The SEC Has Adopted Final Amendments To Rule 15C2-11; Major Change For OTC Markets Companies
Despite an unusual abundance of comments and push-back, on September 16, 2020, one year after issuing proposed rules (see HERE), the SEC has adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11. The primary purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities. The SEC believes the final amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors. From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealer to rely on that confirmation. Importantly the new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer. The final rule release contains an in-depth discussion of the numerous comments received (I was one of the many comment writers), especially related to the piggyback exception. As part of the comment process, the OTC Markets, and many of its supporters, suggested the creation of a new “expert market” which would allow the trading of securities with no or limited information, by institutions and other qualified individual traders. In rejecting the proposal, the SEC indicated that there was not enough detail and information around how such a market would operate, but that it was open to considering such a segregated expert qualified marketplace in the future following the appropriate groundwork. The final rules entail a complete overhaul of the current rule structure and as such will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system. I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks. The final rule release contains a section on guidance related to the rules implementation and use. The guidance includes information on determining the reliability of information sources, conducting information reviews, and red flags that may heighten a review requirement. The effective date of the rule is 60 days following publication in the federal register. The rule will be published any day now. Compliance with the majority of the rule is required nine months after the effective date. However, compliance with the provision requiring a catch-all category of company to have current information for the preceding two years in order to qualify for the piggyback exception is not until two years from the effective date. As discussed more fully below, a catch-all company is generally an alternatively reporting company on OTC Markets. Background Rule 15c2-11 was enacted in 1971 to ensure that proper information was available to a broker and its clients prior to quoting a security in an effort to prevent micro-cap fraud. The last substantive amendment was in 1991. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA. The specific information required to be maintained by the broker-dealer when it initiates a quotation is delineated in Exchange Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or Regulation A under wand quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv). In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. This reasonable basis requirement has altered the initial quotation process dramatically over the last ten years. In particular, FINRA uses this requirement to conduct a deep dive into the due diligence and background of a company when processing a 211 Application. As discussed below, although the amended rule continues to require that a broker-dealer have a reasonable basis to believe information is accurate and from a reliable source, the revamped structure itself may help shift the burden back to the broker-dealer, where it belongs, and reduce FINRA’s overlapping merit review. Importantly as discussed, OTC Markets will not be required to submit a Form 211 but rather its determination of compliance with the rules will be self-effectuating, and a broker-dealer relying on OTC Markets review, will also not be required to submit a Form 211 to FINRA. This alone will make a tremendous difference in the process. The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed by a market maker and approved by FINRA and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. The disparity is so extreme that a quotation can take on a life of its own and continue long after a company has ceased to exist or closed operations. The SEC’s rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies. However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity). Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company. The final rules: (i) require that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allow OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamline the rule and eliminate obsolete provisions. The final rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA. However, if new IDQS platforms or national securities associations develop, they would also be covered by the rule. Final Amendments OTC Markets Review The new rule allows a qualified IDQS to comply with the information review requirements. As mentioned, in reality, the qualified IDQS is OTC Markets. In complying with the information review requirements under Rule 15c2-11, OTC Markets will be subject to the same review, responsibility and record keeping requirements of a broker-dealer and must have reasonably designed written policies and procedures associated with the rule’s compliance. OTC Markets would then “make known” to the public that it has completed a review and that a broker-dealer can quote or resume quoting the securities, and be in compliance with Rule 15c2-11. Likewise, OTC Markets can make a determination that a company qualifies for an exception to the 211 rule requirements and a broker-dealer can rely on that determination. A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review. Keeping the rule’s current 3 business day requirement, a broker-dealer’s quotation must be published or submitted within three business days after the qualified IDQS (OTC Markets) makes a publicly available determination. Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies, to file Forms 211 with FINRA. I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews. Current Public Information Requirements; Location of Information The final rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed. In addition, the amendment will restructure and renumber paragraphs and subparagraphs. To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation. The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation. The catch-all category encompasses companies that alternatively report on OTC Markets (see HERE for more information), as well as companies that are delinquent in their SEC reporting obligations. Provided however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggy-back exception. For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence. The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet. Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied. In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension. The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggy-back exception, for continued quotations. Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications. I’ve included a brief discussion of red flags in the section titled guidance below. The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties. Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements. Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer . The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information. Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security. The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation. A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet. The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors. In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder. As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10% or greater shareholders unless the company has current publicly available information. The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security. Exceptions in General The final rule amendments add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception; and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met. Piggyback and Unsolicited Quote Exception Changes The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. As discussed, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme. There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception. The final rule, which contains a 60 page discussion on the piggyback exception, will amend the exception to: (i) require that information be current and publicly available (see below chart); (ii) require at least a one-way priced quotation (either bid or ask) – which is a modification from the proposal which would have required a two-way quotation; (iii) eliminate the current 30 calendar day window before the exception can be relied upon but retain the requirement that that no more than 4 days in succession can elapse without a quotation; (iv) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (v) allow a period in which the exception can be relied upon for quotations of shell companies (modified from the rule proposal); and (vi) provide a conditional 15 day grace period to continue quotations when current information is no longer available (this provision was not in the rule proposal); and (vi) revise the frequency of quotation requirement. Notably, the SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggy-back exception, rather, the amended rule provides a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations. In particular, a broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period. Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter end. Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility. Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility. The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:| Category of Company | 15c2-11 Current Information |
| Exchange Act reporting company | Filed within 180 days following end of the reporting period |
| Regulation A reporting company | Filed within 120 days of fiscal year end and 90 days of semi-annual period end |
| Regulation Crowdfunding filer | Filed within 120 days of fiscal year end |
| Foreign Private Issuer | Since first day of most recent completed fiscal year, information required to be filed by the laws of home country or principal exchange traded on |
| Catch-all company | Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet. Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e. approximately 2 years and 2 months). A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date – i.e. 9 months after the effective date. |
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SEC Adopts Amendments To Accredited Investor Definition
The much anticipated amendments to the accredited investor definition and definition of qualified institutional buyer under Rule 144A were adopted by the SEC on August 26, 2020. The amendments come almost five years after the SEC published a report on the definition of “accredited investors” ( see HERE) and nine months after it published the proposed amendments (see HERE). The rule changes also took into account the input and comment letters received in response to the SEC’s concept release and request for public comment on ways to simplify, harmonize and improve the exempt offering framework (see HERE).
As a whole industry insiders, including myself, are pleased with the rule changes and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. As the SEC pointed out historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets. The amendments are meant to improve the definition to include institutional and individual investors with knowledge and expertise in the marketplace.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify with $5 million in assets and a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC has also amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
The amendments become effective 60 days after publication in the Federal Register.
Background
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including Rules 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows an investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2019 the estimated capital raised in exempt offerings was $2.7 trillion compared to $1.2 trillion in registered offerings. The amended definition of accredited investor is part of the SEC’s larger effort to simplify, harmonize, and improve the exempt offering framework. Earlier this year the SEC published broader proposed rule changes to the exempt offering structure, which I broke down into a 5-part blog series. The first centered on the offering integration concept (see HERE); the second on offering communications, testing the waters and a new demo day exemption (see HERE); the third on Regulation D, Rule 504 and bad actor rules (see HERE); the fourth on Regulation A (see HERE); and the fifth on Regulation Crowdfunding (see HERE).
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
- Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
- Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
- Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
- Any entity in which all of the equity owners are accredited investors.
Summary of Amendments
The amendment to the accredited investor definition adds new categories of natural persons based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In particular, to start the amendment provides that a holder in good standing of a Series 7, 65 or 82 license qualifies as an accredited investor. The SEC further provides that it may add additional certifications, designations, or credentials in the future. In addition, a knowledgeable employee of a private fund will now be considered accredited. The amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test for natural persons.
The amendments also: (i) clarify that limited liability companies with $5 million in assets qualify as accredited and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify; (ii) add a new catch-all category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (iii) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (iv) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The amendments to the qualified institutional buyer definition in Rule 144A add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The amendments also add a catch-all category that permits institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
Noting that relying solely on financial thresholds as an indication of financial sophistication is suboptimal, including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth, the final amendment adds new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations. The final amendments track the proposed amendments in this area except that the final amendments require that any certification, license or designation be in good standing in order to qualify for accreditation.
The final amendment provides that the SEC may designate qualifying professional certifications, designations, and other credentials by order, with such designation to be based upon consideration of all the facts pertaining to a particular certification, designation, or credential. The final amendment includes a non-exclusive list of attributes the SEC will consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status will be posted on the SEC’s website.
Concurrent with adopting the final amendments, the SEC issued an order designating good standing holders of a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and would leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Requiring that a list of individuals that hold the certifications be publicly available will reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC has added a new category based on the person’s status as a “knowledgeable employee” of the fund. A knowledgeable employee is defined as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund who in connection with his or her regular functions or duties, participates in the investment activities of the fund and has been doing so for at least 12 months.
The private fund category is meant to encompass funds that rely on the investment company registration exemptions found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, prior to this amendment, if the knowledgeable employee does not qualify as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded.
Spousal Equivalents
The SEC has added a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent is defined as a cohabitant in a relationship generally equivalent to a spouse. The rule does not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules add the following entities to the accredited investor definition: (i) limited liability companies with total assets in excess of $5 million that were not formed for the specific purpose of making the investment; (ii) SEC and state registered investment advisers and exempt reporting advisors; (iii) rural business investment companies (RBICs); (iv) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (v) “family offices” with at least $5 million in assets under management, that were not formed for the purpose of making the investment, and their “family clients,” as each term is defined under the Investment Advisers Act as long as the prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.
These additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
Qualified Institutional Buyer – Rule 144A
The SEC has amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. Rule 144A(a)(1)(i) specifies the types of institutions that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested threshold. The amendments expand the definition of qualified institutional buyer by adding RBICs, limited liability companies, and all entities, including Indian tribes that meet the $100 million threshold.
The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
« Nasdaq Rule Amendments 2020 NYSE Continues To Struggle With Direct Listing Rule Changes »
A COVID IPO
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
« SEC Spring 2020 Regulatory Agenda Nasdaq Rule Amendments 2020 »
SEC Spring 2020 Regulatory Agenda
In July 2020, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the spring 2020 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame has decreased to 42 items as compared to 47 on the fall 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months. Portfolio margining harmonization was the only item listed in the pre-rule stage in the fall 2019 and remains so on the current list.
Nineteen items are included in the proposed rule stage, down from 31 on the fall list. Still on the proposed rule list is executive compensation clawback (HERE). Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.
Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements), and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list. The SEC has recently amended the rules and issued a concept release (see HERE and HERE) and appears committed to enacting much-needed updates and improvements to the rules.
Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the spring 2019 list and up to proposed in fall 2019 where it remains. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments to the transfer agent rules remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). SEC top brass speeches suggested that it would finally be pushed over the finish line last year but so far it remains stalled (see, for example, HERE).
Other items that are still on the proposed rule list include amendments to Guide 5 on real estate offerings and Form S-11; amendments to the custody rules for investment advisors; investment company summary shareholder report; amendments to Form 13F filer thresholds; amendments to the family office rule; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and broker-dealer reporting, audit and notifications requirements.
Items moved up from long-term to proposed-rule stage include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to the Family Office Rule; amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and amendments to the rules regarding the consolidated audit trail.
New to the list and appearing in the proposed rule stage is a rule regarding the valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company. Also new to the list and in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC. Another new item that made it to the proposed stage is a proposal to amend Regulation ATS to increase operational transparency and foster oversight of ATSs that transact in government securities.
Twenty-one items are included in the final rule stage, increased from 16 on the fall list, including a few of which are new to the agenda. Amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019 – see HERE) moved up from the proposed list to final rule stage.
Still in the final rule stage is the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE). The SEC previously made some changes to risk factor disclosures in an amendment adopted in March 2019 (see HERE) but the newest proposals would go further to: (i) require summary risk factor disclosure 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.
Financial disclosures about acquired businesses are still listed in the final rule stage although final rules were adopted in May 2020, which are still on my list as a catch-up blog. The proposed amendments were published in May 2019 (see HERE). Similarly, amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE) still appear on the final rule list although final rules were adopted in July 2020 (also on my future blog list).
Jumping from a long-term action item to final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.
Moving up from proposed rule to final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE); proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); procedures for investment company act applications; NMS Plan amendments; use of derivatives by registered investment companies and business development companies; market data infrastructure including market data distribution and market access (proposed rules published in February 2020); amendments to the SEC’s Rules of Practice; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; amendments to marketing rules under the Advisors Act; and amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendments to MD&A were adopted in March 2019 (see HERE)
The much-needed amendments to the accredited investor definition moved from the proposed list to the final rule stage. The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE). As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, moved from the proposed rule list to the final agenda. The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change. I’ve written about 15c2-11 many times, including HERE and HERE . In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject. Comments and responses to the proposed rules have been voluminous and largely negative. The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system.
Other items remaining in the final rule stage include Fund of fund arrangements (proposed rules were issued in December 2018); customer margin requirements for securities futures (proposed rules published in July 2019); and amendments to the whistleblower program.
At least partially, new to the agenda and in the final rule stage is the harmonization of exempt offerings. In March 2020 the SEC proposed sweeping rule changes. For my five-part blog on the proposed rules, see HERE, HERE, HERE, HERE, and HERE. Regulation A and Regulation CF amendments were on the fall 2019 proposed rule list and although dropped off as separate items, are encompassed in the harmonization of exempt offerings proposed amendments.
Several items have dropped off the agenda as they have now been implemented and completed, including financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE) and the final rules adopted in March 2020 (see HERE). Amendments to the definition of an accelerated and large accelerated filer were finalized in March 2020 (see HERE) and thus removed from the list.
Items also completed and removed from the agenda include offering reform for business development companies (adopted in April 2020); amendments to Title VII cross-border rules (final rules adopted in September 2019); recordkeeping and reporting for security-based swap dealers (adopted in September 2019); disclosure for unit investment trusts and offering variable insurance products (adopted in May 2020); a new definition for covered clearing agency (adopted in April 2020); and risk mitigation techniques (adopted on December 2019).
Thirty items are listed as long-term actions (down from 37 in fall 2019 and 52 in spring 2019), including many that have been sitting on the list for a long time now. Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now. Other items still on the long-term list include asset-backed securities disclosures (last amended in 2014); corporate board diversity (although nothing has been proposed, it is a hot topic); conflict minerals amendments (prior proposed rules were challenged in lengthy court proceedings on a constitutional First Amendment basis and yet another proposal was published in December 2019 – HERE); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); and stress testing for large asset managers.
Also still on the long-term action list is the modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; covered broker-dealer provisions under Title II of Dodd-Frank; additional changes to exchange-traded products; short sale disclosure reforms; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.
A few electronic filing matters remain on the long-term list including electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.
Several swap-based rules remain on the long-term list including ownership limitations and governance requirements for security-based swap clearing agencies, security-based swap execution facilities, and national exchanges; end user exception to mandatory clearing of security-based swaps; registration and regulation of security-based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
New to the list are requests for comments on fund names; amendments to improve fund proxy systems; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); records to be preserved by certain exchange members, brokers and dealers; and proposed Rule 15 to Regulation S-T, administration of the EDGAR system.
Items that dropped from the agenda without action include amendments to the registration of alternative trading systems and clawbacks of incentive compensation at financial institutions. Sadly, completely dropped from the agenda is Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See here for more information HERE.
« SEC Final Amendments On Disclosures For Registered Debt Offerings A COVID IPO »
SEC Final Amendments On Disclosures For Registered Debt Offerings
Writing a blog once a week during a time when almost daily events are publish-worthy means that some topics will be delayed, at least temporarily. Back in March, the SEC adopted final amendments to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed rule changes were published in the summer of 2018 (see HERE).
The amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The SEC also created a new Article 13 in Regulation S-X, renumbered Rules 3-10 and 3-16 to Rules 13-01 and 13-02, and made conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.
As stated in the SEC press release on the new rules, the amended rules focus on the provision of material, relevant, and decision-useful information regarding guarantees and other credit enhancements, and eliminate prescriptive requirements that have imposed unnecessary burdens and incentivized issuers of securities with guarantees and other credit enhancements to offer and sell those securities on an unregistered basis. The amendments are intended to improve disclosure and reduce the SEC registration-related compliance burdens for issuers. It is hoped that the rules will encourage registered debt offerings over unregistered offerings and thus improve disclosures and protections for investors.
The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.
Rule 3-10
Under the Securities Act, a guarantee of a debt is a separate security requiring either registration, with audited financial statement, or an exemption from registration upon its offer or sale. Rule 3-10 of Regulation S-X requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements and that the subsidiary be 100% owned. If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.
The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.
The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.
To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.
When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.
The amendments streamline the current structure, which has differing criteria depending on which exemption is being relied upon to unify all criteria. The amendments broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the eligibility requirements to rely on the exception are met and the parent company includes specific financial and non-financial disclosures about those subsidiaries.
The amended rule will:
(i) Allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned;
(ii) Replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis;
(iii) New non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities;
(iv) Permit disclosures to be provided outside the footnotes of the parent’s audited and interim unaudited financial statements in the registration statement covering the offering and in the Exchange Act reports thereafter;
(v) Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, provided however, if the acquisition is significant, summarized financial information must be provided; and
(vi) Reduce the time in which additional Alternative Disclosure must be made to the period for which the issuer and guarantors have Exchange Act reporting obligations instead of the entire period that the guaranteed securities are outstanding.
To be eligible to rely on the exception, the following conditions must be met:
(i) The consolidated financial statements of the parent company have been filed;
(ii) The subsidiary or guarantor is a consolidated subsidiary of the parent;
(iii) The guaranteed security is debt or debt-like; and
(iv) One of the following issuer and guarantor structures is applicable: (a) the parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or (b) a consolidated subsidiary issues the security or co-issues the security with one or more other consolidated subsidiaries of the parent company, and the security is guaranteed fully and unconditionally by the parent company.
Importantly, as noted, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subjects the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
The new rules include conforming amendments to also apply to the Rule 8-01 of Regulation S-X dealing with smaller reporting companies and Forms 1-A, 1-K and 1-SA to apply to Regulation A issuers.
Rule 3-16
Current Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.
The amendments replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security. The amended financial and non-financial disclosures are included in new Rule 13-02.
The level of disclosure is based on materiality and would include certain line items of the balance sheet and income statement of the affiliate. Where more than one affiliate provides collateral, financial information can be included on a consolidated rather than individual basis. However, when information is applicable to one or more, but not all, affiliates, it will need to be separated out. For example, when one or more affiliates separates trades, it would need to be clear which affiliate trading market information is being provided for.
In addition, the amendment changes the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.
Furthermore, the amendments replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered, with a requirement to provide the financial and non-financial disclosures to the extent material, eliminating numerical thresholds. The rule leans towards materiality with the need to determine information is immaterial for it to be omitted.
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SEC Statements On Capital Markets Amid Covid-19
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
« SEC Further Comments On Emerging Markets Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards »
SEC Further Comments On Emerging Markets
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets. On July 9, 2020, the SEC held an Emerging Markets Roundtable where Chair Clayton reiterated his concerns about emerging market investment risks. Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
SEC and PCAOB Joint Statement
On April 21, 2020, SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III issued a joint public statement warning of the significant disclosure, financial and reporting risks of investing in emerging markets, and the limited remedies where such investments turn bad.
Over the past years, emerging markets have increased their access to U.S. capital markets with China becoming the largest emerging market economy and world’s second largest overall economy. The ability for regulators to enforce financial reporting and disclosure requirements for entities either based in, or with significant operations in, emerging markets is limited and dependent on the cooperation and assistance of local authorities. As a result, in many emerging markets, including China, there is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to U.S. domestic companies. The joint statement summarizes specific risks and considerations for market participants.
Risk Disclosures
I have written about risk factors and the importance of company-specific risk disclosures in the past (see HERE). Companies that have significant operations in emerging markets often face greater risks and uncertainties, including idiosyncratic risks, than in more established markets. The operational risk disclosures for companies in emerging markets need to be robust including considering industry and jurisdiction-specific factors.
Likewise, the varying standards for financial reporting and oversight in different jurisdictions create unique risks that must be disclosed. Companies should discuss these matters with their independent auditors and where applicable, audit committees, and should disclose the related material risks.
Companies based in emerging markets should consider providing a U.S. domestic investor-oriented comparative discussion of matters such as (i) how the company has met the applicable financial reporting and disclosure obligations, including disclosure control procedures and internal controls over financial reporting and (ii) regulatory enforcement and investor-oriented remedies including, as a practical matter, in the event of a material disclosure violation or fraud or other financial misconduct.
Quality of Financial Information; Varying Requirements and Standards
The foundation of investor confidence in capital markets is high-quality, reliable financial statements. The SEC regulatory regime contains numerous rules and regulations to ensure these high-quality financial statements, including rules related to internal controls over financial statements (ICFR); auditor attestations; CEO and CFO attestations (see HERE); independent audit committees; auditor independence standards, PCAOB review and oversight and SEC review and enforcement.
While the form of disclosure may appear substantially the same as that provided by U.S. issuers and FPIs in many jurisdictions, it can often be quite different in scope and quality. Furthermore, that scope and quality of disclosure can significantly vary from company to company, industry to industry, and jurisdiction to jurisdiction.
In addition, if a foreign entity does not report to the SEC, the information and standards for preparing that information may be completely unreliable. Some jurisdictions have much lower regulatory, accounting, auditing or auditor oversight requirements or none at all.
The bottom line is that investors and financial professionals should carefully consider the nature and quality of financial information, including financial reporting and audit requirements, when making or recommending investments. Companies should ensure that relevant financial reporting matters are discussed with their independent auditors and, where applicable, audit committees.
PCAOB’s Inability to Inspect Audit Work Papers in China
The SEC and PCAOB’s first statement on this matter in December 2018 drilled down on the fact that China will not cooperate with their requests to review, investigate or audit local PCAOB member firms in China, thereby casting doubt and a lack of transparency on the quality and reliability of audits. The newest statement reiterates this situation and specifically notes a lack of improvement despite ongoing efforts. Investors should understand the potential impacts of the PCAOB’s lack of access when investing in companies whose auditor is based in China and public companies with operations in China must disclose these risks in SEC reports.
Limited Rights or Remedies
The SEC, U.S. Department of Justice (“DOJ”) and other authorities often have substantial difficulties in bringing and enforcing actions against non-U.S. companies and non-U.S. persons, including company directors and officers, in certain emerging markets, including China. Likewise, shareholder claims, including class action lawsuits, can be difficult or impossible to pursue in emerging markets. Even if investors successfully sue in the U.S., judgments may be impossible to enforce or collect upon.
Companies should clearly disclose the related material risks in their SEC reports.
Passive Investing
Passive investing strategies, such as through or following an index fund, often fail to consider the increased and specific risks associated with emerging markets.
Investment Advisers, Broker-Dealers and Other Market Participants Should Consider Emerging Market Risks
The SEC reminds investment professionals to consider the risks discussed in their statement when making investment decisions or providing investment advice or recommendations involving emerging markets.
« SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions SEC Statements On Capital Markets Amid Covid-19 »
SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions
In March, 2020 the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer.” The amendments were adopted largely as proposed in May 2019 (see HERE).
A company that is classified as an accelerated or large accelerated filer is subject to, among other things, the requirement that its outside auditor attest to, and report on, management’s assessment of the effectiveness of the issuer’s internal control over financial reporting (ICFR) as required by Section 404(b) of the Sarbanes-Oxley Act (SOX). The JOBS Act exempted emerging growth companies (EGCs) from this requirement. Moreover, historically the definition of a smaller reporting company (SRC) was set such that an SRC could never be an accelerated or large accelerated filer, and as such would never be subject to Section 404(b) of SOX.
In June 2018, the SEC amended the definition of an SRC to include companies with less than a $250 million public float (increased from $75 million) or if a company does not have an ascertainable public float or has a public float of less than $700 million, an SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year (see HERE). At that time the SEC did not amend the definitions of an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRC’s remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of SOX.
Under the new rules, smaller reporting companies with less than $100 million in revenues are not required to obtain an attestation of their internal controls over financial reporting (ICFR) from an independent outside auditor under Section 404(b) of SOX. In particular, the amendments exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and that had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
All Exchange Act reporting companies, whether an SRC or accelerated filer, will continue to be required to comply with SOX Rule 404(a) requiring the company to establish and maintain ICFR and disclosure control and procedures and have their management assess the effectiveness of each. This management assessment is contained in the body of all quarterly and annual reports and amended reports and in separate certifications by the company’s principal executive officer and the principal financial officer.
The new rules also increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new rules will assist with capital formation for smaller companies and reduce compliance burdens while maintaining investor protections. The SEC also hopes that the amendments will catch the attention of companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets.
In the press release announcing the rule change, Chair Jay Clayton stated: “[T]he JOBS Act provided a well-reasoned exemption from the ICFR attestation requirement for emerging growth companies during the first five years after an IPO. These amendments would allow smaller reporting companies that have made it to that five-year point, but have not yet reached $100 million in revenues, to continue to benefit from that exemption as they build their businesses, while still subjecting those companies to important investor protection requirements.”
Background
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been prolific over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
| Filer Category | Form 10-K | Form 10-Q |
| Large Accelerated Filer | 60 days after fiscal year-end | 40 days after quarter-end |
| Accelerated Filer | 75 days after fiscal year-end | 40 days after quarter-end |
| Non-Accelerated Filer | 90 days after fiscal year-end | 45 days after quarter-end |
| Smaller Reporting Company | 90 days after fiscal year-end | 45 days after quarter-end |
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues.
Detail on Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million, would be both an SRC and an accelerated filer.
The SEC has now amended the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC and that had annual revenues of less than $100 million during its most recently completed fiscal year for which audited financial statements are available. The effect of this change is that such a company will not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement under SOX Section 404(b).
The rule change does not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the amendments:
| Relationships between SRC’s and Non-Accelerated and Accelerated Filers | ||
| Status | Non-Affiliated Public Float | Annual Revenues |
| SRC and Non-Accelerated Filer | Less than $75 million | N/A |
| $75 million to less than $700 million | Less than $100 million | |
| SRC and Accelerated Filer | $75 million to less than $250 million | $100 million or more |
| Accelerated Filer (not SRC) | $250 million to less than $700 million | $100 million or more |
| Large Accelerated Filer (not SRC) | Over $700 million | N/A |
The amendments also revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million and increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the amendments allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the amendments on transition provisions:
| Amendments to the Non-Affiliate Public Float Thresholds | |||
| Initial Public Float Determination | Resulting Filer Status | Subsequent Public Float Determination | Resulting Filer Status |
| $700 million or more | Large Accelerated Filer | $560 million or more | Large Accelerated Filer |
| Less than $560 million but
$60 million or more |
Accelerated Filer | ||
| Less than $60 million | Non-Accelerated Filer | ||
| Less than $700 million but $75 million or more | Accelerated Filer | Less than $700 million but
$60 million or more |
Accelerated Filer |
| Less than $60 million | Non-Accelerated Filer | ||
Determining Non-Affiliated Public Float
To determine the value of the public float, a company must multiply the aggregate worldwide number of shares of common equity held by non-affiliates by the price at which it was last sold, or the average of the bid and asked prices, in the principal trading market. Derivative securities such as options, warrants and other convertible or non-vested securities are not included in the calculation. An “affiliate” of, or a person “affiliated” with, a company, is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the company. The term “control” (including the terms “controlling,” “controlled by” and “under common control with”) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a company, whether through the ownership of voting securities, by contract, or otherwise.
From a top line, directors, executive officers and their spouses and relatives living with them are always considered affiliates as are trusts and corporations of which that director, executive officer or their spouses control in excess of 10%. There is a rebuttable presumption that 10% or greater stockholders are affiliates. Beyond that, the SEC has consistently refused to provide definitive guidance on the matter, rather requiring companies and their management to make an analysis based on their individual facts and circumstances.
Through various guidance, including comment letters and SEC enforcement actions, important facts to consider in determining control/affiliate status include:
- Distribution of voting shares among all stockholders – Consider whether a stockholder has a large percentage of the company’s voting stock as compared to all other stockholders;
- Impact of possible resale – if a particular larger shareholder threatens to sell their stock into the market unless management takes certain actions, and management believes that such sale would have a material negative impact on the stock price, that person could be considered to have control;
- Influence of a stockholder – a particular stockholder could have influence because of their general position or power over other stockholders – this could be because of a direct or indirect relationship with other stockholders or because of the person’s reputation as a whole. For example, certain activist shareholders such as Carl Icahn can exert control over management of companies in which they invest;
- Voting agreements – if a person has the right to vote on behalf of other people’s shares, they may have control;
- Contractual arrangements – any other contract that gives a person the right to assert control over management decisions.
« Proposed 2021 U.S. Budget SEC Further Comments On Emerging Markets »
SEC Proposed Rule Changes For Exempt Offerings – Part 5
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this fifth and final blog focusing on amendments to Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see HERE. To review the third blog in this series which focused on Regulation D, Rule 504 and the bad actor rules, see HERE. To review the fourth blog in this series related to changes to Regulation A, see HERE.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c) and Section 4(a)(6) known as Regulation Crowdfunding. For more background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Regulation Crowdfunding
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
Increase in Offering Limit
The proposed amendments would increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding would become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The proposed amendments would increase the investment limit by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits would only apply to non-accredited investors whereas currently they apply to all investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The proposed amendments would allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles would be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding issuer and would not have a separate business purpose. Investors in the crowdfunding vehicle would have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying crowdfunding issuer in an offering made under Regulation Crowdfunding.
The proposed rule would benefit companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders, which can make these companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle would also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle may constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available it is required to register, if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Security Types
The proposed amendments would narrow the types of securities eligible under Regulation Crowdfunding to debt securities, equity securities, and debt securities convertible or exchangeable into equity securities, including guarantees of such securities, to harmonize the provisions of Regulation Crowdfunding regarding eligible security types with those of Regulation A. Other types of securities would be excluded from eligibility under the proposed 260 amendments. For example, Simple Agreements for Future Equity (SAFE) securities would no longer be eligible under Regulation Crowdfunding.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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« SEC Proposed Rule Changes For Exempt Offerings – Part 4 Proposed 2021 U.S. Budget »
SEC Proposed Rule Changes For Exempt Offerings – Part 4
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this fourth blog focusing on amendments to Regulation A other than integration and offering communications which affect all exempt offerings and were discussed in the first two blogs in this series. The final blog in this series will discuss changes to Regulation Crowdfunding.
To review the first blog in this series, which centered on the offering integration concept, see HERE. To review the second blog in the series, which focused on offering communications, the new demo day exemption, and testing-the-waters provisions, see HERE. To review the third blog in this series, which focused on Regulation D, Rule 504 and the bad actor rules, see HERE.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). Currently, the requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more background on the current exemption framework, including a chart summarizing the most often used exemptions and their requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Regulation A
The current two tier Regulation A offering process went into effect on June 19, 2015, as part of the JOBS Act. Since its inception there has been one rule modification opening up the offering to SEC reporting companies (see HERE) and multiple SEC guidance publications including through C&DI on the Regulation A process. For a recent summary of Regulation A, see HERE.
Increase in Offering Limit
On March 15, 2018, the U.S. House of Representatives passed H.R. 4263, the Regulation A+ Improvement Act, increasing the Regulation A+ Tier 2 limit from $50 million to $75 million in a 12-month period. On June 8, 2017, the U.S. House of Representatives passed the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (the “Financial Choice Act 2.0”), which also included a provision increasing the Tier 2 offering limit to $75 million.
Following suit, the new proposed rule changes will increase the maximum Regulation A Tier 2 offering from $50 Million to $75 million in any 12-month period. As such, the 30% offering limit for secondary sales would increase from $15 million to $22.5 million. Tier 1 offering limits would remain unchanged.
Simplification
The SEC is also proposing to simplify the requirements for Regulation A and establish greater consistency between Regulation A and registered offerings by permitting Regulation A issuers to: (i) file certain redacted exhibits using the process previously adopted for registered offerings (see HERE); (ii) make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements; (iii) incorporate financial statement information by reference to other documents filed on EDGAR and generally allow incorporation by reference to the same degree as a registered offering (see HERE); and (iv) to have post-qualification amendments declared abandoned.
In March 2019, the SEC amended parts of Regulation S-K to allow companies to mark their exhibit index to indicate that portions of the exhibit or exhibits have been omitted, 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 be competitively harmful if publicly disclosed, and indicate with brackets where the information has been omitted from the filed version of the exhibit. At the time, the Regulation A rules were not changed such that Regulation A filers are still compelled to submit an application for confidential treatment in order to redact immaterial confidential information from material contracts and plans of acquisition, reorganization, arrangement, liquidation, or succession.
SEC staff would continue to review Forms 1-A filed in connection with Regulation A offerings and selectively assess whether redactions from exhibits appear to be limited to information that meets the appropriate standard. Upon request, companies would be expected to promptly provide supplemental materials to the SEC similar to those currently required, including an unredacted copy of the exhibit and an analysis of why the redacted information is both not material and the type of information that the company both customarily and actually treats as private and confidential.
Companies would also still be able to request confidentiality under Rule 83. For more on confidential treatment in SEC filings, see HERE
The SEC is also proposing to make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements. Currently confidential submittals must be filed as an exhibit to a public filing, which adds time and expense to the process. To the contrary, confidential registration statements filed under the Securities Act can simply be recoded to become publicly available. The proposed rules would add the same process for Regulation A filers.
The SEC is also proposing to allow previously filed financial statements to be incorporated by reference into a Regulation A offering circular. As proposed, companies that have a reporting obligation under Rule 257 or the Exchange Act must be current in their reporting obligations. In addition, companies would be required to make incorporated financial statements readily available and accessible on a website maintained by or for the company, and disclose in the offering statement that such financial statements will be provided upon request. Companies conducting ongoing offerings would still need to file an annual post-qualification amendment with updated financial statements.
Excluding Delinquent Reporting Companies
The proposed amendments would exclude reporting companies that are not current in periodic reports required under Section 13 or 15(d) of the Exchange Act from using Regulation A. Excluding companies that are subject to, but not current in, Exchange Act reporting obligations from eligibility under Regulation A may reduce the average level of information asymmetry about Regulation A issuers and incrementally increase investor interest in securities offered in this market.
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