with the SEC, there are no particular SEC filing requirements. On the other hand, if the information is written and goes beyond the statutory prospectus, it may be considered a “free writing prospectus” and be subject to specific eligibility requirements for use, form and content and SEC filing requirements all as set forth in Rule 433 and discussed herein.
Securities Act Rule 405 of the Securities Act defines a free writing prospectus (“FWP”) as “any written communication as defined in this section that constitutes an offer to sell or a solicitation of an offer to buy the securities relating to a registered offering that is used after the registration statement in respect of the offering is filed… and is made by means other than (i) a prospectus satisfying the requirements of Section 10(a) of the Act…; (2) a written communication used in reliance on Rule 167 and Rule 426 (note that both rules relate to offerings by asset backed issuers); or (3) a written communication that constitutes an offer to sell or solicitation of an offer to buy such securities that falls within the exception from the definition of prospectus in clause (a) of Section 2(a)(10) of the Act.” Section 2(a)(10)(a), in turn, exempts written communications that are provided after a registration statement goes effective with the SEC as long as the effective registration statement is provided to the recipient prior to or at the same time.
Types of Road Shows; Oral/Live vs. Written; Free Writing Prospectus (FWP) Requirements
The rules distinguish between a “live” vs. a “written” road show communication, with one being an “oral offer” and more freely allowed and the other being a “written offer” and more strictly regulated. In addition, the rules differentiate requirements based on whether a road show is for a registered or private offering and, if a registered offering, whether such offering is an initial public offering (IPO) involving common or convertible equity.
Where a road show communication is purely oral, even if virtual, it is not an FWP and thus there are no specific SEC filing requirements (though see the discussion on Regulation FD below). Where an oral communication implicates Regulation FD, a Form 8-K would need to be filed regardless of whether the communication is during a road show or in any other forum.
Although road shows are generally live and specifically designed to constitute oral offers, they can also be electronic using prepared written presentation materials. Both live and electronic road shows may be made available for replay electronically over the Internet. The live virtual road show has made the recording and replay process even easier.
Live road shows include: (i) a live, in-person presentation to a live, in-person audience; (ii) a live, real-time presentation to a live audience or simultaneous multiple audiences transmitted electronically; (iii) a concurrent live presentation and real-time electronic transmittal of such presentation; (iv) a webcast or video conference that originates live and is transmitted in real time; (v) a live telephone conversation, even if it is recorded; and (vi) the slide deck or other presentation materials used during the road show unless investors are allowed to print or take copies of the information.
The explanatory note to Rule 433(d)(8) states: “A communication that is provided or transmitted simultaneously with a road show and is provided or transmitted in a manner designed to make the communication available only as part of the road show and not separately is deemed to be part of the road show. Therefore, if the road show is not a written communication, such a simultaneous communication (even if it would otherwise be a graphic communication or other written communication) is also deemed not to be written.”
Accordingly, road show slides and video clips are not considered to be written offers as long as copies are not left behind. Even handouts are not written offers so long as they are collected at the end of the presentation. If they are left behind, however, they become a free writing prospectus (FWP) and are subject to Securities Act Rules 164 and 433, including a requirement that the materials be filed with the SEC. Accordingly, if a company is not FWP eligible, it is important to make sure that there are no downloadable materials when completing a virtual road show.
A video recording of the road show meeting will not need to be filed as an FWP so long as it is available on the Internet to everyone and covers the same ground as the live road show. Such video road shows are considered a “bona fide electronic road show.” Rule 433(h)(5) defines a “bona fide electronic road show” as a road show “that is a written communication transmitted by graphic means that contains a presentation by one or more officers of an issuer or other persons in an issuer’s management….” It is permissible to have multiple versions of a bona fide electronic road show as long as all versions are available to an unrestricted audience. For example, different members of management may record different presentations and, although access must be unrestricted, management may record versions that are more retail investor facing or institutional investor facing.
On the other hand, a FWP would include any written communication that could constitute an offer to sell or a solicitation of an offer to buy securities subject to a registration statement that is used after the filing of a registration statement and before its effectiveness. A FWP is a supplemental writing that is not part of the filed registration statement. If the writing is simply a repetition of information contained in the filed registration statement, it may be used without regard to the separate FWP rule.
Rule 405 of the Securities Act defines a written communication as any communication that is “written, printed, a radio or television broadcast or a graphic communication.” A graphic communication includes “all forms of electronic media, including but not limited to, audiotapes, videotapes, facsimiles, CD Rom, electronic mail, internet websites, substantially similar messages widely distributed (rather than individually distributed) on telephone answering or voice mail systems, computers, computer networks and other forms of computer data compilation.” Basically, for purposes of rules related to FWP’s, all communications that can be reduced to writing are considered a written communication. Accordingly, radio and TV interviews, other than those published by unaffiliated and uncompensated media, would be considered a FWP and subject to the SEC use and filing rules.
Electronic road shows that do not originate live and in real time are considered written communications and FWP’s. Once it is determined that a road show includes a FWP, unless an exemption applies, an SEC filing is required. As mentioned, bona fide electronic road shows are not required to be filed with the SEC. In addition, Rule 433 only requires the filing of a FWP for an IPO of common or convertible equity.
A non-exempted FWP must be filed with the SEC, using Form 8-K, no later than the date of first use. An after-hours filing will satisfy this requirement as long as it is on the same calendar day. Moreover, all FWP’s must be filed with the SEC, whether distributed by the registrant or another offering participant and whether such distribution was intentional or unintentional.
The use of a FWP has specific eligibility requirements. A FWP may not be used by any issuer that is “ineligible” for such use. The following entities are ineligible to use a free writing prospectus: (i) companies that are or were in the past three years a blank-check company; (ii) companies that are or were in the past three years a shell company; (iii) penny-stock issuers; (iv) companies that conducted a penny-stock offering within the past three years; (v) business development companies; (vi) companies that are delinquent in their Exchange Act reporting requirements; (vii) limited partnerships that are engaged in an offering that is not a firm commitment offering; and (viii) companies that have filed or have been forced into bankruptcy in the last three years.
Small- and micro-cap issuers will rarely be eligible to use a free writing prospectus. Accordingly, small and micro-cap companies generally are limited to live road shows involving oral offers not constituting a FWP.
Moreover, underwriters generally require specific representations and warranties and indemnification related to FWP’s regardless of whether they are required to be filed with the SEC.
Content
The road show presentation usually covers key aspects of the offering itself, including the reasons for the offering and use of proceeds. In addition, management will also cover important aspects of their business and growth plans, industry trends, competition and the market for their products or services. An important aspect of the road show is the question-and-answer period or Q&A, though obviously this is only included in live or virtual real-time interactive road shows. It is common for materials to include drilled-down information that is provided on a higher level in the prospectus as well as theory and thoughts behind business plans and management goals.
The preparation of the road show content is usually a collaborative effort between the company, underwriters and legal counsel. Although the road show begins much later in the process, since its content is derived from the registration statement, ideally the planning begins at the same time as the registration statement drafting. Also, slides, PowerPoint presentations and other presentation materials should be carefully prepared to get the most out of their effectiveness.
The lawyer generally reviews all materials for compliance with the rules related to offering communications as well as potential liability for the representations themselves. Part of the compliance review is ensuring that no statements conflict with or provide a material change to the information in the filed offering prospectus that could be deemed materially misleading by content or omission, and compliance with Regulation FD if applicable.
Also from a technical legal perspective, all road show materials should contain a disclaimer for forward-looking statements, and that disclaimer should be read in live, virtual or prerecorded road show presentations. Where the road show content includes a FWP, it is required to contain a legend indicating that a prospectus has been filed, where it can be read (a hyperlink can satisfy this requirement), and advising prospectus investors to read the prospectus.
Pursuant to Rule 433(b)(2), the FWP for a non-reporting or unseasoned company must be accompanied with or preceded by the prospectus filed with the SEC. The delivery requirement can be satisfied by providing a hyperlink to the filed prospectus on the EDGAR database.
Road show materials, even those that are also a FWP, generally are not subject to liability under Section 11 of the Securities Act. Section 11 provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement. Road-show materials, including FWPs, are not a part of the registration statement, but rather are supplemental materials. Section 12 liability, however, does apply to road-show materials. Section 12 provides liability against the seller of securities for material misstatements or omissions in connection with that sale, whether oral or in writing.
Follow-on Offerings and Regulation FD
Regulation FD requires that companies subject to the SEC reporting requirements take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Consequently, Regulation FD would be implicated in connection with communications in a road show for a follow-on offering by a company already subject to the Exchange Act reporting requirements. Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence, such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence; and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings).
Where a road show is being conducted by a company subject to the Exchange Act reporting requirements, counsel should ensure that that the presentation either does not include material non-public information or that the information is simultaneously disclosed to the public in a Form 8-K. As a backstop where Regulation FD applies, the company should also consider having all road-show attendees sign a confidentiality agreement.
« The SEC Has Adopted Final Amendments To Rule 15C2-11; Major Change For OTC Markets Companies SEC Proposed To Modernize Auditor Independence Rules »