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Financial Statement Disclosure Relief Under Rule 3-13

Posted by Securities Attorney Laura Anthony | November 6, 2018

Rule 3-13 of Regulation S-X allows a company to request relief from the SEC from the financial statement disclosure requirements if they believe that the financial information is burdensome and would result in disclosure of information that goes beyond what is material to investors. Consistent with the ongoing message of open communication and cooperation, the current SEC regime has been actively encouraging companies to avail themselves of this relief and has updated the CorpFin Financial Reporting Manual to include contact information for staff members that can assist.

As part of its ongoing disclosure effectiveness initiative, the SEC is also considering amendments to the financial statement disclosure process and the publication of further staff guidance. In addition to advancing disclosure changes, allowing for relief from financial statement requirements could help encourage smaller companies to access public markets, an ongoing goal of the SEC and other financial regulators. For a review of the October 2017 Treasury Department report to President Trump, including discussions related to the need to promote public markets, see HERE. For a review of Nasdaq’s publication “The Promise of Market Reform: Reigniting American’s Economic Engine,” see HERE.

In fact, the SEC, under Chair Jay Clayton, has used current rules and staff prerogative to implement changes over the past two years for the direct purpose of removing barriers to capital formation and making the U.S public markets more attractive. For example, In June 2017 the SEC announced that the Division of Corporation Finance will permit all companies to submit draft registration statements, on a confidential basis. For more information see HERE.

Rule 3-13 of Regulation S-X

Rule 3-13 of Regulation S-X reads in total:

The Commission may, upon the informal written request of the registrant, and where consistent with the protection of investors, permit the omission of one or more of the financial statements herein required or the filing in substitution therefor of appropriate statements of comparable character. The Commission may also by informal written notice require the filing of other financial statements in addition to, or in substitution for, the statements herein required in any case where such statements are necessary or appropriate for an adequate presentation of the financial condition of any person whose financial statements are required, or whose statements are otherwise necessary for the protection of investors.

That is, the Rule gives the SEC the authority to modify or waive financial statement requirements under Regulation S-X as long as the modification is consistent with investor protections. The SEC has delegated the authority to the Division of Corporation Finance. Rule 3-13 applies to all financial statement requirements under Regulation S-X including financial information that a company may have to provide from other entities such as acquired businesses, subsidiaries, tenants with triple net lease arrangements that comprise a concentration of assets, certain related parties and others. For more information on financial statement requirements for entities other than the registrant, see HERE.

Although the requirement that relief be consistent with investor protections is not defined by any rules, the SEC uses the concept of materiality as guidance. Materiality requires a facts-and-circumstances analysis. In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.

The Financial Accounting Standards Board (FASB) has also published guidance on the utilization of the materiality standard in financial reporting. In September 2015, FASB published two concept papers recommending changes to the rules and analysis related to determining materiality. The changes would have given companies more flexibility in determining materiality. FASB’s proposed changes met with opposition from investor groups. After two years of a back-and-forth process, in November 2017, FASB abandoned its proposed changes and reverted to an earlier materiality standard.

FASB now defines materiality in the context of “the magnitude of an omission or misstatement of accounting information that, in light of the surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.” The FASB materiality analysis is primarily quantitative although circumstances, such as whether a particular matter is outside the ordinary course of business or could have an impact on larger contractual obligations, must also be considered.

This definition is consistent with the standard used by the SEC, the PCAOB and the AICPA. The old and now new again materiality standard is set forth in FASB’s Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information.

A materiality analysis must also take into account the relevance of the information. That is, information may be material based on pure magnitude but it may lack relevance. Relevance is generally information that would make a difference to a decision maker such as in making predictions about outcomes of past, present, and future events or to confirm or correct prior expectations. By its very nature, relevant information is timely. If information is not available when it is needed or becomes available so long after the reported events that it has no value for future action, it lacks relevance and is of little or no use.

How to Seek Relief

As with all communications with the SEC, the company should ensure it is prepared prior to seeking relief. Being prepared includes conducting research to see if the SEC has issued guidance on a particular topic or provided relief, such as no-action relief, to other companies in similar circumstances. The SEC’s Financial Reporting Manual (FRM) should always be reviewed.

The FRM may even provide for self-executing relief from certain requirements, especially where the SEC has granted similar relief on a regular basis. For example, the FRM now allows a company to file a “super 10-K” to catch up delinquent reports, without seeking relief from the SEC prior to doing so. As another example, companies may provide abbreviated financial statements for certain oil and gas properties without first seeking SEC relief. Furthermore, the FRM provides guidance on seeking relief in certain circumstances, including the criteria the staff will consider.

As indicated in the rule, a request for relief should be in writing to the appropriate staff member(s). However, under the new regime, the SEC encourages companies to engage in conversations with the SEC staff prior to submitting the written request. The company can discuss any items they believe are relevant to the determination, why they believe a particular disclosure is not necessary for that company’s investors and how and why preparation of the rule-mandated financial statements would be overly burdensome. To avoid unnecessary logjam, the SEC staff cautions against providing unnecessary background or peripheral information.

Further

Background on SEC Disclosure Effectiveness Initiative

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

In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. The comment letter focused on disclosures related to materiality, known trends or uncertainties, critical accounting estimates, strategy, intellectual property rights, sustainability, litigation and risk factors. For a review of the comment letter, see HERE.

In October, 2017 the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.

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

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. This proposal is slated for action in this year’s SEC regulatory agenda.

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

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Both of these items are slated for action in this year’s SEC regulatory agenda.

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

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

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

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

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.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.

Listen toour podcast on iTunes Podcast channel.

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« SEC Commissioner Hester Peirce Continues to Support Technology Recent Notable Changes To Delaware Corporate Law »

SEC Commissioner Hester Peirce Continues to Support Technology

Posted by Securities Attorney Laura Anthony | October 30, 2018 Tags: SEC, SEC Commissioner Hester Peirce Continues to Support Technology

In three recent speeches, SEC Commissioner Hester Peirce continued to proclaim her support for technological innovation and freedom in capital markets. On September 12, 2018, Ms. Peirce gave a speech at the Cato Institute’s FinTech Unbound Conference which she titled Motherhood and Humble Pie, on September 24 she spoke at the University of Michigan Law School titling her speech Wolves and Wolverines, and then on October 2 she spoke at the Financial Planning Association 2018 Major Firms Symposium, calling that speech Pickups and Put Downs. Besides the great titles, I applaud her content and perspective.

Motherhood and Humble Pie

A prevailing theme in all three speeches centered on her dissent to the SEC’s rejection of an exchange traded product or mutual fund. As an aside, since I wrote this blog on the SEC’s published concerns related to a cryptocurrency-related exchange traded product or mutual fund, HERE, the SEC has continued to deny several more applications for such a product.

As the title of her first speech in the series indicates, she uses motherhood as a metaphor to express her view that the SEC has been acting like a helicopter mother as opposed to a free-range mother, by refusing to let its “children” take risks by exploring new financial products that involve cryptocurrencies. In one of my favorite lines in her speech, she states, “[B]etter, we naturally think, not to allow the investor to leave the house, even for a quick trip down the street, unless properly helmeted, swaddled in regulation protective gear, and strapped into a vaguely European-branded car seat that is secured exactly in the center of the back seat of the largest SUV that an upper-middle class professional’s salary can buy.”

Certainly there is risk that investors will lose money and that there will be backlash against the regulatory body for failing to put proper protections in place, but Ms. Peirce thinks that the free-market environment should support such risk. Regardless of the level of regulatory protection, there will always be investor losses. Companies will fail, fraudsters will cheat and markets will downturn. Furthermore, capital markets are, by nature, risky. As Ms. Peirce notes, “[A] key purpose of financial markets is to permit investors to take risks, commensurate with their own risk appetites and circumstances, to earn returns on their investments.”

Ms. Peirce opines that the protection against the risk of cryptocurrency investments could go beyond the SEC’s actual authority. Congress has not empowered the SEC with eliminating risk or substituting the SEC’s investment judgment for that of an investor. The SEC also does not have the authority to regulate or require regulation of assets underlying securities, including digital assets. As I’ve written about in my blogs several times, the SEC regulatory framework centers around disclosure and not a merit review. For example, the SEC does not have the power to prohibit a registration statement from going effective if the disclosures are complete and compliant with Regulations S-K and S-X, regardless of how terrible the investment may be.

Specifically, the SEC’s high-level mandates are to protect investors, facilitate capital formation and maintain fair, orderly and efficient markets. For more on the SEC’s purpose, see HERE. Ms. Peirce believes this mandate requires the SEC to ensure that investors have access to products to allow them to create their own investment portfolios, including with new and expanding asset classes such as cryptocurrencies.

People already invest in cryptocurrencies, but they must do so through direct purchases on various exchanges, outside of their regular investment accounts. The individual investor is charged with keeping records and having a certain technical know-how to play in this marketplace. It is clear that there is a strong interest among investors to access this new type of investment, and for it to be available via exchange traded products, thus the consistent new applications by industry institutions.

Ms. Peirce lists five lessons that the SEC should learn when considering cryptocurrency products and technological innovation. In particular:

The SEC should avoid supplanting its own judgment with that of investors’ and avoid attempting to ascertain the viability of new technology in advance of its release in the marketplace as long as proper disclosures are in place.
The SEC’s efforts to protect investors from the risks of innovation will not change the desire for the marketplace to have access to these products and instead will cause investors to seek investment opportunities in other countries and markets that may be even less regulated than the US markets.
The SEC must be more accessible and willing to engage with entrepreneurs and market participants seeking to bring cryptocurrency products to market. Furthermore, the SEC needs to provide clear and reasonable rules for innovators.
The SEC needs to commit to expanding investor access to financial markets, including through innovative technology. Innovation does not just mean cryptocurrency products but includes mobile access to investment products, online disclosures, and all fintech.
The SEC has to consider the resources it requires in meeting regulatory burdens, including financial, coding and data analytics. These regulatory burdens take away resources that could be used on customer-serving innovation and stifle smaller businesses from pursuing technological innovation.

Ms. Peirce ends with calling for an SEC Office of Innovation, a request that was granted. On October 18, 2018, the SEC launched its new Strategic Hub for Innovation and Financial Technology (FinHub), which is a topic for an upcoming blog.

Wolves and Wolverines

Commissioner Peirce’s September 24 speech at the University of Michigan Law School focused on arbitration between public companies and their shareholders and my favorite topic, digital assets. Solidifying me as a fan even more, Ms. Peirce begins by pointing out that corporate law is a form of public interest law, noting that “[T]he hunt for profit drives companies to strive to identify and meet people’s needs using as few resources as possible.” The corporate ecosystem, including dealing with customers, supplies, creditors, shareholders, employees and communities, requires mutual responsibility and an obligation to exercise sound judgment and respectable ethics.

This sentiment, however, acted as a segue to discuss the fact that failures in corporate ethics, such as the Enron scandal, have resulted in a more conservative SEC and regulatory regime. Repeating her earlier speech, Ms. Peirce conveys her views that the SEC should not be substituting its judgment for that of the investment community. Rather, the SEC should be ensuring that the regulatory framework requires proper disclosure so that investors can make an informed decision, whether it be to trade in particular stocks or products on the public markets, or invest in a private company with “world-changing ideas.”

In addition to her views on access to cryptocurrency, Ms. Peirce has been targeted by pro-regulatory enthusiasts for her statement on mandatory arbitration in the corporate context. In particular, in response to a reporter’s question, she answered that she supports mandatory arbitration since shareholder litigation is expensive and costs all shareholders regardless of the merits of the claims. Arbitration can be more effective, quicker and less costly. Despite the fact that the topic of arbitration between corporations and their shareholders is within the jurisdiction of state corporate law, the SEC could exert its influence by using public policy to affect the ability of a company to register securities if it has an offending policy. Ms. Peirce is consistent with her conviction that on this topic, as with others, the SEC should not impose its judgment on such free-market matters but rather leave it to supply, demand and the investors’ own due diligence.

Ms. Peirce then turned to the topic of cryptocurrency-related exchange traded products and mutual funds. She reiterated much of her sentiment from her prior speech, spending even more time on her concern that the regulatory treatment of cryptocurrencies will stifle all technological innovation in the capital markets, not just those related to digital assets.

Ms. Peirce also impressively took on the question as to whether she thinks all ICOs involve the offering of securities and whether a token security can become a non-security (utility) thereafter. Although months earlier William Hinman, the Director of the SEC Division of Corporation Finance, had expressed his views that a token can become a utility or non-security (see HERE), Commissioner Peirce hedged on the answer but left the impression that she may lean toward continuing to view cryptocurrencies as securities over the long term. Interestingly, although she is very clear that she does not support any merit review, no matter how veiled behind investor protection, she also seems to support some new regulatory structure that would cover digital assets through a longer period of time, while fostering and allowing development and market testing.

Pickups and Put Downs

On October 2, Commissioner Peirce spoke at the Financial Planning Association 2018 Major Firms Symposium. Although Commissioner Peirce stays true to her belief in a more technology- and innovation-friendly SEC, this speech was geared towards its audience and concentrated on the fund management marketplace.

Of course, she could not resist expressing her disappointment with the SEC for denying cryptocurrency-related exchange traded products, stating that “[T]he regulatory process can be a formidable roadblock to the development of new products that could provide investors with more diversity and protection in their investment portfolios.” Ms. Peirce believes the SEC should be less concerned with the volatility and risk associated with a cryptocurrency investment, which involves an investor’s personal decision as long as they have proper disclosure, and instead consider.

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.

Listen toour podcast on iTunes Podcast channel.

law·cast

Noun

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SEC Adopts Amendments to Simplify Disclosure Requirements

Posted by Securities Attorney Laura Anthony | October 16, 2018 Tags: SEC Adopts Amendments to Simplify Disclosure Requirements

In August the SEC voted to adopt amendments to certain disclosure requirements in Regulations S-K and S-X (the “S-K and S-X Amendments”) as well as conforming changes throughout the federal securities laws and related forms. The amendments are intended to simplify and update disclosure requirements that are redundant, duplicative, overlapping, outdated or superseded with the overriding goal of reducing compliance burdens on companies without reducing material information for investors. The new amendments finalize and adopt the proposed rules that had previously been issued on July 13, 2016. See my blog on the proposed rule change HERE. The final rule changes were substantially, but not entirely, as proposed.

The Regulation S-X and S-K Amendments come as a result of the Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72002 of the FAST Act. The proposing release also requested public comment on a number of disclosure requirements that overlap with, but require information incremental to, U.S. GAAP to determine whether further changes should be made.

The S-K and S-X Amendments cover:

Duplicative requirements, including duplications between financial footnote requirements and disclosures in the body of a registration statement or report;
Overlapping requirements which may not be completely duplicative. The S-K Amendments consider whether to delete certain disclosure requirements that are covered in GAAP or other financial reporting or integrate such disclosures into a single rule source;
Outdated requirements which have become obsolete due to the passage of time or changes regulations, business or technology; and
Superseded requirements which are inconsistent with recent legislation or updated rules and regulations.

The amendments are set to go effective thirty (30) days after publication in the federal register. As of the date of this blog, the amendments have not been published. There have been a few blogs and some commentary as to the reason for the delay, but regardless of the reason, the delay has caused some question as to whether certain changes will need to be implemented in the upcoming 10-Q’s to be filed for companies with a September 30 quarter-end. In particular, the new amendments will require companies to present a change in shareholders’ equity as part of its quarterly financial statements, which statement was previously only required in annual reports.

Responding to the marketplace questions, on September 25, 2018, the SEC published a new Compliance and Disclosure Interpretation (C&DI) on the matter. New question 105.09 clarifies that the amendments are effective for all filings made 30 days after publication in the federal register. However, despite this effective date, the SEC would not object if the first quarterly statement of changes in shareholder’s equity is included in a company’s Form 10-Q filed for the quarter that begins after the effective date of the amendments.

Disclosure Location

Some of the amendments change the location of information in a filing which can have a material impact. Location changes involve:

Prominence Considerations – the location of a disclosure may provide for a certain level of prominence of the information.
Financial Statement Considerations – some amendments relocate disclosure from outside to inside the financial statements, thus subjecting the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Furthermore, forward-looking statement safe-harbor protection is not available for information inside the financial statements. Conversely, some amendments relocate disclosures from inside to outside the financial statements.
Bright-line Disclosure Threshold Considerations – some amendments removed bright-line disclosure requirements.

Redundant or Duplicative Requirements

The Regulation S-K and S-X Amendments eliminate a laundry list of 25 redundant and duplicative disclosures. Most of these changes are technical and nuanced related to particular Regulation S-X GAAP and other financial statement disclosures—for example, foreign currency, financial statement consolidation, income tax disclosures, contingencies and interim accounting adjustments. As these eliminations are duplicative, they will not change the financial reporting or disclosure requirements.

Overlapping Requirements

Similar to redundant and duplicative disclosures, the SEC has identified numerous disclosure requirements that are related to, but not exactly the same as, GAAP, IFRS and other SEC disclosure obligations. The Regulation S-K and S-X Amendments delete, scale back or integrate the overlapping disclosures to eliminate the overlap.

The proposed rule release categorized changes as either deleting a disclosure requirement or integrating a requirement with another rule. Some of the proposed changes involved a change in disclosure location, with considerations outlined above in my discussion of disclosure location.

A complete detail of all the Regulation S-K and S-X Amendments related to overlapping disclosures is beyond the scope of this blog; however, a few items deserve discussion.

In general, many of the changes proposed by the SEC relate to interim financial reporting. In some cases where items are fully required to be reported in a Form 8-K, annual report or management discussion and analysis (MD&A), the SEC has eliminated the same or similar requirement from interim financial statements. For example, the SEC eliminated significant business combination pro forma financial statement requirements from interim financial statements for smaller reporting companies and Regulation A filers. The pro forma financial statements are already sufficiently required by Item 9.01 of Form 8-K. However, at this time the SEC retained the financial reporting in interim reports for a significant business disposition or discontinued operation.

In some cases, the SEC eliminated disclosures in financial statements, leaving only the disclosure in the body of the filing. For example, the SEC eliminated segment financial information from the footnotes, leaving it only in the MD&A.

In other cases, the SEC eliminated disclosure in the body of a document in favor of a financial statement disclosure. For example, the SEC eliminated a discussion of warrants, rights and convertible instruments from the body of a Form 10 or S-1, noting that a complete disclosure, including dilution, is required in financial statements.

Not all of the proposed amendments were included in the final S-K and S-X Amendments. For example, rules related to the financial disclosure requirements related to repurchase and reverse repurchase agreements have overlapping provisions. However, the comments to the proposed elimination of these overlapping requirements prompted the SEC to retain the provisions as is, and refer the requirements to FASB for potential incorporation into U.S. GAAP. Similarly, although most of the proposed amendments related to derivative accounting were included in the final rule release, the requirement to disclose where in the statement of cash flows the effect of derivative financial instruments is reported remains, again with a referral to FASB to consider incorporation with U.S. GAAP. Likewise, disclosures related to equity compensation plans remain unchanged but were referred to FASB for potential incorporation with U.S. GAAP.

Outdated Requirements

The SEC has identified disclosure requirement that have become obsolete as a result of time, regulatory, business or technological changes. The Regulation S-K and S-X Amendments amend and sometimes add, but not delete, disclosure as a result of outdated requirements.

Again, most of the outdated requirements are technical (for example, income-tax disclosures) in nature and beyond the scope of this blog. Some are common sense; for example, a reference to information being available in the SEC public reference room has been amended to include only a reference to the SEC Internet address for EDGAR filings. Another common-sense change is the elimination of the requirement to post the high and low bid or trading prices for each quarter for the prior two fiscal years in an annual 10-K. The SEC reasons that the daily market and trading prices of a security are readily available on a number of websites. Moreover, these websites allow for the download and collation of trading prices over periods of time and provide much more robust information than currently contained in a 10-K.

Superseded Requirements

The constant change in accounting and disclosure requirements and regulations have created inconsistencies in Regulation S-K and S-X. The SEC has effectuated amendments to eliminate such inconsistencies. For example, certain provisions in Regulation S-X still refer to development-stage companies, a concept that was eliminated by FASB in June 2014.

The SEC also took this opportunity to clean up some nonexistent or incorrect references that resulted from regulatory changes over time.

Further Background on SEC Disclosure Effectiveness Initiative

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

On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE. The initial proposed amendments were published on June 27, 2016, (see HERE).

In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special-interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.

On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE.. March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.

The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

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

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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SEC Strategic Plan

Posted by Securities Attorney Laura Anthony | September 18, 2018 Tags: SEC, SEC Strategic Plan, Strategic Plan

On June 19, 2018, the SEC published a draft Strategic Plan and requested public comment on the Plan. The Strategic Plan would guide the SEC’s priorities through fiscal year 2022. The Plan reiterates the theme of serving the interests of Main Street investors, but also recognizes the changing technological world with a priority of becoming more innovative, responsive and resilient to market developments and trends. The Plan also broadly focuses on improving SEC staff’s performance using data and analytics.

The Strategic Plan begins with a broad overview about the SEC itself, a topic I go back to and reiterate on occasion, such as HERE. The SEC’s mission has remained unchanged over the years, including to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. In addition, according to the Strategic Plan, the SEC:

Engages and interacts with the investing public directly on a daily basis through a variety of channels, including investor roundtables and education programs and alerts on SEC.gov;
Oversees approximately $82 trillion in securities trading annually on U.S. equity markets;
Oversees approximately $40 trillion in the U.S. fixed-income market;
Selectively reviews the disclosures and financial statements of approximately 4,300 exchange-listed public companies with an aggregate market capitalization of $30 trillion;
Oversees the activities of over 26,000 registered market participants, including investment advisors, mutual funds, exchange-traded funds, broker-dealers, municipal advisors, and transfer agents, who employ at least 940,000 individuals in the United States;
Oversees 21 national securities exchanges, 10 credit-rating agencies, 7 active registered clearing agencies, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation (SIPC), and the Financial Accounting Standards Board (FASB); and
Provides critical market services through information technology systems, such as the more than 50 million pages of disclosure documents available on the EDGAR system.

The Strategic Plan describes three main goals: (i) focusing on the long-term interests of Main Street investors; (ii) recognizing significant developments and trends in evolving capital markets and adjusting efforts to ensure the effective allocation of resources; and (iii) elevate the SEC’s performance by enhancing analytical capabilities and human-capital development.

Long-term Interests of Main Street Investors

The American workforce is getting older and living longer. Moreover, many companies no longer manage retirement plans, instead leaving individuals to manage their own 401(k)’s and similar plans. The SEC is concerned that investors do not understand the difference between a stockbroker and an investment advisor or what the responsibilities are for investment advisor.

Furthermore, the SEC is concerned that fewer companies are going public, or are going public later, leaving fewer investment opportunities for Main Street investors. The slow IPO market has been a consistent theme with the SEC and market participants over the past year. See HERE, for example, a summary of Commissioner Piwowar’s speech and HERE for this summary of a U.S. Department of Treasury report.

The SEC identified five initiatives to further their first strategic goal.

Enhance the SEC’s understanding of how retail and institutional investors access capital markets.
Enhance the SEC’s outreach, education and consultation efforts, including taking into account the diversity of businesses and investors.
Pursue enforcement and examination proceedings focused on identifying and addressing misconduct that impacts retail investors. This effort includes uncovering new methods to administer scams and Ponzi schemes and the continued focus on penny stocks.
Modernize the delivery and content of disclosures so that investors can access readable, usable and timely information. The SEC will continue to examine business and accounting disclosures and make appropriate changes and to upgrade the EDGAR system to make it more usable to retail investors.
Identify ways to increase the number and type of long-term, cost-effective investment options available to retain investors, including by increasing the number of IPO’s and public companies.

Developments and Trends in Capital Markets; Effective Allocation of Resources

Technology has fundamentally changed the way consumers interact with the securities markets. Investors rely less on traditional personalized advisory services and instead are increasingly seeking advice and pursuing trades using data analytics and executed via algorithms on electronic platforms. This trend is expected to not only continue but to grow and expand with the advent of blockchain technology. Although these changes are beneficial, there are also increased risks, especially related to cybersecurity.

In addition, with the increase in technology there is a global marketplace that interconnects geographical areas and time zones on a 24-hour cycle. Information from one market impacts others, and capital flows across markets, both geographically and in asset type, in amounts that would have been unimaginable only a few decades ago. These changes add challenges to the SEC, especially related to global market participants that may be outside the jurisdiction of the SEC’s authority. The Strategic Plan specifically refers to the recent advent of ICO’s and those that plan offerings to avoid the US federal securities laws. The SEC will need to increase its coordination with other US regulatory bodies and with foreign regulators.

The SEC identified four initiatives to further their second strategic goal of recognizing significant developments and trends in evolving capital markets and adjusting their efforts to ensure the effective allocation of resources:

Expand market knowledge and oversight capabilities to identify, understand, analyze and respond effectively to market developments, including related to market operations, clearing and settlement, and electronic trading.
Identify and correct existing SEC rules and approaches that are outdated, including by monitoring new rules which may not be functioning as intended.
Examine cyber and infrastructure strategies related to risks faced by capital markets and market participants. In addition to focusing on its own direct risks, the SEC must also ensure that market participates are effectively managing their cybersecurity risks.
Promote SEC preparedness and emergency response capabilities, including through training and testing.

Enhance Analytical Capabilities and Human Capital Development

The SEC’s success, as with all agencies and companies, depends on using resources wisely. The SEC has a goal of improving its own workforce and finding ways to utilize data and technology to improve productivity and efficiency.

The SEC has identified five initiatives to further this third strategic goal:

Focus on the SEC’s workforce to increase capabilities and promote diversity and equality.
Expand the use of risk and data analytics, including through developing a data management program that is available on an SEC-wide basis but that provides privacy protections for sensitive information.
Enhance analytics of market and industry data to prevent, detect and prosecute improper behavior.
Enhance the SEC’s internal control and risk management capabilities related to cybersecurity.
Promote collaboration among SEC offices.

The Author

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SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part II

Posted by Securities Attorney Laura Anthony | September 4, 2018 Tags: SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part II

On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law. Section 507 of the Act directed the SEC to increase the threshold under Rule 701 of the Securities Act, for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation-adjusted every five years. The Act required that the amendment be completed within 60 days and on July 18, 2018, the SEC complied and published the amendments. The amendments were effective immediately upon publication in the federal register.

On the same day, the SEC issued a concept release on potential further amendments to both Rule 701 and SEC Form S-8. The SEC is seeking public comment on ways to modernize the rules related to compensatory plans acknowledging the significant changes in both types of compensatory offerings and workforce composition in the past few decades.

Part I of this blog series discussed the Rule Change and Rule 701 in general. This Part 2 discusses the Concept Release.

Concept Release on Rule 701 and Form S-8

As the SEC notes in its press release announcing the rule change and concept release, equity compensation can be an important component of the employment relationship. In addition to preserving cash for the company’s operations, equity compensation aligns the interests of the employer with the employee and helps facilitate recruitment and retention.

Where Rule 701 allows non-reporting companies to sell securities to their employees, Securities Act Form S-8 provides a simplified registration form for reporting companies to use to issue and register securities pursuant to employee stock option or purchase agreements. Since Rule 701 and Form S-8 were last amended, forms of equity compensation have continued to evolve, and new types of contractual relationships between companies and the individuals who work for them have emerged.

The Concept Release focuses on soliciting comments related to:

“Gig economy” relationships, in light of issuers using Internet platforms to provide workers the opportunity to sell goods and services, to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption;
Whether the SEC should further revise the disclosure content and timing requirements of Rule 701(e); and
Whether the use of Form S-8 to register the offering of securities pursuant to employee benefit plans should be further streamlined.

Rule 701 Eligibility

As mentioned in my summary above, Rule 701 allows for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors under written compensatory plans. Furthermore, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

However, with the rise in technology and the Internet, there has been the concurrent increase in new and different types of employment relationships including short-term, part-time or freelance arrangements. Huge companies have developed using this “gig economy” structure including in areas of ride sharing, lodging, food delivery, household repairs, dog sitting, marketing, web development, logo design, and tech support as just a few examples.

Individuals can have relationships with multiple companies and careers based on a particular service as opposed to a particular employer. These individuals may not fit within the parameters of an “employee” or consultant or advisor for purposes of Rule 701 eligibility. However, despite the non-traditional relationship, the company would have the same motivations to provide equity compensation including cash preservation, aligning company and workforce interests and facilitating recruitment and retention.

The SEC Concept Release solicits comment regarding these “gig economy” relationships to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption. The concept release drills down on the issue with 21 questions on this subject alone.

In addition to the high-level questions related to how employees, consultants and advisors should be defined and the impact on investors and going public transactions of a larger eligibility pool, the SEC seeks input on the working of the gig economy in general such as whether an individual actually performs services for a company, or just customers and end users with the company just being a platform to obtain these customers and end users. Thought must be given to the level of control a company has over the individual and level of participation of the individual with the company in determining if such individuals should be included in an expanded eligibility regulation.

Rule 701(e) Disclosure Requirements

Although the SEC has amended Rule 701(e) to increase the threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000, it has not amended how the rule operates. In particular, the rule requires that all investors, including prior investors, receive disclosures as soon as the aggregate amount of sales reaches the $10,000,000 mark or the exemption is lost. Disclosures must be delivered within a reasonable period of time before the date of sale. The rule does not specify the manner of delivery of the disclosure. Accordingly, a company must carefully monitor issuances and ensure that disclosure goes out to all recipients of Rule 701 securities prior to actually reaching the threshold.

The SEC seeks comment on whether the rule should continue to operate such that prior investors must receive disclosure before the threshold amount is exceeded. Moreover, the SEC questions whether the consequence of failing to do so should continue to be the loss of the exemption for the entire offering. As an alternative, the SEC could create a mechanism for a company to post information made available to all investors concurrently.

Rule 701 requires that the disclosure match the financial statement requirements in Regulation A. Under Regulation A, financial statements go stale after 180 days; accordingly, once the threshold is reached, disclosures must be updated to remain current. The SEC seeks comment on this aspect of the rule as well.

Additionally, the SEC seeks comment on the timing and manner of delivery of disclosures, including issues of confidentiality of the disclosure materials.

Rule 701 Issuance Caps

The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. The SEC seeks comment on the current caps including whether the $1,000,000 figure should be increased, including eliminating the cap altogether and whether the 15% figure should have an annual cap in dollar amount.

Form S-8

Form S-8 was originally adopted in 1953 as a simplified form for the registration of securities to be issued pursuant to employee stock purchase plans. Form S-8 requires certain disclosures that can be incorporated by reference to Securities Act and Securities Exchange Act periodic reports and registration statements. A Form S-8 is effective immediately upon filing, though like any filing with the SEC, may be subject to review and comment.

A Form S-8 may only be used to register securities issued or to be issued to natural persons who are employees, consultants or advisors to a company, pursuant to a written plan. The definition of a “consultant” is consistent with Rule 701. The types of written plans vary and can include different types of employee benefit plans, Internal Revenue Code 401(k) plans, other retirement saving plans, employee stock option plans, nonqualified deferred compensation plans, incentive plans, restricted stock plans, and direct contracts for services with individual employees, consultants or advisors. The form can register new issuances or the resale of restricted securities.

The form may not be used for capital-raising purposes. In particular, no securities may be issued through a Form S-8 to consultants either (i) as compensation for any service that directly or indirectly promotes or maintains a market for the registrant’s securities, or (ii) as conduits for a distribution to the general public.

To be eligible to use Form S-8, a company must be subject to the periodic reporting requirements of Section 13 or 15(d) of the Exchange Act and must have filed all reports required to be filed in the preceding 12 months. A shell company cannot use Form S-8; however, a company is eligible 60 days after ceasing to be a shell company and the filing of Form 10 information related to operations.

The filing fee for a Form S-8 is calculated the same way as filing fees for at-the-market offering registration statements.

Request for Comment

The questions in the concept release focus on how to reduce costs and further streamline the form.

The SEC asks for input on whether the definition of a consultant under Rule 701 and Form S-8 should remain the same, including if the scope of eligible securities recipients under Rule 701 is expanded to include individuals participating in the “gig economy.”

The SEC asks several questions related to the administrative burdens associated with Form S-8 and how the form and its processing could be further simplified, such as by, for example, allowing the registration of all shares under compensatory plans as opposed to a specific number of shares.

Finally, the SEC requests comment on general matters related to Form S-8 including whether it should be eliminated and Rule 701 expanded to reporting companies. My personal view is that would not work as Form S-8 shares are registered and thus freely tradeable and Rule 701 shares are restricted.

Commissioner Kara M. Stein’s Public Statement on the Rule Change and Concept Release

Commissioner Stein issued a statement related to the Rule 701 amendments and Concept Release in which she expressed her mild pessimism about the SEC actions. Ms. Stein notes that compensatory securities issuances are not always beneficial and that the SEC should be considering whether more companies should be able to use Rule 701 and S-8 as a gating question rather than just thinking about how to expand their use. As such, she is very interested in the responses to the Concept Release.

Although she voted in favor of the rule change, she notes that “[W]hile I am still uncertain of all of the costs and benefits of such an increase, Congress did not give us discretion. Accordingly, I will support this recommendation.”

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SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part I

Posted by Securities Attorney Laura Anthony | August 28, 2018 Tags: Form S-8, Rule 701, SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part I

This Part I of the blog will focus on the rule change and Rule 701 in general.

Rule 701 – Exemption for Offers and Sales to Employees of Non-reporting Entities

Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Rule 701 is available for both domestic companies and foreign private issuers. The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

As required by Section 507 of the Act, the SEC has increased Rule 701’s threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000.

Refresher on Rule 701

Under the Securities Act, every offer and sale of securities must be registered or subject to an exemption from registration. Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. Under the rule, consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

These measures are calculated on an aggregate basis for a company and not based on separate plans or employment arrangements. For option grants, the aggregate sales price is determined when the option grant is made, not when the option becomes exercisable. For deferred compensation plans, the amount is calculated at the time of the recipient’s irrevocable election to defer. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701, a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12 month period exceeds $10 million (formerly $5 million), the company provides the following disclosures to investors within a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement(s) as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors a reasonable time before the date of the irrevocable election to defer is made.

When a company grants a restricted stock award, the date of sale is the date of grant of the award and thus the disclosure must be provided a reasonable time before the date of grant. Unlike an option or warrant, the employee does not need to take additional action to convert or exercise a restricted stock award; rather, the award vests and the stock becomes irrevocably granted to the employee by the satisfaction of conditions (such as time of employment). Accordingly, Rule 7(e)(6) requiring disclosure be delivered prior to the exercise of an option or warrant would not apply.

Rule 701 requires that the same financial statements required in Regulation A be provided as disclosure to share recipients. Rule 701 was not amended or modified when the new Regulation A/A+ rules came into effect on June 19, 2015, leaving open the question as to which of the different Regulation A+ financial statement requirements need be used in a Rule 701 disclosure. The SEC subsequently issued a C&DI to clarify that a company can elect to provide the financial statements required under either Tier 1 or Tier 2 of Regulation A, regardless of the value of securities being offered or issued under Rule 701.

The Rule 144 holding period begins for the recipient “when the person who will receive the securities is deemed to have paid for the securities and thereby assumed the full risk of economic loss with respect to them.” For negotiated employment agreements, the holding period begins on the date the investment risk passes to the employee, which generally is the date of the agreement. For restricted awards that vest over time and are conditioned solely on continued employment or satisfaction of other conditions not tied to the employee’s performance, the holding period begins on the date of the agreement. Like any other derivative security, if the employee is required to pay additional consideration for the securities (such as through exercise of a warrant or option), a new holding period would begin on the date of that payment (i.e., the date of the new investment decision).

As with all other Securities Act registration exemptions, the company is still subject to the antifraud, civil liability and other provisions of the federal securities laws. In addition, Rule 701 is not available for plans or schemes to circumvent the purpose of the rule, which is for compensatory purposes, and not to raise capital. Moreover, Rule 701 is not available to exempt any transaction that is in technical compliance with this section but is part of a plan or scheme to evade the registration provisions of the Securities Act.

In 2016 the SEC issued several C&DI related to Rule 701, focusing on merger and acquisition transactions, including reverse mergers. In a merger transaction where the acquirer assumes derivative securities of the target (such as options and warrants) and, as such, they become economically equivalent derivative securities of the acquirer, no exemption need be relied upon for the assumption and transfer of the obligation to the acquirer as long as the derivative securities (again, such as employee options and warrants) were properly issued under Rule 701 and the transfer to the acquirer does not require the consent of the holders of the derivative securities.

In other words, if a company issued options or warrants to its employees under a Rule 701 plan and that company is later acquired, such as through a reverse merger with a public shell company, the options or warrants could become obligations of the public company, without further registration or reliance on a registration exemption. As long as the options or warrants were properly issued under Rule 701 in the first place, the later exercise and conversion into other securities of the acquiring company, such as common stock, would also be exempt from registration. Moreover, where the acquiring company is subject to the Securities Exchange Act reporting requirements, the Exchange Act reports would satisfy any disclosure requirements under Rule 701(e).

Securities issued under Rule 701 would aggregate with securities issued under the same rule after a merger or acquisition. Rule 701 issuances by the target and acquirer aggregate for all purposes, including determining issuance limits under the rule and disclosure obligations to share recipients. Assuming the $1,000,000 limit, if the target company had issued Rule 701 securities up to $500,000, the combined post-merger entity would only be able to issue an additional $500,000 in that 12-month period. However, the combined companies could use a post-merger balance sheet in determining total assets for purposes of calculating allowable continued issuances under Rule 701. Likewise, the combined companies can use post-merger financial statements to satisfy the disclosure obligations required under Rule 701.

Rule 701 does not preempt state law and accordingly, in addition to complying with Rule 701, the company also must comply with any applicable state law relating to the issuance.

Other Exemptions for Compensatory Issuances

Although Rule 701 is the most commonly used exemption for the issuance of compensatory securities, companies may also directly rely on Securities Act Section 4(a)(2) or the “no sale” theory, which would not require specific disclosures. The “no sale” theory relates to the issuance of compensatory grants made by employers to broad groups of employees pursuant to broad-based stock bonus plans without Securities Act registration under the theory that the awards are not an offer or sale of securities under the Securities Act. Where securities are awarded to employees at no direct cost through broad-based bonus plans, the SEC has taken the position generally that there has been no sale since employees do not individually bargain to contribute cash or other tangible or definable consideration to such plans. To the contrary, where securities are awarded to or acquired by employees pursuant to individual employment arrangements, such arrangements involve separately bargained consideration, and a sale of the securities has occurred.

Application of Exchange Act Section 12(g) to Employee Compensation Plans; Determining Holders of Record

A company that is not a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. The same thresholds apply to termination of registration and suspension of reporting obligations.

Section 12(g) establishes a non-exclusive safe harbor that companies may follow to exclude persons who received securities pursuant to employee compensation plans when calculating the shareholders of record for purposes of triggering the registration requirements. Exchange Act Section 12(g)(5) provides that the definition of “held of record” shall not include securities held by persons who received them pursuant to an “employee compensation plan” in exempt transactions. By its express terms, this new statutory exclusion applies solely for purposes of determining whether an issuer is required to register a class of equity securities under the Exchange Act and does not apply to a determination of whether such registration may be terminated or suspended.

The statute establishes an exclusion for security holders who received their stock in unregistered employee stock compensation plans, and provides a safe harbor for determining whether holders of their securities received them pursuant to an employee compensation plan in exempt transactions.

In its Section 12(g) rules, the SEC incorporates Rule 701(c) and the guidance under that rule for issuers to rely on in their Section 12(g) analysis. The proposed safe harbor allows an issuer to conclude that shares were issued pursuant to an employee compensation plan in an unregistered transaction as long as all the conditions of Rule 701(c) are met, even if other requirements of Rule 701, such as 701(b) (volume limitations) or 701(d) (disclosure delivery requirements), are not met.

Under the definition of “held of record,” for purposes of Section 12(g), an issuer may exclude securities that are either:

held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or
held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

The SEC also excludes securities issued under the “no sale” exemption to registration theory from the “held of record” definition, including shares issued as a dividend to employees. That is, the SEC is excluding securities that did not involve a sale within the meaning of Section 2(a)(3), as well as exempt securities issued under Section 3 of the Securities Act. Examples of securities issued under Section 3 include exchange securities under sections 3(a)(9) and 3(a)(10).

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SEC Adopts Inline XBRL

Posted by Securities Attorney Laura Anthony | August 21, 2018 Tags: Inline XBRL, SEC, SEC Adopts Inline XBRL, XBRL

On June 28, 2018, the SEC adopted amendments to the XBRL requirements to require the use of Inline XBRL for financial statement information and fund risk/return summaries. Inline XBRL involves embedding XBRL data directly into the filing so that the disclosure document is both human-readable and machine-readable. Accordingly, no separate XBRL filings are required. The amendments also eliminate the requirement for companies to post XBRL data on their websites.

In 2009 the SEC adopted rules requiring companies to provide the information from the financial statements accompanying their registration statements and periodic and current reports in machine-readable format using XBRL by submitting it to the SEC as exhibits to their filings and posting it on their websites, if any. Since that time, however, many industry participants have expressed concerns regarding the quality of, extent of use of, and cost to create XBRL data. In fact, the SEC itself has discovered quality issues with the data in XBRL. As with all regulatory requirements, XBRL has its proponents and supporters as well.

Pressure from both the naysayers and proponents, as well as the clear inefficiency of duplicative postings, drove the current amendments.

The requirement for companies and funds to post XBRL data on their websites will be eliminated upon the effective date of the amendments. The Inline XBRL requirements will become effective on a phased schedule as follows:

Large accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2019.
Accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2020.
All other filers will be required to comply beginning with fiscal periods ending on or after June 15, 2021.
Filers will be required to comply beginning with their first Form 10-Q filed for a fiscal period ending on or after the applicable compliance date.

In its press release announcing the amendments, the SEC cited the following potential benefits:

Is expected to reduce, over time, XBRL preparation time and effort by eliminating duplication and facilitating the review of XBRL data.
Gives the preparer full control over the presentation of XBRL disclosures within the HTML filing.
Is expected to reduce the likelihood of inconsistencies between HTML and XBRL filings and improve the quality of XBRL data.
Enhances the usability of structured disclosures for investors through greater accessibility and transparency of the data and enhanced capabilities for data users, who would no longer have to view the XBRL data separately from the text of the documents.

Statement of Commissioner Hester M. Peirce

Commissioner Hester Peirce dissented from the amendments and made a statement related to her dissenting position. Although Ms. Peirce supports a shift to Inline XBRL in general and supports the elimination of website-posting requirements, she doesn’t in general support the use of Inline XBRL for smaller public companies or funds due to the costs associated with switching to this technology.

Commissioner Peirce, who is consistently pro-business and very thoughtful in her role as a regulator, states:

As regulators, we have broad authority—authority we do not hesitate to use—to reach into the day-to-day operations of the companies we oversee. Our rules can radically change the way companies conduct their business, organize their workflow, and allocate resources. Today’s rule will require the adoption of very specific technology to be used in a very specific way on an ambitious timeline. When we issue such a mandate, it has wide-ranging effects on the industry, including knock-on effects on vendors, investors, and others who interact with the relevant filers. By mandating the use of inline XBRL, we are privileging one form of technology over present and potential future competitors. When we take this step, therefore, we must be very certain that we are choosing the right technology at the right time for the right purpose in the right set of companies.

She notes that companies have been able to voluntarily use Inline XBRL under a pilot program, but the uptake on that use has been minimal, with only 1.8% of all eligible filers using the technology and most of those being accelerated or large accelerated filers. She further points out that the benefit of XBRL at all for smaller companies is questionable, with few investors utilizing its technology, adding, “[B]efore requiring small filers to invest considerable resources in implementing inline XBRL, we should be sure that the data is actually useful to their investors.”

The costs and burdens on funds will be even greater, with investors bearing the cost burden without real benefit. In fact, Ms. Peirce suggests that the users of fund XBRL risk/return data are primarily data aggregators who sell the information.

The Author

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SEC Issues Additional C&DI On Use Of Non-GAAP Measures

Posted by Securities Attorney Laura Anthony | August 7, 2018 Tags: Non-GAAP Measures, Use Of Non-GAAP Measures

On April 4, 2018, the SEC issued two new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies in connection with business combinations. The two new C&DI follow two other C&DI which were issued on October 17, 2017 (see HERE).

The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

My prior two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE and HERE.

GAAP continues to be and has consistently been criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.

On the flip side, the plaintiff’s bar has habitually used Regulation G and Item 10(e) of Regulation S-K, and in particular the GAAP reconciliation disclosure requirements, to pursue frivolous lawsuits in the context of business combinations. Business combinations as a whole are one of the most frequent targets for such litigation.

The fall 2017 C&DI was an effort by the SEC to provide some clarity on the requirements. CD&I 101.01 addressed whether forecasts provided to a financial advisor in relation to a business combination transaction would be considered non-GAAP financial measures requiring compliance with applicable rules. In particular, the SEC confirmed that providing forecasts to a financial advisor in connection with a business combination transaction would not be considered non-GAAP financial measures.

Item 10(e)(5) of Regulation S-K and Rule 101(a)(3) of Regulation G provide that a non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, SEC rules, or pursuant to specific government regulations or SRO rules that are applicable to a company. Accordingly, financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (i) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (ii) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

Although the disclosure of projections to a financial advisor in a business combination transaction does not implicate rules related to non-GAAP financial measures, that same disclosure in a registration statement, proxy statement or tender offer statement would need to comply with Regulation G and Item 10(e) of Regulation S-K.

In the second C&DI issued in the fall, the SEC addressed the limited exemptions from the non-GAAP rules for communications relating to business combination transactions. In particular, Rule 425 of the Securities Act requires that certain business combination communications, that would not be considered solicitation materials in other contexts, be filed with the SEC, generally as part of a registration statement on Form S-4, proxy statement or tender offer statement. Likewise, limited solicitations under Exchange Act Rule 14a-12 and 14d-2(b)(2) that are made prior to filing a proxy statement are exempted from the non-GAAP measure requirements.

Other than the limited exemptions set forth in the rules listed above, and communications to a financial advisor, business combination communications must comply with Regulation G and Item 10(e) of Regulation S-K related to non-GAAP financial measures, including a reconciliation to comparable GAAP numbers and the reasons for presenting the non-GAAP numbers.

Following the issuance of those C&DI, some plaintiffs’ lawyers took advantage of a perceived lack of clarity and suggested that projections disclosed to bidders or a board of directors did require GAAP reconciliation and when none was provided, a violation had occurred.

Accordingly, on April 4, 2018, the SEC provided further clarity. New C&DI 101.02 is direct and to the point, providing:

Question: Can the registrant rely on the Answer to Question 101.01 if the same forecasts provided to its financial advisor are also provided to its board of directors or board committee?

Answer: Yes.

New question 101.03 likewise provides:

Question: A registrant provides forecasts to bidders in a business combination transaction. To avoid anti-fraud concerns under the federal securities laws or ensure that the other disclosures in the document are not misleading, it determines that such forecasts should be disclosed. Are the financial measures contained in forecasts disclosed for this purpose considered non-GAAP financial measures?

Answer: If a registrant determines that forecasts exchanged between the parties in a business combination transaction are material and that disclosure of such forecasts is required to comply with the anti-fraud and other liability provisions of the federal securities laws, the financial measures included in such forecasts would be excluded from the definition of non-GAAP financial measures and therefore not subject to Item 10(e) of Regulation S-K and Regulation G.

Refresher on Regulation G and Item 10(e) of Regulation S-K

Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K.

Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

Definition of non-GAAP financial measure and exclusions

A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

Regulation G and Item 10(e) requirements

Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading.

As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.

Regulation G

Item 10(e)

Scope

All public disclosures by Exchange Act registrants of information that contains non-GAAP financial measures, including:

press releases;
conference calls;
PowerPoint presentations; and
other media.

Limited exclusion for business combination communications.

All filings with the SEC under the Securities Act and the Exchange Act, including:

Securities Act registration statements;
free writing prospectuses (if included or incorporated by reference into a registration statement);
annual reports on Form 10-K;
quarterly reports on Form 10-Q;
current reports on Form 8-K; and
proxy statements.

Does not apply to registered investment companies. Special rules apply to foreign private issues. Limited exclusion for business combination communications.

Required Disclosure

Whenever a registrant makes public a non-GAAP financial measure, it must:

present the most directly comparable financial measure calculated and presented in accordance with GAAP; and
reconcile the differences between the non-GAAP financial measure to the most directly comparable GAAP measure.
For oral, telephonic, webcast or similar disclosures, the required disclosure of a comparable GAAP measure and reconciliation can be satisfied by posting the information on the company’s website at the time of the disclosure and disclosing the website location in the disclosure.

Whenever a registrant presents a non-GAAP financial measure, it must (in addition to the requirements for Regulation G):

present, with equal or greater prominence, the most directly comparable financial measure calculated and presented in accordance with GAAP;
reconcile the differences between the non-GAAP financial measure and the comparable GAAP measure;
disclose the reasons why the company’s management believes that the presentation of the non-GAAP financial measure provides useful information to investors regarding the company’s financial conditions and results of operations; and
to the extent material, disclose the additional purposes, if any, for which the registrant’s management uses such non-GAAP financial measure.

Earnings Releases

A registrant must:

present the most directly comparable GAAP financial measure in the release
reconcile the two measures; and
be cognizant of Rule 100(b) preventing misleading information.

Subsection (1)(i) of Item 10(e) applies to a registrant’s Item 2.02 Form 8-K (pursuant to which earnings releases are required to be furnished to the SEC). Registrants must either include in the body of the current report or in the earnings release itself:

disclosure as to why management believes any non-GAAP financial measure included in the release is useful; and
for what additional purposes, if any, management uses the measure.

SEC Non-GAAP Measure Prohibitions

A registrant is not permitted to make any non-GAAP financial measure public if it contains a material misstatement or omits information needed to make the measure not misleading.

Measures of performance may be presented on a per-share basis; however, per-share presentation of measures of liquidity is prohibited.

A full non-GAAP income statement may not be used as it places undue prominence on the non-GAAP information.

A registrant is not permitted to:

exclude charges or liabilities that required or will require cash settlement from non-GAAP liquidity measures (except for EBIT and EBITDA);
adjust a non-GAAP performance measure to eliminate or smooth a nonrecurring, infrequent or unusual item where such item is reasonably likely to recur within two years or there has been a similar charge or gain within the prior two years; or
use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.

Companies may adjust for recurring charges within the two-year look-forward/look-back window, but the adjustment may not be classified as non-recurring, infrequent or unusual.

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SEC Amends Definition of “A Smaller Reporting Company”

Posted by Securities Attorney Laura Anthony | July 17, 2018 Tags: SEC, Smaller Reporting Company

On June 28, 2018, the SEC adopted the much-anticipated amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. The amendments come almost two years to the day since the initial publication of proposed rule changes (see HERE).

Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.

As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.

The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton as directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

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”) have come to the forefront over the past couple of years. 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.

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Over the years Regulation S-K has not been kept current with other Rule changes, the arduous reporting requirements for smaller companies has resulted in stifled capital formation and fewer smaller IPOs, and investors have questioned the quality and relevancy of information required to be included in reports.

The SEC disclosure requirements are scaled based on company size. The SEC established the smaller reporting company category in 2007 to provide general regulatory relief to these entities. Prior to this rule change, a “smaller reporting company” was defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K, as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

The following table, copied from the SEC rule release, summarizes the scaled disclosure accommodations available to smaller reporting companies:

Regulation S-K
Item	Scaled Disclosure Accommodation
101 − Description of Business	May satisfy disclosure obligations by describing the development of its business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non- smaller reporting companies.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters	Stock performance graph not required.
301 – Selected Financial Data	Not required.
302 – Supplementary Financial Information	Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)	Two-year MD&A comparison rather than three-year comparison. Two year discussion of impact of inflation and changes in prices rather than three years. Tabular disclosure of contractual obligations not required.
305 – Quantitative and Qualitative Disclosures About Market Risk	Not required.
402 – Executive Compensation	Three named executive officers rather than five. Two years of summary compensation table information rather than three. Not required: · Compensation discussion and analysis. · Grants of plan-based awards table. · Option exercises and stock vested table. · Pension benefits table. · Nonqualified deferred compensation table. · Disclosure of compensation policies and practices related to risk management. · Pay ratio disclosure.
Regulation S-K
Item	Scaled Disclosure Accommodation
404 – Transactions With Related Persons, Promoters and Certain Control Persons16	Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance	Audit committee financial expert disclosure not required in first year. Compensation committee interlocks and insider participation disclosure not required. Compensation committee report not required.
503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges	No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits	Statements regarding computation of ratios not required.
Regulation S-X
Rule	Scaled Disclosure
8-02 – Annual Financial Statements	Two years of income statements rather than three years. Two years of cash flow statements rather than three years. Two years of changes in stockholders’ equity statements rather than three years.
8-03 – Interim Financial Statements	Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired	Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information	Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired	Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements	Less stringent age of financial statements requirements.

Final Amendments to Smaller Reporting Company Definition

The SEC has competing goals of protecting investors and the marketplace through requiring companies to provide disclosure needed to make informed investment and voting decisions and promoting capital formation and reducing compliance costs for smaller companies. The SEC believes that by raising the financial thresholds for the smaller reporting company definition and thereby expanding the number of companies eligible to use the available scaled disclosure, it will be satisfying its goals and appropriately responding to comments and recommendations by the Advisory Committee on Small and Emerging Growth Companies, the SEC Government Business Forum on Small Business Capital Formation, Congress and industry commenters.

The SEC summarizes many of these recommendations, initiatives and comments in its rule release. For example, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For a summary of the recommendations, see my blog HERE. The FAST Act, which was passed into law on December 4, 2015, required the SEC to scale or eliminate duplicative, antiquated or unnecessary disclosure requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K.

The SEC considered comments it received to the initial proposed rule release (see HERE) and comments it received in response to the published concept release and request for public comment on Regulation S-K. My two-part blog on that concept release can be read HERE and HERE. As indicated above, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

My blog HERE contains a summary of the scaled disclosures available to smaller reporting companies. In addition, the FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies. A smaller reporting company may now incorporate any documents filed by the company, following the effective date of a registration statement, into such effective registration statement. In what was probably unintended in the drafting, the FAST Act changes only include smaller reporting companies and not emerging growth companies or non-accelerated filers. Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference. Accordingly, among the other benefits of the current proposed rule change, the number of companies that can utilize forward incorporation by reference in a Form S-1 will increase.

Amendments to Accelerated Filer and Large Accelerated Filer Definitions

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton has directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

The public float threshold for an accelerated filer is $75 million. Companies that currently file as an accelerated filer would continue to do so under the new rules, but would be able to benefit from the scaled disclosure requirements available to smaller reporting companies. 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

Statements of Commissioners on Rule Amendment

Commissioners Hester Peirce and Michael Piwowar made public statements regarding the rule change both supporting the amendment but expressing disappointment that it did not also include a change in the definition of an accelerated filer. Both commissioners think it is not enough to reduce regulatory burdens to encourage more companies to go public. Section 404(b) of the Sarbanes-Oxley Act is one of the largest burdens that face smaller public companies and Commissioner Piwowar believes that until that is changed, there will be no improvement in efforts to raise capital by smaller companies. Ms. Peirce goes further, stating that the failure to make a conforming change to the definition of an accelerated filer will actually be confusing to companies. That is, prior to the rule change, a smaller reporting company was always exempted from Section 404(b) compliance; however, now that will not be the case.

Ms. Peirce points to a poignant example from the comment letters. A group of biotech companies rightfully stated that money spent on compliance is less money spent on research and development and that investors in a smaller biotech company are more interested in getting FDA approval than the auditors’ blessing on internal controls.

On the upside, Chair Clayton has committed to continue to review this matter and work on changes to the definition of accelerated filer and/or changes to the requirements of 404(b) compliance.

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FinCEN’S Role In Cryptocurrency Offerings

Posted by Securities Attorney Laura Anthony | July 10, 2018 Tags: Cryptocurrecy, Cryptocurrecy Offerings, Cryptos, FinCEN, FinCEN’S Role In Cryptocurrecy Offerings

In the continuing dilemma over determining just what kind of asset a cryptocurrency is, multiple regulators have expressed opinions and differing views on regulations. Likewise, multiple regulators have conducted investigations and initiated enforcement proceedings against those in the cybersecurity space. The SEC has asserted the opinion that most, if not all, cryptocurrencies are securities; the CFTC has found them to be commodities; the IRS’s official definition is the same as the CFTC, and in particular a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value, and now the Financial Crime Enforcement Network (FinCEN) has asserted that issuers of cryptocurrencies are money transmitters.

In particular, in a letter written to the US Senate Committee on Finance on February 13, 2018, FinCEN indicates that it expects issuers of initial coin offerings (ICOs) to comply with the Bank Secrecy Act (BSA), including its anti-money laundering (AML) and know your customer (KYC) requirements. FinCEN’s letter responded to a December 14, 2017 directed to it from the US Senate Committee on Finance requesting information on FinCEN’s oversight and enforcement capabilities over virtual currency financial activities. As with other agencies such as the SEC and CFTC, FinCEN desires to promote the financial innovation that can come with blockchain technology and cryptocurrencies, while preventing criminals, hackers, sanctions evaders and hostile foreign actors.

Virtual currency exchanges and administrators

FinCEN has been working with the Office of Terrorism and Financial Intelligence (FTI) to ensure that AML and procedures to combat the financing of terrorism apply to virtual currency exchanges and administrators that are in the US or do business in whole or part in the US, but do not have a physical presence here. Virtual currency exchanges and administrators have been subject to the BSA’s money transmitter requirements since 2011. In 2013 FinCEN issued specific guidance that explicitly states that virtual currency exchangers and administrators are money transmitters that must comply with the BSA. An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency or other value that substitutes for currency, is a money transmitter that is subject to the BSA.

To assist in identifying risks and the illicit use of virtual currency, including the abuse of virtual currency to facilitate cyber crime, money laundering, terrorist financing, black market sales of illegal or illicit products and services and other high-tech crimes, FinCEN examines BSA filings from virtual currency money services businesses (MSB) and other emerging payments providers, including filings pertaining to digital coins, tokens and ICOs. Trends, red flags and risks and reported to US law enforcement and other governmental agencies.

Entities that are subject to the BSA must: (i) register with FinCEN as a MSB; (ii) prepare a written AML compliance program that is designed to mitigate risks, including AML risks, and to ensure compliance with all BSA requirements including the filing of suspicious activity reports (SAR) and currency transaction reports; (iii) keep records for certain types of transactions at specific thresholds; and (iv) obtain customer identification information sufficient to comply with the AML program and recordkeeping requirements.

SAR reports that are filed with FinCEN have identifying information about the owner/customer. In cases where a bitcoin address is identified, FinCEN performs a blockchain analysis which can often enable investigators to tie it to a virtual currency exchanger, hosted wallet, or other source that may have the identity of the account owner. Blockchain network analytic tools can also tie a targeted bitcoin address to other persons that have transacted with a particular bitcoin address. The investigative process may involve the issuance of subpoenas and FinCEN cooperates with law enforcement to help identify and trace bitcoin used in criminal activity.

FinCEN also conducts reviews and exams of registered MSBs. Of the approximate 100 registered entities, FinCEN has examined approximately one-third and has initiated several enforcement proceedings as a result of those exams. However, financial crimes and terrorism are international issues and not all countries regulate virtual currency businesses or require them to keep records. Accordingly, FinCEN has been working to encourage foreign countries to regulate these businesses and to cooperate in criminal investigations.

ICO issuers

FinCEN is working with the SEC and CFTC to clarify and enforce AML and counterterrorism obligations of businesses that engage in ICO activities. Although the FinCEN letter indicates that the obligation to comply with the BSA and its ensuing AML, registration, SAR and other requirements depends on the nature of the financial activity and a facts-and-circumstances analysis, ICO participants have unilaterally interpreted the FinCEN letter as requiring all ICO issuers to comply in one way or another.

FinCEN specifically states that an issuer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value, including fiat currency, is a money transmitter that must register as an MSB and comply with the BSA, including AML and KYC procedures. However, to the extent that an ICO involves the sale of securities or derivatives that would be under the jurisdiction of the SEC through its regulation of broker-dealers or CFTC through its regulation of merchants and brokers in commodities, those entities could comply with the SEC and CFTC’s AML and counterterrorism requirements.

The Securities Exchange Act of 1934 (“Exchange Act”) specifically requires brokerage firms to comply with the BSA and FinCEN rules. Brokerage firms are also required to comply with AML rules established by FINRA, including FINRA Rule 3310. The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. FINRA also provides a template to assist small firms in establishing and complying with AML procedures.

In May 2016, FinCEN issued new final rules under the BSA requiring financing institutions, including brokerage firms, to adopt additional anti-money laundering (AML) procedures that include specific due diligence and ongoing monitoring requirements related to customer risk profiles and customer information. The rules also require financial institutions to collect and verify information about beneficial owners and control person of legal entity customers. My blog on those rules can be read HERE.

FinCEN requires that financial institutions address the following four key elements in all of their AML programs: (i) customer identification and verification; (ii) beneficial ownership identification and verification; (iii) understanding the nature and purpose of customer relationships to develop risk profiles; and (iv) ongoing monitoring for reporting suspicious transactions and maintaining and updating customer information.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on platforms that trade cryptocurrencies and more on the continued regulatory confusion in the space, see HERE.

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