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SEC Spring 2018 Regulatory Agenda

Posted by Securities Attorney Laura Anthony | June 26, 2018 Tags: SEC Chairman Jay Clayton, SEC Spring 2018 Regulatory Agenda

On May 9, 2018, the SEC posted its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. According to the preamble, information in the agenda was accurate as of March 13, 2018. On April 26, 2018, SEC Chairman Jay Clayton gave testimony before the Financial Services and General Government Subcommittee of the House Committee on Appropriations regarding the SEC’s requested fiscal year 2019 budget. This blog will summarize the newest regulatory agenda and SEC upcoming budgetary requests.

Usually the agenda is separated into two categories: (i) Existing Proposed and Final Rule Stages; and (ii) Long-term Actions. The Spring 2018 agenda is broken down by (i) “Prerule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame have been consistently reduced in each agenda over the last two years. The newest agenda has 21 items, the semiannual list published in December, 2017 had 26, the July 2017 list contained 33 legislative action items to be completed, and the prior Fall 2016 list had 62 items.

Whereas the agenda concentrates on specific rulemaking, the SEC’s budget request seems more focused on the SEC’s need to modernize its information technology infrastructure and improve cybersecurity risk management. Of course budgetary needs encompass enforcement which would not appear on a rulemaking agenda. Chair Jay Clayton does, however, address the regulatory agenda in his budget request testimony, specifically noting that the reduced number of items on the short term regulatory list does not indicate a shift in the SEC’s needs and focus, but rather is meant to be more realistic regarding what the SEC can accomplish in a 12-month period.

Whereas the SEC asked for an increase of $100 million in its budget for fiscal year 2018, the current requested increase is $60 million from $1.652 billion to $1.658 billion. Chair Clayton’s particular areas of focus include (i) leveraging technology and enhancing cybersecurity and risk management; (ii) facilitating capital formation; (iii) protecting Main Street investors through multiple channels, including focusing on the most vulnerable investors, markets that are fertile ground for fraud and market integrity efforts such as combating insider trading, market manipulation and accounting fraud; (iv) maintaining effective oversight of changing markets; and (v) supporting SEC leasing efforts. The increased budget would also lift the current hiring freeze and allow the hiring of approximately 100 positions to help fill the approximately 400 position that were lost during the freeze.

Related to technology and cybersecurity, the SEC has an immediate plan to (i) invest in information security to improve monitoring, protect against advanced persistent threats and strengthen risk management; (ii) retire antiquated IT systems to improve cybersecurity; (iii) expand data analytics tools to facilitate earlier detection of potential fraud or suspicious behavior and better identify high-risk activities deserving examination; and (iv) modernize the EDGAR electronic filing system to make it more secure, more useful for investors and less burdensome for filers. For more information on the SEC’s cybersecurity efforts and the EDGAR hacking, see HERE and HERE

Regarding the need to facilitate capital formation, Chair Clayton testified about different initiatives the SEC has already undertaken, such as the staff rule allowing confidential submissions of registration statements (see HERE). On a forward-looking basis, Chair Clayton admits that there is a need to encourage small and emerging growth companies to access public markets; however, he does not make any particular suggestions, but rather just states that the SEC is trying to come up with ideas and initiatives.

In the area of protections for Main Street investors and markets, the SEC is focused on conduct by investment advisors and broker-dealers. Where Clayton sees the need to increase standards of conduct for both investment advisors and broker-dealers, he, like many in the marketplace, is not an advocate of the Department of Labor’s fiduciary rule. The SEC also supports “vigorous enforcement” against fraud and improper market activity by both market insiders such as investment advisors and broker-dealers, and by all market participants.

The Unified Agenda of Regulatory and Deregulatory Actions

The first Agendas published after the 2016 presidential election stated that the Agenda “represents the beginning of fundamental regulatory reform and a reorientation toward reducing unnecessary regulatory burden on the American people.” Furthermore, the Office states, “[B]y amending and eliminating regulations that are ineffective, duplicative, and obsolete, the Administration can promote economic growth and innovation and protect individual liberty.”

Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives. Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action. The SEC is not the only agency with a reduced Agenda. Agencies withdrew over 1,600 actions that were initially proposed in the Fall 2016 Agenda. Also, adding transparency for those of us who like to stay up on these matters, the agencies will now post and make public their list of “inactive” rules.

SEC Flex Regulatory Agenda

Only 11 items are listed in the final rule stage. On the Agenda in the final rule stages are Regulation S-K disclosure updates and simplification rule changes we have all expected. The proposed rule change was issued in October 2017, a summary of which can be read HERE. Business, Financial and Management Disclosure Required by Regulation S-K remains in the proposed rule stage, continuing the topic of disclosure reform.

Included in the final rule stage are amendments to the smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems. Amendments to the interactive data (XBRL) program have been moved up from proposed to final rule stage since July 2017.

Disclosure on hedging by employees, officers and directors was moved from long-term action to final rule stage. The proposed rules were issued in February 2015 (see HERE) and will result in checking another box on the Dodd-Frank rulemaking list. Also moved from proposed to final is implementation of FAST Act report recommendations (see HERE).

Also included for final rules are amendment to the SEC’s Freedom of Information Act Regulations, modernization of property disclosure for mining companies, investment company reporting modernization and amendments to the Investment Advisers Act, disclosure or order handling information, and amendments to municipal securities rules.

Items of interest in the proposed rule stage include amendments extending the testing-the-waters provisions to non-emerging growth companies (see current testing-the-waters provisions HERE) which were previously on the long-term list; financial disclosures about entities other than the registrant (see HERE), disclosure of payments by resource extraction issuers, amendments to the financial disclosure for registered debt security offerings, filing fee processing updates, bank holding company disclosures, exchange traded funds, auditor independence with respect to loans or debtor-creditor relationships, amendments related to fair access to investment research, fund of fund arrangements, investment company liquidity disclosure, and amendments to the Whistleblower Program Rules.

Rule on disclosure for unit investment trusts and offering variable insurance products, use of derivatives by registered investment companies and business development companies, Business, Financial and Management Disclosure Required by Regulation S-K, personalized investment advice standards of conduct, and amendments to marketing rules under the Advisors Act, are also included in the proposed rule stage.

Still on the long-term actions are rules related to reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), Form 10-K summary, and revisions to audit committee disclosures.

Items on the long-term agenda include amendments to the accredited investor definition (see HERE), registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

Other items of interest on the long-term action list include simplification of disclosure requirements for emerging growth companies and forward incorporation by reference on Form S-1 for smaller reporting companies (EGCs may already incorporate by reference – see HERE), Regulation Crowdfunding amendments, several securities-based swaps regulatory actions, conflict minerals amendments, amendments to Guide 5 on real estate offerings and Form S-11, and incentive-based compensation arrangements.

Added as a Prerule Stage item is fund retail investor experience and disclosure requests for comment.

Regulation A amendments are on the long-term action list. I am hopeful that these amendments may include an increase in the offering limits and opening up Regulation A to reporting issuers. See HERE. Moreover, now that the Economic Growth, Regulatory Relief and Consumer Protection Act has been signed into law requiring that Regulation A be amended to allow for use by reporting companies, I suspect this item will be moved up the line.

Not included in previous lists, and now on the long-term action list, is Regulation Finders. The topic of finders has been ongoing for many years, and I am extremely pleased to see it make the list. See HERE for more information.

Still not on the short-term agenda are future Dodd-Frank rules, including proposed regulatory actions related to pay for performance (see HERE), executive compensation clawback (see HERE) (which is not on the agenda at all), and clawbacks of incentive compensation at financial institutions (also not on the list at all), although some of these items remain on the “long-term actions” schedule.

The SEC rulemaking agenda may not include further rulemaking on many Dodd-Frank rules, but it also does not include specific rulemaking to repeal existing regulations, such as the pay ratio disclosure rules which were adopted in August 2015 and initially apply to companies for their first fiscal year beginning on or after January 1, 2017. See HERE for more information on this rule. The pay ratio rules do not apply to emerging-growth companies, smaller reporting companies, foreign private issuers, U.S-Canadian Multijurisdictional Disclosure System filers, and registered investment companies. All other reporting companies are subject to the new rules. In October 2016 the SEC published five new compliance and disclosure interpretations (C&DIs) on certain aspects of the final rules. The C&DIs covered two main topics: (i) the use of a consistently applied compensation measure in identifying a company’s median employee; and (ii) the application of the term “employee” to furloughed employees and independent contractors or “leased” workers.

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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The 2017 SEC Government-Business Forum On Small Business Capital Formation Final Report

Posted by Securities Attorney Laura Anthony | June 12, 2018 Tags: Small Business Capital Formation, The 2017 SEC Government-Business Forum On Small Business Capital Formation Final Report

The SEC has published the final report and recommendations of the 2017 annual Government-Business Forum on Small Business Capital Formation (the “Forum”). As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation. The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation. I previously summarized the opening remarks of the SEC Commissioners. See HERE.

The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations. Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. In 2015 the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also in 2015 the forum recommended changes to Rules 147 and 504, which recommendations were considered in the SEC’s rule changes that followed. See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

The 2017 Forum had two breakout groups which discussed exempt securities offerings, including micro offerings and smaller registered and Regulation A offerings. Many of the recommendations relate to Regulation A. I recently wrote an update on Regulation A, including many suggestions recommended by the Forum. For a complete review of Regulation A and suggested changes, see HERE.

Forum Recommendations

The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

The first recommendation was also the first recommendation last year. As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
The SEC should issue guidance for broker-dealers, transfer agents and clearing firms regarding Regulation A issued securities and OTC securities. Moreover, the SEC should revise Regulation A to: (i) mandate blue sky preemption for secondary trading of Regulation A Tier 2 securities; (ii) allow at-the-market offerings; (iii) allow all reporting companies to use Regulation A; (iv) increase the maximum offering amount in any twelve-month period from $50 million to $75 million for Tier 2 offerings; (v) consider overriding any state advance notice requirements and putting a limit on state filing fees; (vi) require portals conducting Regulation A offerings to be registered similar to funding portals under Regulation Crowdfunding and require the portals to make disclosures, including those related to compensation.
The SEC should lead a joint effort with FINRA to provide clear guidance for Regulation Crowdfunding offerings.
Related to Regulation Crowdfunding, the SEC should: (i) remove the cap for investments by accredited investors; (ii) raise the investment cap for non-accredited investors by making the limit applicable to each investment instead of the aggregate; (iii) rationalize the investment cap by entity type, not income; (iv) allow portals to receive compensation on different terms such as warrants, and allow portals to co-invest in offerings; (v) amend the rules for small debt offerings to limit the ongoing reporting requirements to only the note holders and to scale the regulatory obligations to reduce the legal, accounting and other costs of the offering; (vi) increase the offering limit to $5 million in any twelve-month period; (vii) allow the use of special purpose vehicles (SPVs); and (viii) allow testing the waters before a filing.
Small intermittent finders should be exempt from broker-dealer registration. See HERE.
The SEC should clarify the relationship between exempt offerings that allow general solicitation (506(c)) and those that do not (506(b)) by: (i) applying the facts and circumstances analysis as to whether a particular investor was brought into an offering as a result of general solicitation (thus avoiding the necessity to verify accredited status); and (ii) apply Rule 152 to a Rule 506(c) offering to avoid integration with a follow-on registered offering. I note, however, that I believe Rule 152 already applies or if it does not, that a subsequent registered offering is not otherwise prohibited.
Permit an alternative trading system, such as OTC Markets, to file a Form 211 application with FINRA and review the FINRA process to reduce the Form 211 application process burdens. See HERE.
Amend the definition of smaller reporting company and non-accelerated filer to include a company with a public float of less than $250 million or with annual revenues of less than $100 million.
Related to venture exchanges, Congress and the SEC should look to existing alternative venture exchanges (OTC Markets) and work within the existing framework. See HERE.
The SEC should mandate additional disclosure on short positions and enforce Regulation SHO and Regulation T for all IPOs.
Proxy advisory firms should be brought under SEC registration so that the SEC may oversee how these firms make recommendations and mitigate conflicts of interest.
Withdraw the proposed rule changes to Regulation D, Form D and Rule 156. See HERE.
The SEC should lead a joint effort with NASAA and FINRA to implement the private placement broker-dealer as recommended by the American Bar Association. See HERE.
The SEC should allow a quick response (QR) code to suffice for delivery prospectus requirements after effectiveness of a registration statement or qualification of an offering circular.
Study and propose a revised regulatory regime for true peer-to-peer lending platforms for small businesses and consumers, using current European regulatory and other models as reference.
The SEC should expand disclosure requirements for stock promotion activity, including updating Section 17(b) to require better disclosures when a company is engaging promotional and investor relations firms.
The SEC should amend unlisted trading privileges rules to allow small and medium-size public companies the option to consolidate secondary trading to one or more trading platforms.
The SEC should allow for flexibility in tick sizes and consider making the pilot program permanent. See HERE.
The SEC should provide greater clarity with respect to which courts and authorized governmental entities may act to satisfy the exemption from registration for exchange transactions under Securities Act Section 3(a)(10), and communicate the same to broker-dealers.

The Author

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Multiple Classes of Stock and the Public Company

Posted by Securities Attorney Laura Anthony | May 29, 2018 Tags: Classes of Stock, ETFs, Inc., IPO, Multiple Classes of Stock and the Public Company, NYSE, Public Company, Snap

In March 2017, Snap Inc. completed its IPO, selling only non-voting Class A common shares to the investing public and beginning an ongoing discussion of the viability and morality of multiple classes of stock in the public company setting. No other company has gone public with non-voting stock on a U.S. exchange. Although Facebook and Alphabet have dual-class stock structures, shareholders still have voting rights, even though insiders hold substantial control with super-voting preferred stock.

Snap’s stock price was $10.79 on May 7, 2018, well below is IPO opening price of $17.00. Certainly the decline has a lot to do with the company’s floundering app, Snapchat, which famously lost $1.3 billion in value when reality star Kylie Jenner tweeted that she no longer used the app, but the negativity associated with the share structure has made it difficult to attract institutional investors, especially those with a history of activism. Although there was a net increase of $8.8 million in institutional ownership in the company for the quarter ending March 2018, the approximate 20% total institutional ownership is below average for the Internet software/services industry and the increase in the quarter resulted from purchases by 2 institutions where 8 others decreased their holdings.

Moreover, many institutions, including pension funds, have holdings in Snap because they buy index funds, including ETFs, and Snap is in the S&P 500. The Council of Institutional Investors has even sent Snap a letter urging it to reconsider its share structure.

The discussion has gained regulatory attention as well. On February 15, 2018, SEC Commissioner Robert J. Jackson Jr. gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” in which he talked about the detriments of closely held perpetual control stock in a public company.

Days prior to Commissioner Jackson’s speech, Commissioner Kara Stein gave a speech at Stanford University about the role of corporate shareholders. Commissioner Stein posits that the relationship between a company and its shareholders should be mutual, including in areas involving cyber threats, board composition, shareholder activism and dual-class capital structures. Stein sees dual-class structures as purposefully disenfranchising shareholders and being inherently undemocratic.

Perhaps feeling the pressure, on May 2, 2018, Zynga founder Mark Pincus announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure. As a result of the conversion, Pincus’ voting power was reduced from 70% to 10%. His prior 10% economic stake remains unchanged.

SEC Commissioner Robert J. Jackson Jr.’s Speech: Perpetual Dual-Class Stock: The Case Against Corporate Royalty

On February 15, 2018, SEC Commissioner Robert J. Jackson Jr., gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” at the University of California, Berkley campus. Commissioner Jackson began the substantive portion of his speech with a summary background of a dual-class stock structure. I’ve supplemented his explanation with additional information.

Dual-class voting typically involves two more or more classes of stock, with one class having significantly more voting power than the others. The higher voting shares are often called “super-voting.” Typically, in a dual-class structure, the equity issued to the public is common equity with one vote per share and equity issued to insiders would be super-voting preferred stock. A company may also have other classes of preferred stock with various rights issued to different investors. Snap’s issuance of non-voting common stock to the public takes this structure one step further.

Historically, the NYSE did not allow companies to go public with dual-class voting structures. However, the takeover battles in the 1980s resulted in a change in the rules to allow for insider and management anti-takeover voting protection. Today, it is common for companies to go public with dual classes of voting stock. Public companies using dual-class are today worth more than $5 trillion, and more than 14% of the 133 companies that listed on U.S. exchanges in 2015 have dual-class voting. That compares with 12% of firms that listed on U.S. exchanges in 2014, and just 1% in 2005. Nearly half of the companies with dual-class shares give corporate insiders super-voting rights in perpetuity.

Commissioner Jackson acknowledges the reasons for a dual-class structure, and the desire by entrepreneurs and founders to go public while retaining control; however, he also quickly asserts that such a structure undermines accountability. Prior to accessing public markets, management control is beneficial in that it allows visionaries and entrepreneurs to innovate and disrupt industries without the short-term pressure of a loss of control over their efforts. However, perpetual outsized voting rights not only provide ultimate control to founders and entrepreneurs, but to their heirs as well, who may or may not be strong managers, entrepreneurs and visionaries.

Although many market players are recently strongly advocating for a change in rules to prohibit companies from going public with a dual-class structure, Commissioner Jackson advocates a change such that a dual-class structure has a time limit or expiration date. There may be benefits to management control for a period of time, but that benefit ultimately runs out after a company is public and certainly once the founding management retires, leaves, passes away or otherwise ceases their entrepreneurial run. He suggests that the exchanges propose amended rules in this regard.

Commissioner Jackson waxes philosophical pointing out the foundation of the United States origins, the Constitution and government structure, all of which are designed to allow for a change in regime and a vote by the masses. Even in public markets, power is not meant to continue in perpetuity, which is one of the reasons that the U.S. requires public companies to report and provide disclosure to investors and shareholders. Jackson likens perpetual super-voting stock as creating corporate royalty.

However, for the sake of the debate, I note that in the free market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate royalty would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.

In fact, Jackson continues his speech with analytics indicating that companies with super-voting insider control, do not perform as well as their counterparts. A recent study by Martijn Cremers, Beni Lauterbach, and Anete Pajuste entitled The Life-Cycle of Dual-Class Firms (Jan. 1, 2018) shows that the costs and benefits of dual-class structures change over time, with such companies trading at a premium shortly after the IPO, but decreasing over time.

Jackson’s staff studied 157 dual-class IPOs that occurred within the past 15 years. Of the 157 companies, 71 had sunset provisions or provisions that terminated the dual-class structure over time, and 86 gave insiders control forever. Whereas the companies traded relatively equally for the first few years, after seven years, those with a perpetual dual-class structure traded at a substantial discount to the others. Furthermore, when a company with a perpetual dual-class structure voluntarily eliminated the second control class, there was a significant increase in valuation.

As mentioned, institutional investors and market participants have vocally opposed dual-class structures for public companies. In December 2017, the Investor as Owner Subcommittee of the SEC’s Investor Advisory Committee published a report entitled Discussion Draft: Dual Class and Other Entrenching Governance Structures in Public Companies strongly opposing the structure. In addition to its letter to Snap, the Council of Institutional Investors has published a page on its website discussing and advocating for one-share equal voting rights for public companies.

Furthermore, the FTSE Russell index will now exclude all companies whose float is less than 5% of total voting power, the S&P Dow will now exclude all dual-class companies and the MSCI will reduce dual-class companies from its indexes. Commissioner Jackson is concerned that excluding dual-class stock companies from indexes does more harm than good. Many Main Street investors own public equities through funds or ETFs that in turn either own or mirror indexes. By removing dual-class companies from index funds, Main Street investors lose the opportunity to invest in these companies, some of which are the most innovative in the country today.

Commissioner Jackson’s suggestion of finding a middle ground whereby a company could complete an IPO with a dual-class structure and allow its visionaries to build without short-term shareholder pressure, but then limiting that sole control to a defined period, was met with praise and approval. Several market participants, including the SEC’s Investor Advisory Committee and the Council of Institutional Investors, made comments supporting the suggestion.

More on Preferred Equity

Although the topic of super-voting features in dual-class stock structures has been hotly debated recently, it is not the only feature that may be in preferred stock. Preferred stock is the most commonly used investment instrument due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. It can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:

Dividends – a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an issuer to pay a dividend is based on state corporate law, the majority of which require that the issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments;

– As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);

– Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;

– Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities;

Voting Rights – as discussed, preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes);
Liquidation Preferences – a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company issuer. Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset. In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;

– In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, preferred stockholder gets entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company issuer; or preferred stockholder gets entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference);

Conversion or exchange rights – a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

– Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000);

– Conversion rights are generally at the option of the stockholder, but the issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (the issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

– The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

– conversion rights usually specify whether they are in whole or in part and, for public companies, limits are often set (conversion limited such that cannot own more than 4.99% of outstanding common stock at time of conversion);

Redemption/put rights – a redemption right in the form of a put right is the right of the holder to require the issuer to redeem the preferred stock investment (to “put” the preferred stock back to the issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor;
Redemption/call rights – a redemption right in favor of the issuer is a call option (the issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA);
Anti-dilution protection – anti-dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation. Generally the issuer agrees to issue additional securities to the holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (the holder will never own below 10% of the total issued capital of the issuer);
Registration rights – registration rights refer to SEC registration rights and can include demand registration rights (the holder can demand that the issuer register their equity securities) or piggyback registration rights (if the issuer is registering other securities, it will include the holder’s securities as well);
Transfer restrictions – preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the issuer or other security holders, or both;
Co-sale or tag along rights – co-sale or tag-along rights are rights of holders to participate in certain sales of stock by management or other key stockholders;
Drag-along rights – drag-along rights are the rights of the holder to require certain management or other key stockholders to participate in a sale of stock by the holder;
Other non-financial covenants – preferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the board of directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; prohibitions against the sale of certain key assets or intellectual property rights; in essence non-financial covenants can be any rights that the preferred stockholder investor negotiates for.

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« SEC Continues to Review, And Delay, Crypto Funds Online Platforms Trading Cryptocurrencies; Continued Uncertainty In Crypto Space »

SEC Continues to Review, And Delay, Crypto Funds

Posted by Securities Attorney Laura Anthony | May 22, 2018 Tags: And Delay, Crypto Funds, SEC Continues to Review, SEC Continues to Review Crypto Funds

On January 18, 2018, the SEC issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or mutual fund. The letter, authored by SEC Division of Investment Management director Dalia Blass, explains the SEC’s reservations and concerns about approving a crypto-related mutual fund or ETF. The letter advised against seeking registration of funds that invest heavily in cryptocurrency-related products until the raised questions and concerns can be properly addressed.

The SEC letter comes a year after the SEC rejected a proposal by Cameron and Tyler Winklevoss, famously linked to the founding of Facebook, to create a bitcoin-tracking ETF. Since that time the SEC has privately rejected several similar requests. Many in the industry appreciate the SEC letter as it offers specific guidance and concrete issues to be addressed as the march towards the eventual approval of a crypto-related fund continues.

Since the January 18 letter, the SEC has been reviewing and conducting proceedings on a New York Stock Exchange (NYSE) proposal to list and trade five bitcoin-related ETFs. The proceedings are expected to go on for a few months. This blog will begin with an explanation of what exactly is an ETF and then address the SEC’s concerns related to the clearance of crypto-related ETFs.

What is an ETF?

Exchange traded funds or ETFs are funds that track indexes. Historically, exchange traded funds have tracked big-board indexes such as the Nasdaq 100, S&P 500 or Dow Jones; however, as ETFs have risen in popularity, there are now funds that track lesser-known indexes or specially created indexes to feed the ETF market. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small-growth, large-growth, etc.); and commodities. The primary difference between an ETF and other index funds is that an ETF does not try to outperform the corresponding index, but rather tries to track and replicate the performance.

An ETF allows an investor the advantage of copying an index with a single stock trade, without the risk associated with a fund manager trying to outperform the market. Since the fund manager is simply copying and mirroring the particular index, the management style is referred to as “passive management.”

Passive management reduces the administrative costs from an actively managed portfolio, and that savings can be passed down to the investors. A typical private hedge fund charges 2% per annum for administrative fees. That fee is reduced to 1% for mutual or registered funds. The typical fee for an ETF is less than .20% per year. Moreover, since an ETF does not trade as actively as typical funds, it has fewer capital gain events and therefore lower taxes.

An ETF trades just like a stock, with continuous trading throughout a day. ETFs are generally margin-eligible and accordingly can be sold short. Conversely, mutual funds are generally only priced once a day after market closings and are not margin-eligible.

ETFs have become increasingly popular over the years, especially with investors that are interested in market sectors, regions or asset types. It is not surprising that investors are interested in crypto-related ETFs and that fund creators are likewise trying to meet this investor demand.

SEC Position on Crypto-related Mutual Funds and ETFs

As mentioned, On January 18, 2018, the SEC Division of Investment Management issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or similar investment product such as a mutual fund.

The SEC begins with its commitment to fostering innovation and the development of new types of investment products, ETFs being a primary example, but quickly continues with the assertion that multiple investor protection issues need to be resolved before a crypto-related fund could be offered. The primary issues are valuation, liquidity, custody, arbitrage, potential manipulation and other risks.

The concerns and questions raised by the SEC will also impact future changes to exchange listing standards by the Division of Corporation Finance, the Division of Trading and Markets and the Office of the Chief Accountant. The SEC foresees needed changes to accounting, auditing and reporting requirements for crypto-related funds and ETFs.

Valuation

Mutual funds and ETFs must value their assets on each business day in order to reach a net asset value (“NAV”). NAV is used to determine fund performance, what investors pay for mutual funds and what authorized participants pay for ETFs as well as what they receive when they redeem or sell. The SEC is concerned that a fund or ETF would not have the necessary information to value a cryptocurrency as a result of their volatility, fragmentation, lack of regulation, nascent state and current trading volume (or lack thereof) in the cryptocurrency futures markets.

The SEC has requested that the industry evaluate and provide information as to how valuations would be conducted. Furthermore, the SEC has asked how funds would develop and implement policies and procedures related to crypto-related valuations to ensure that the requirements as to fair value are met. Likewise, the SEC would need satisfaction that a fund or ETF could adequately address the accounting and valuation impacts of “forks” such as when a cryptocurrency diverges into two separate currencies with different prices.

The SEC questions the policies a fund would implement to identify and determine eligibility and acceptability for newly created cryptocurrencies. The SEC has concern as to how a fund would consider the impact of market information and manipulation in the underlying cryptocurrency markets as related to the determination of the settlement price of cryptocurrency futures.

Liquidity

Investments in open-ended funds such as mutual funds and ETFs are redeemable on a daily basis and as such, the funds must maintain sufficient liquid assets to satisfy redemptions. Rule 22e-4 promulgated under the Investment Company Act of 1940 (the “1940 Act”) requires funds to implement liquidity risk management programs. Under the rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets.

The SEC is concerned with the steps a fund or ETF that invests in cryptocurrencies or crypto-related products would take to ensure that it would have sufficient liquidity to meet daily redemptions. Moreover, the SEC raises questions as to how such funds would satisfy Rule 22e-4 and in particular, how could any crypto-related investment be classified as anything other than illiquid under the rule.

The SEC specifically asks how such funds would take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market-depth analysis in light of these factors. Similarly, given the fragmentation and volatility in the cryptocurrency markets, would these funds need to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the value of underlying assets.

Custody

The 1940 Act provides for certain requirements related to the custody of securities held by funds, including who may act as a custodian and when funds must verify holdings. The SEC questions how a fund or ETF could satisfy the custody requirements for cryptocurrency-related products. The SEC notes that there are currently no custodians providing fund custodial services for cryptocurrencies. Likewise, although currently all bitcoin future contracts are cash-settled, if physical settlement contracts develop, the SEC questions how a fund will custody the bitcoin to make delivery.

The SEC further questions how a fund will validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records. Another issue for cryptocurrencies is cybersecurity and the threat of hacking. The SEC has concerns about how custodians can satisfy their requirements for the safekeeping of crypto assets.

Arbitrage for ETFs

ETFs obtain SEC orders that enable them to operate in a specialized structure that provides for both exchange trading of their shares throughout the day at market-based prices, and “creation unit” purchases and redemptions transacted at NAV by authorized participants. In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV. The SEC questions how an ETF could comply with the terms of an order considering the fragmentation, volatility and trading volume in the cryptocurrency marketplace.

The SEC would like funds to engage with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products. The SEC also questions how trading halts or the shutdown of a cryptocurrency exchange would affect the market price or arbitrage.

Potential Manipulation and Other Risks

The SEC believes that the current cryptocurrency markets have substantially fewer investor protections than traditional securities markets. Moreover, the SEC, other federal regulators, and state regulators have found considerable fraud in the cryptocurrency marketplace. The SEC is concerned about how a fund would address fraud concerns in the underlying markets when offering investments in the fund to retail investors. Similarly, the SEC is concerned about the disclosure of, and ability for a retail investor to understand, the risks of an investment in a crypto-related fund.

Likewise, the SEC would like funds to engage in discussions with broker-dealers who may distribute the funds, as to how the broker-dealer will satisfy their suitability requirements. The SEC is also concerned with how an investment advisor will satisfy their fiduciary obligations when recommending a crypto-related fund.

Further Reading on DLT/Blockchain and ICOs

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.

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ABA Comment Letter On Disclosures Under Regulation S-K

Posted by Securities Attorney Laura Anthony | May 1, 2018 Tags: ABA Comment Letter On Disclosures Under Regulation S-K

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. Like the SEC’s ongoing Disclosure Effectiveness Initiative, the ABA has a Disclosure Effectiveness Working Group as part of its Federal Regulation of Securities Committee (of which I am a member) and its Law and Accounting Committee.

The ABA comment letter begins with a general discussion of the materiality concept, which is the underlying basis of disclosure, and then provides input on various specific areas of disclosure under Regulation S-K. The ABA comment letter specifically responded to the SEC 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.

I’ve been writing about Regulation S-K and the SEC Disclosure Initiative since at least early 2015. Although consistently a priority, with the finalization of proposed rule changes on the SEC short-term agenda (see HERE), a complete overhaul of Regulation S-K (and Regulation S-X) is a fluid, ongoing process that will likely continue for years to come.

Materiality

Materiality is a concept I’ve written about several times (see HERE, for example,). Regulation S-K and Regulation S-X provide specific disclosure requirements that are measured and supplanted by the materiality concept. Specific disclosure requirements generally involve objective quantitative or bright-line-rule-based standards. In addition, to those specific disclosure requirements, a company must disclose any other material information necessary to make required disclosures not misleading. 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 ABA comment letter discusses the materiality standard’s application to specific Regulation S-K disclosure requirements. As noted by the ABA, the SEC recognizes that it has “adopted different approaches to guide registrants in evaluating materiality for purposes of disclosure, including in some cases using quantitative thresholds to address uncertainty in the application of materiality.” In some cases, Regulation S-K is “principles-based” in that it directs the company to apply the materiality standard directly to the facts at hand. A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required.

The ABA comment letter notes the necessity of balancing rule-based disclosures with those that require a materiality analysis. There is a degree of uncertainty in a materiality analysis and coupled with situations with a potential conflict of interest, such as disclosures related to officers and directors, or those that have a social application such as conflict minerals, the SEC leans towards a more specific rule-based approach. However, with ever-lengthening disclosure documents filled with irrelevant and non-material information, the principles-based materiality standard is gaining favor.

To balance the approaches, the ABA suggests subjecting almost all Regulation S-K disclosure items to a materiality analysis. A company would be required to evaluate each Item in Regulation S-K , thereby preserving the rigor of a rules-based system, but would be permitted to omit information, even if disclosure would otherwise be specifically required, if such information is not material and the inclusion of the information is not necessary to make any required statements not materially misleading. Exceptions to this approach would include disclosures involving conflicts of interest such as related party transactions and executive compensation.

The ABA specifically recommend amending Item 10 of Regulation S-K to add the following subsection (g):

(g) In addition to the information expressly required to be disclosed, the registrant shall disclose such additional material information, if any, as may be necessary to make the required statements in the light of the circumstances under which they are made not misleading. Issuers may omit information otherwise called for by a line item, except for Items 402 and 404, if such information is not material, as long as the effect of omitting the information would not be materially misleading. It shall be presumed, in the absence of facts to the contrary, that the omission of any disclosure called for by a Regulation S-K line item was an intentional omission by the registrant in reliance upon this sub-section (g) and not a failure to provide the disclosure called for by such line item.

Known Trends or Uncertainties

Known trends and uncertainties is a category of discussion included in Management Discussion and Analysis of Financial Conditions (MD&A). Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons. The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others). The SEC proposed rule change published on October 11, 2017 would allow a company to eliminate the earliest year in its discussion as long as (1) the discussion is not material to an understanding of the current financial condition; and (ii) the company has filed a prior Form 10-K with an MD&A discussion of the omitted year. The proposed amendment would also eliminate the reference to a five-year look-back in the instructions, but rather a company would be able to use any presentation or information that it believes will enhance a reader’s understanding. The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.

Item 303(a) also requires a discussion of known trends or uncertainties that have had or that the company reasonably expects will have a material effect, either positive or negative, on its liquidity, capital resources or results of operations. A discussion of trends is forward-looking, related to potential future performance. Although the ABA believes the information is relevant and important, it expresses concerns about the SEC’s interpretations and guidance on the disclosure requirement.

The SEC guidance on trends (SEC Release 33-6385, published in 1989) states that where a trend, demand, commitment, event or uncertainty is known, management must: (i) assess whether the trend is reasonably likely to come to fruition, and if not disclosure is not required; (ii) if unsure, management should assume it is reasonably likely and then determine the impact on the company financial condition and if such impact is material. Unless the impact is not material, disclosure is required.

The ABA advocates replacing the SEC’s current guidance with an analysis based on the Supreme Court case of Basic, Inc. v. Levinson, which created a probability vs. magnitude test for materiality. In Basic the Supreme Court set the standard as “Under such circumstances, materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’”

The ABA also notes recent uncertainty in the law on the question of whether a failure to disclose is necessarily a violation of the antifraud provisions under Section 10(b) and Rule 10(b)(5). In particular, different federal circuit courts have reached different conclusions on the subject, and the U.S. Supreme Court has recently refused to review the matter to provide clarity. The ABA would like the SEC to address this discrepancy in rule making by affirmatively asserting that whether a failure to disclose is a violation of antifraud provisions depends on a facts-and-circumstances analysis.

Critical Accounting Estimates

MD&A also requires a discussion of critical accounting estimates. The ABA suggests that the SEC amend Item 303 to specifically require a discussion of the judgements and assumptions that management must make in order to prepare, and that have the most significant impact on, the company financial statements. The ABA suggests that the SEC clarify that the discussion should not just be a cut-and-paste of the critical accounting footnote in the financial statements, as is often the case now. Rather, the MD&A discussion should supplement the more technical footnote disclosure to help investors have a better understanding of the impact these assumptions have on the company’s financial disclosure. The discussion could even provide examples of what the financial statements might contain if different assumptions were made.

The SEC has made inroads into eliminating duplicative disclosure, including requesting comment and raising the issue of whether items duplicated in financial statement footnotes and other parts of a report should be maintained in only one or the other section or incorporated by reference from the footnotes to another section such as MD&A. Several important factors affect this dialogue, including that (i) an auditor must audit and therefore has responsibility for the contents in the financial statement footnotes, including any related discussion in the audit report (see HERE related to the new audit report requirements) which could increase audit costs and burdens; and (ii) items in the financial statement footnotes are not protected by the forward-looking statements’ safe harbors. As such, the ABA recommends any enhanced disclosure related to accounting estimates and judgments only be included in the MD&A section of a report.

Strategy

Although SEC rules do not require a disclosure of business strategy, many companies include a stand-alone discussion, especially in an IPO context. The ABA suggests adding business strategy as a required category under Item 101 Description of Business. The ABA also suggests leaving the category undefined instead letting companies look to generally accepted understandings and their own business ideas. I do not agree with this suggestion from the ABA. I am generally not an advocate of additional requirements and would suggest leaving it as is with voluntary discussion where appropriate.

Intellectual Property Rights

The SEC has discussed expanding the intellectual property disclosures in Item 101. The ABA advocates protection of intellectual property and trade secret information. Among many issues is the loss of protection afforded trade secret or confidential information once published and in the public, the ability to identify copyright information created by employees, and identifying which distinctive marks are subject to common law trademark protection. As such, it recommends that the SEC not expand its current requirements.

Sustainability

The topic of social disclosure has been much debated over the past few years. In a report issued in October 2017, the U.S. Department of the Treasury recommended eliminating special interest and social disclosure from the SEC disclosure rules, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Financial Choice Act would eliminate these provisions as well. See HERE. Climate change disclosure is another area of debate. On the other hand, institutional investors have asserted a social agenda, and disclosure of same, in the proxy process and voting on directors. The power of these funds and investors is not one a company can ignore.

The ABA supports the SEC’s guidance related to social issues, which is principles-based and generally would be included in MD&A or risk factor disclosures. The ABA includes sustainability, public policy, environmental, social and governance matters in this broad category. The comment letter supports a materiality analysis related to disclosure. However, I note that materiality would require an analysis as to whether such disclosure is important to a “reasonable investor.” As noted above, many institutional investors push their own social agenda, and thus disclosures related to same, even if a reasonable investor may not find the information material.

Disclosure of these social issues breeds emotional arguments and extreme viewpoints. Those that advocate for eliminating the disclosure requirements do so strongly, and those that believe there is not enough disclosure or enforcement in the area, believe so fervently. The ABA comment letter suggests adding rules that will assist companies in determining the level of disclosure, but qualifying those rules with a materiality standard. However, the ABA notes the complexity in this area and the need for careful evaluation, as well as the probability of a fluid, changing investor environment and thus a changing view of the “reasonable investor.”

Litigation

Item 103 requires disclosure of material pending private civil and governmental regulatory legal proceedings and certain other specified pending or contemplated legal proceedings to which an issuer or its property is subject. Legal proceeding disclosures may also be appropriate in MD&A, risk factors and financial footnotes. Although Item 103 puts all matters in one location, it often does not include any important information beyond factual information about the proceedings. The ABA suggests even further reducing the disclosure in Item 103 to a catalogue with cross-references to more robust disclosures in other sections of a report. Finally, the ABA recommends reevaluating the requirement related to disclosure of “contemplated” governmental proceedings to those that have been asserted or have a probability of being asserted.

Risk Factors

The disclosure of risk factors is complex enough that I once wrote a blog on just that topic. See HERE. Almost all SEC guidance on disclosure matters includes a discussion of risk factors, such as the recent guidance on cybersecurity disclosure (see HERE).

Risk factor disclosures are entirely principles-based. That is, there are no bright-line prescriptive rules that require a specific risk disclosure. Although the SEC consistently suggests only including risk factors that actually impact a company, and not boilerplate disclosures that could impact all businesses, most companies include the boilerplate disclosures. Companies are more concerned with the plaintiff’s bar and potential shareholder lawsuits for the failure to include a risk factor than the SEC guidance in this regard. Likewise, an SEC suggestion to limit the number of risk factor disclosures, or to order these disclosures in terms of management’s view of their priority or assessment of probability and magnitude of the potential impact, was met with strong issuer opposition—again, likely from a fear of shareholder litigation.

The ABA comment letter makes a number of specific recommendations related to risk factor disclosures. Despite opposition, the ABA suggests that the SEC consider limiting the number of risk factors and require that they be listed in order of priority. Similarly, the ABA suggests a specific requirement that companies omit generic risk factors from their reports and registration statements. Although it does not suggest disclosing the probability of a particular risk, the ABA does advise that companies conduct a probability/magnitude assessment in its risk factor disclosures.

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 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.

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.

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What is a SAFT?

Posted by Securities Attorney Laura Anthony | April 24, 2018 Tags: What is a SAFT

A Simple Agreement for Future Tokens (“SAFT”) is an investment contract originally designed to provide a compliant alternative to an initial coin offering (ICO). A SAFT as used today was intended to satisfy the U.S. federal securities laws, money services and tax laws and act as an alternative to an ICO when the platform and other utilization for the cryptocurrency or token was not yet completed. The form of the SAFT is the result of a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” As discussed in this blog, the SAFT’s compliance with federal securities laws has now come into question by both the SEC and practitioners.

SAFT’s are offered and sold to accredited investors as an investment to fund the development of a business or project in a way not dissimilar to the way equity changes hands in traditional venture capital. A SAFT was developed from the oft-used simple agreement for future equity (SAFE) contract in the venture capital setting. In a SAFT sale, no coins are ever offered, sold or exchanged. Rather, money is exchanged for traditional paper documents that promise access to future product. Fundamentally, a SAFT has been relying on the premise that the future product is not in and of itself a security.

Although the SEC had been looking at ICO’s for a while, on July 25, 2017 it issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO concluding that the ICO was a securities offering. The Section 21(a) Report established that the Howey Test is the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. SEC Chair Jay Clayton has confirmed this standard in several public statements and in testimony before the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”). For a review of the Howey Test, see HERE.

Following the Section 21(a) Report, in a slew of enforcement proceedings by both the SEC and state securities regulators, and in numerous public statements, it is clear that regulators have viewed most, if not all, ICO’s as involving the sale of securities. At the same time, the SAFT grew in popularity as an attempt to comply with the securities laws. The SEC’s position is based on an analysis of the current market for ICO’s and the issuance of “coins” or “tokens” for capital raising transactions and as speculative investment contracts.

SAFT users rely on the premise that a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility. Investors in a SAFT automatically receive the cryptocurrency when it is publicly distributed in an ICO. The SAFT investors generally receive the crypto at a discount to the public offering price. However, this premise is taking a direct hit lately. Although I’ll lay out more on the SAFT history and why it was thought of as a solution further in this blog, I’ll jump right to the current analysis, and why a SAFT might not provide the intended protections.

The SAFT Problem

Although everyone, including regulators, agree that the state of the law in the area of cryptocurrencies and tokens is unsettled, regulators, including both the CFTC and SEC, have increasingly taken positions that would bring cryptocurrencies within their jurisdiction. I believe regulators are reacting to overarching fraud and therefore a necessity to take action to protect investors. Without congressional rule making and definitive guidance, regulators have no choice but to make the current law fit the circumstances. In some cases that works fine, but in others it does not and I suspect continuing changes in interpretations, enforcement premises and ultimately rule making will occur.

As I’ve previously discussed, the CFTC first found that Bitcoin and other virtual currencies were properly defined as commodities in 2015. Accordingly, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law. See HERE.

The SEC has also taken the stance that ICO’s involve the sale of securities, and that exchanges providing for the after-market trading of cryptocurrencies must register unless an exemption applies. The SEC is now taking it one step further, postulating that the tokens or cryptocurrencies underlying the SAFT could also be a security (and when I say “could” I mean “are”), in which case the SAFT structure is nothing more than a convertible security and fails to comply with the federal securities laws and makes it even more likely that it would result in an enforcement proceeding, or private litigation.

A SAFT is a type of pre-ICO investment with the investors automatically receiving the crypto when the company completes its public ICO. If the underlying token is a security, then the future ICO fails to comply with the federal securities laws and the original SAFT also fails to comply.

Getting ahead of this issue, many companies have structured a SAFT such that the future ICO is also labeled a security, and the SAFT investor will receive the crypto when the future ICO is registered with the SEC. However, this results in a private pre-public security sale, which in and of itself is prohibited by the securities laws.

In particular, Securities Act CD&I 139.01 provides:

Question: Where the offer and sale of convertible securities or warrants are being registered under the Securities Act, and such securities are convertible or exercisable within one year, must the underlying securities be registered at that time?

Answer: Yes. Because the securities are convertible or exercisable within one year, an offering of both the overlying security and underlying security is deemed to be taking place. If such securities are not convertible or exercisable within one year, the issuer may choose not to register the underlying securities at the time of registering the convertible securities or warrants. However, the underlying securities must be registered no later than the date such securities become convertible or exercisable by their terms, if no exemption for such conversion or exercise is available. Where securities are convertible only at the option of the issuer, the underlying securities must be registered at the time the offer and sale of the convertible securities are registered since the entire investment decision that investors will be making is at the time of purchasing the convertible securities. The security holder, by purchasing a convertible security that is convertible only at the option of the issuer, is in effect also deciding to accept the underlying security. [Aug. 14, 2009] (emphasis added)

In a Crowdfund Insider article published March 26, 2018, one practitioner (Anthony Zeoli) has had discussions with the SEC on the subject. As reported in the article, the SEC has stated that if the SAFT investor will automatically receive tokens in the future when and if the tokens are registered, without any further action on the part of the investor, then the tokens must be registered as of the date of the SAFT investment.

Of course, the future ICO or token offering could be completed in a private offering in compliance with the federal securities laws, such as using Rule 506(c) and limiting all sales to accredited investors (see HERE on Rule 506(c)). However, assuming the token or coin really is designed to create a decentralized community or to have utility value that can be widely used by the public, limiting sales to accredited investors does not meet the needs of the issuers. Moreover, even if the future offering is structured as a private securities offering, the SAFT sale disclosure documents would need to include full disclosure on the future coin or token such that the investor could make an informed investment decision at the time of the SAFT investment.

In the same article, Zeoli delves into a more nuanced issue, which is the rising difference in the meaning of a “coin” vs a “token.” A SAFT is a simple agreement for future “tokens” but is being used to pre-sell initial “coin” offerings. If a coin and a token are two very different things (as Zeoli suggests—think stock vs. LLC interest), then the underlying contract has systemic problems beyond the registration and exemption provisions of the federal securities laws and may be a misrepresentation resulting in fraud claims.

More On SAFT; Background

As mentioned, the current form of a SAFT was created by a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” The SAFT was intended to comply with the federal securities, money transmittal and tax laws. Also, as discussed, the SAFT relies on the premise that a cryptocurrency which today may be an investment contract (security) will tomorrow be a non-security digital asset satisfying the Howey Test. The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility.

The original SAFT white paper states:

The SAFT is an investment contract. A SAFT transaction contemplates an initial sale of a SAFT by developers to accredited investors. The SAFT obligates investors to immediately fund the developers. In exchange, the developers use the funds to develop genuinely functional network, with genuinely functional utility tokens, and then deliver those tokens to the investors once functional. The investors may then resell the tokens to the public, presumably for a profit, and so may the developers.

The SAFT is a security. It demands compliance with the securities laws. The resulting tokens, however, are already functional, and need not be securities under the Howey test. They are consumptive products and, as such, demand compliance with state and federal consumer protection laws.

Despite its good intentions, as of today, the model SAFT no longer works.

Further Reading on DLT/Blockchain and ICO’s

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 summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

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

The Author

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The Division of Corporation Finance’s Disclosure Review And Comment Process

Posted by Securities Attorney Laura Anthony | April 11, 2018 Tags: CorpFin, The Division of Corporation Finance's Disclosure Review And Comment Process

Those that regularly read my blog know that I sometimes like to go back to basics. This blog will revisit and discuss the SEC’s Division of Corporation Finance (“CorpFin”) comment and review process. Back in March 2016, I wrote about the SEC comment and review process, including a description of the internal review process, review levels and breakup of industry sector reviewers. That blog can be read HERE. Since that time, the SEC has eliminated the Tandy Letter requirement. See HERE. Furthermore, on March 22, 2018, CorpFin updated its “Filing Review Process” page on the SEC website.

At the end of each calendar year, the big four accounting firms generally publish studies on CorpFin’s Comment Priorities. Their studies, and other recent publications, uniformly found that the number of comments, especially in a registration process, has dramatically declined. I have noticed this trend as well in my practice.

Also consistent in reports is a list of recent comment priorities, including: (i) non-GAAP financial measures (see HERE for more information on this topic; (ii) application of the new revenue recognition standards; (iii) disclosure of cyber risks and cyber incidents; (iii) management, discussion and analysis presentation and disclosures, including segment reporting and income taxes; (iv) disclosures of intangible assets and goodwill; (v) state sponsors of terrorism; (vi) related to acquisitions, mergers and business combinations; and (vii) signatures, exhibits and agreements.

This past year, in September 2017, the SEC Office of Inspector General published an Evaluation of the Division of Corporation Finance’s Disclosure Review and Comment Letter Process (the “September 2017 Report”). The purpose of the Inspector General’s examination and report was to review CorpFin’s process for issuing, tracking and facilitating public access to comment letters and related correspondence.

In addition to summarizing the September 2017 Report, this blog includes information on the updated CorpFin Filing Review Process page and general commentary and information on the process.

Background

The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and the general anti-fraud provisions which require disclosure of material information necessary to make required disclosures, not misleading. The standard for required disclosure is generally the materiality of the information. 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.

CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed. The Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 408 of the Sarbanes-Oxley Act requires CorpFin to focus on companies that have the largest market capitalization. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

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

Reviewers are appointed files based on industry sectors. CorpFin has broken down its reviewers into the following 11 broad industry sectors: healthcare and insurance; consumer products; information technologies and services; natural resources; transportation and leisure; manufacturing and construction; financial services; real estate and commodities; beverages, apparel and mining; electronics and machinery and telecommunications. Each industry office is staffed with an assistant director and approximately 25 to 35 professionals, primarily accountants and lawyers. Each filing has more than one reviewer with a frontline contact person and supervisor. A full review file will have an accounting and legal reviewer as well as a supervisor.

Internally at CorpFin, a file will have a reviewer and an examiner. The examiner conducts an initial review and recommends comments to the reviewer. The reviewer may accept the examiner’s work, add comments or remove proposed comments. In addition, other CorpFin support offices may propose comments for a particular company. Each participant in the process is required to keep detailed notes and reports and upload the information into an internal workstation.

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

Comment Letters and Responses

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

A company generally responds to the particular comment letter with a responsive letter that addresses each comment and, where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure. CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses. Where a comment letter asks for additional disclosure in future filings, proposed language should be provided to avoid an additional comment once the disclosure is made.

Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance, and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Responses should address the company’s unique facts and circumstances, and should avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, the company should explain how it is burdened and how the alternative provided by the company will provide adequate disclosure for investors.

The comment-and-response process continues until the staff has resolved all comments. No sooner than 20 business days after completion of its review, the SEC will upload all comment letters and responses to the EDGAR database. These comment letters and responses are searchable but are organized by company, not topic, making particular topic searches difficult. When generally searching for comments and responses on a specific topic, third-party advanced searching software is helpful.

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

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

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

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

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

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

September 2017 Report

The September 2017 Report reveals that CorpFin is developing a new system to improve and streamline certain aspects of the disclosure review process. The new system is called the System for Workflow Activity Tracking, which is referred to as SWAT. SWAT will automate certain aspects of the review process such as providing notifications of filing review status to other review team members. In addition, SWAT will generate a draft comment letter based on comments input into and approved within the system. The reviewer or another designated member of the relevant assistant director’s staff will review and revise the draft letter to ensure that it meets CorpFin’s policies for format, tone, and content. Once the draft letter is approved, a final comment letter will be generated within SWAT.

In its examination, the Office of Inspector General found that: (i) examiners and reviewers did not always properly document comments before issuing comment letters to companies; (ii) some case files were incomplete as of the date CorpFin issued a comment letter to a company; and (iii) examiners and reviewers inconsistently documented oral comments to companies.

As a result, the Office of Inspector General made three recommendations for CorpFin to improve its internal process. In particular, CorpFin should: (i) establish a mechanism or control for staff members to trace all comments provided to companies for inclusion in examiner and reviewer reports before issuing comment letters; (ii) establish a mechanism or control that ensures the staff follows policies to upload all examiner and reviewer reports to the internal workstation before issuing comment letters; and (iii) establish detailed guidance on how examiners and reviewers should document oral comments provided to companies during disclosure reviews. The recommendations were agreed to and will be closed upon verification that the corrective measures have been implemented. It is anticipated that the full implementation of the SWAT process will effectively resolve these issues as well.

Conclusion

A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting. The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included. As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports.

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

For a review of basic public company disclosures, see my blog HERE. For more information regarding officer and director liability associated with signing SEC reports, see my blog HERE.

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The SEC’s 2018 Flex Regulatory Agenda

Posted by Securities Attorney Laura Anthony | April 3, 2018 Tags: SEC Flex Regulatory Agenda, The SEC’s 2018 Flex Regulatory Agenda

In December 2017, the SEC posted its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. Prior to issuing the agenda, SEC Chair Jay Clayton had promised that the SEC’s regulatory agenda’s would be “more realistic” and he seems to have been true to his word.

The agenda is separated into two categories: (i) Existing Proposed and Final Rule Stages; and (ii) Long-term Actions. The Existing Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The semiannual list published in July 2017 only contained 33 legislative action items to be completed in a 12-month time frame, and the newest list is down to 26 items, whereas the prior fall 2016 list had 62 items.

The Unified Agenda of Regulatory and Deregulatory Actions

The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, though the fall edition contains statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year. Interestingly, the SEC did not include a statement on regulatory priorities, letting the list speak for itself.

The Office of Information and Regulatory Affairs, under the current administration, has stated that the Agenda “represents the beginning of fundamental regulatory reform and a reorientation toward reducing unnecessary regulatory burden on the American people.” Furthermore, the Office states, “[B]y amending and eliminating regulations that are ineffective, duplicative, and obsolete, the Administration can promote economic growth and innovation and protect individual liberty.”

Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives. Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action. The SEC is not the only agency with a reduced Agenda. In total, agencies withdrew 1,579 actions that were initially proposed in the fall 2016 Agenda. Agencies moved 700 actions to either long-term or inactive. Also, adding transparency for those of us who like to stay up on these matters, the agencies will now post and make public their list of “inactive” rules.

SEC Flex Regulatory Agenda

On the agenda in the final rule stages are Regulation S-K disclosure updates and simplification rule changes we have all expected. The proposed rule change was issued in October 2017, a summary of which can be read HERE. Included in the final rule stage is amendments to smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems. Amendments to the interactive data (XBRL) program have been moved up from proposed to final rule stage since July 2017.

Also included for final rules are the treatment of communications involving security-based swaps, modernization of property disclosure for mining companies, investment company reporting modernization and amendments to the investment advisor act, disclosure handling information, amendments to covered securities under Section 18 of the Securities Act and amendments to municipal securities rules.

Items of interest in the proposed rule stage include amendments to financial disclosures about entities other than the registrant (see HERE), implementation of FAST Act report recommendations (see HERE), disclosure of payments by resource extraction issuers, amendments to the financial disclosure for registered debt security offerings, auditor independence with respect to loans or debtor-creditor relationships, various rules related to the Investment Company Act and Investment Advisors Act, and amendments to the Whistleblower Program Rules.

Rule on exchange traded products, personalized investment advice standard of conduct, and disclosures of payments by resource extraction issuers were moved from long-term to the proposed rule stage.

Removed from the July 2017 Existing Proposed and Final Rule Stages list and added to long-term actions are rules related to business and financial disclosure required by Regulation S-K, reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), Form 10-K summary, and revisions to audit committee disclosures.

Items on the long-term agenda which were also on the July 2017 long-term list include registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

Other items of interest on the long-term action list include Regulation Crowdfunding amendments, business, financial and management disclosure required by Regulation S-K, hedging disclosures, several securities-based swaps regulatory actions, conflict minerals amendments, amendments to Guide 5 on real estate offerings and Form S-11, extending testing-the-waters provisions to non-emerging growth companies, and incentive-based compensation arrangements.

Regulation A amendments are on the long-term action list. I am hopeful that these amendments may include an increase in the offering limits and opening up Regulation A to reporting issuers. See HERE.

Still not on the short-term agenda are future Dodd-Frank rules, including proposed regulatory actions related to pay for performance (see HERE), executive compensation clawback (see HERE) (which is not on the agenda at all), hedging (see HERE), universal proxies (see HERE), and clawbacks of incentive compensation at financial institutions (also not on the list at all), although some of these items remain on the “long-term actions” schedule.

The SEC rulemaking agenda may not include further rulemaking on many Dodd-Frank rules, but it also does not include specific rulemaking to repeal existing regulations, such as the pay ratio disclosure rules which were adopted in August 2015 and initially apply to companies for their first fiscal year beginning on or after January 1, 2017. See HERE for more information on this rule. The pay ratio rules do not apply to emerging-growth companies, smaller reporting companies, foreign private issuers, U.S-Canadian Multijurisdictional Disclosure System filers, and registered investment companies. All other reporting companies are subject to the new rules. In October 2016 the SEC published five new compliance and disclosure interpretations (C&DI’s) on certain aspects of the final rules. The C&DI’s covered two main topics: (i) the use of a consistently applied compensation measure in identifying a company’s median employee; and (ii) the application of the term “employee” to furloughed employees and independent contractors or “leased” workers.

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The 2017 SEC Government-Business Forum On Small Business Capital Formation

Posted by Securities Attorney Laura Anthony | March 13, 2018 Tags: 2017, SEC, The 2017 SEC Government-Business Forum On Small Business Capital Formation

On November 30, 2017, the SEC held its annual Government-Business Forum on Small Business Capital Formation (the “Forum”). It will be several months until the final report with recommendations from the forum is published, but the opening remarks from SEC Chair Jay Clayton and Commissioners Kara Stein and Michael Piwowar provide ongoing and consistent guidance as to the current focus of the SEC. For a review of the recommendations by last year’s forum, see HERE.

As expected, the topics of cryptocurrency and ICO’s were front and center at the Forum. In his opening remarks at the Forum, Division of Corporation Finance Director William Hinman confirmed that the SEC believes that ICO’s generally involve securities offerings and that the securities laws must be complied with. Hinman continued that the SEC is providing guidance through enforcement and public statements on the topic.

As with other statements and speeches, the SEC hedges by pointing out the validity of an ICO as a capital raising tool, and of course, the innovation potential of blockchain. The SEC is not trying to discourage ICO’s or blockchain innovation; they are trying to discourage ICO’s that fail to comply with securities laws, and the unfortunate, multiple frauds being perpetuated as a result of the frenzy surrounding this new technology.

Remarks by Chairman Jay Clayton

Chair Clayton is consistent with the theme he has been putting forth since taking office: The SEC is committed to helping Main Street investors. The Forum provides a key opportunity for the small-cap marketplace to have their voices heard regarding issues and desired changes to federal securities regulations and the regulatory system.

Chair Clayton reiterates the SEC’s three-part mission to (i) protect investors; (ii) maintain fair, orderly and efficient markets; and (iii) facilitate capital formation. Furthermore, although capital formation is important for all businesses, small and medium-sized businesses contribute the most to U.S. job creation, generating 62% of new jobs. Along the same lines, the SEC wants to open more investment opportunities into small businesses for Main Street investors. In that regard, Jay Clayton points out the Regulation A public offering process. As an aside, I was happy to see him recognize Regulation A as an IPO, whereas when he first took office, he seemed to view Regulation A as outside the IPO realm.

Remarks by Commissioner Michael Piwowar

Michael Piwowar’s statement was short and pointed. As anyone that follows my blog knows, I am a fan of Piwowar, agreeing with most of his views, and more so his willingness to express those views, even when contrary to other SEC chiefs or the legislature. Mr. Piwowar has been vocal about his disagreement with the pay ratio disclosure requirements mandated by the Dodd-Frank Act and uses his statement as an opportunity to reiterate that view, while pointing out that the recent interpretative guidance on the subject will help with the compliance burden. I have not written about that guidance as of yet, but my prior blog on the pay ratio rules can be read HERE.

Commissioner Piwowar also points out other SEC actions to assist with small businesses and capital formation, including the newest proposed rules to modernize and simplify disclosures (see HERE) and the SEC’s action to allow all companies to file confidential registration statements (see HERE).

Commissioner Piwowar ends his statement by promising that he will personally give careful consideration to this year’s recommendations of the Forum. I hope so, as the recommendations are always on point to assist the small-cap marketplace.

Remarks by Commissioner Kara Stein

Commissioner Stein began with the usual niceties regarding the forum and its importance for communication between regulators and the small-cap market. Adding her own perspective, Commissioner Stein points out that a lot of the SEC’s effort and rules are “designed to facilitate trust between… market participants – the small businesses seeking to raise capital, the investors who wish to support their growth, and their service providers.” Continuing to add her own unique voice, Ms. Stein talked about the need for diversity of companies and investors and bringing capital raising (and a voice in the process) to different parts of the country.

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« The Senate Banking Committee’s Hearing On Cryptocurrencies OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules »

The Senate Banking Committee’s Hearing On Cryptocurrencies

Posted by Securities Attorney Laura Anthony | March 6, 2018 Tags: The Senate Banking Committee’s Hearing On Cryptocurrencies

On February 6, 2018, the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”) held a hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.” Both SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo testified and provided written testimony. The marketplace as a whole had a positive reaction to the testimony, with Bitcoin prices immediately jumping up by over $1600. This blog reviews the testimony and provides my usual commentary.

The SEC and CFTC Share Joint Regulatory Oversight

The Banking Committee hearing follows SEC and CFTC joint statements on January 19, 2018 and a joint op-ed piece in the Wall Street Journal published on January 25, 2018 (see HERE). As with other areas in capital markets, such as swaps, the SEC and CFTC have joint regulatory oversight over cryptocurrencies. Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets.

Bitcoin has been determined to be a commodity and as such, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Nevertheless, the CFTC does NOT have regulatory jurisdiction over markets or platforms conducting cash or “spot” transactions in virtual currencies or other commodities or over participants on such platforms. These spot virtual currency or cash markets often self-certify or are subject to state regulatory oversight. However, the CFTC does have enforcement jurisdiction to investigate fraud and manipulation in virtual currency derivatives markets and in underlying virtual currency spot markets.

The SEC does not have jurisdiction over currencies, including true virtual currencies. However, many, if not all, token offerings have been for the purpose of raising capital and have involved speculative investment contracts, thus implicating the jurisdiction of the SEC, in the offering and secondary trading markets.

Chair Clayton repeated that “every ICO I’ve seen is a security,” and added, “[T]hose who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement division.” Chair Clayton is very concerned that Main Street investors are getting caught up in the hype and investing money they cannot afford to lose, without proper (if any) disclosure, and without understanding the risks. He also reiterates previous messaging that to date no ICO has been registered with the SEC and that ICO’s are international in nature such that the SEC may not be able to recover lost funds or effectively pursue bad actors. Cybersecurity is also a big risk associated with ICO investments and the cryptocurrency market as a whole. Chair Clayton cites a study that more than 10% of total ICO proceeds, estimated at over $400 million, has been lost to hackers and cyberattacks.

It is becoming increasingly certain that the U.S. will impose a new regulatory regime over those tokens that are not a true cryptocurrency, which would likely include all tokens issued on the Ethereum blockchain for capital raising purposes. Clayton made the distinction between Bitcoin, which is decentralized, on a public Blockchain and mined or produced by the public and other “securities tokens” which are the cryptocurrencies that developed by an organization and created and issued primarily for capital formation and secondary trading.

Many tokens are being fashioned that outright and purposefully resemble equity in an enterprise as a new way to represent equity and capital ownership. Clearly this falls directly within the SEC jurisdiction, and state corporate regulatory oversight as well. Furthermore, there are instances where a token is issued in a capital-raising securities offering and later becomes a commodity, or instances where a token securities offering is bundled to include options or futures contracts, implicating both SEC and CFTC compliance requirements.

In the Banking Committee testimony, the SEC and CFTC presented a united front, confirming that they are cooperating and working together to ensure effective oversight. Both agencies have established virtual currency task forces and their respective enforcement divisions are cooperating and sharing information. Also, both agencies have launched efforts to educate the public on virtual currencies, with the CFTC publishing numerous articles and creating a dedicated “Bitcoin” webpage.

In addition to cooperating with each other, they are also cooperating and communicating with the NASAA, the Consumer Financial Protection Bureau, FinCen, the IRS, state regulators and others.

The Technology

Consistent with all statements by the regulators, both the SEC and CFTC agree that that blockchain technology is disruptive and has the potential to, and likely will, change the capital markets. Moreover, both agencies consistently reiterate their support of these changes and desire to foster innovation. In fact, the new technology has the potential to help regulators better monitor transactions, holdings and obligations and other market activities.

Chair Giancarlo’s testimony states that “DLT is likely to have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis. When tied to virtual currencies, this technology aims to serve as a new store of value, facilitate secure payments, enable asset transfers, and power new applications.” In addition, smart contracts have the ability to value themselves in real time and report information to data repositories.

However, regulation and oversight need to be fashioned that properly address the new technology and business operations. Both agencies are engaging in discussions with industry participants at all levels. A few of the key issues that will need to be resolved include custody, liquidation, valuation, cybersecurity at all levels, governance, clearing and settlement, and anti-money laundering and know-your-customer matters.

Overall, Chair Giancarlo seemed more positive and excited about blockchain and Bitcoin, pointing out current uses including a recent transaction where 66 million tons of American soybeans were handled in a blockchain transaction to China. Chair Clayton, while likely also very enthusiastic about the technology, is currently more focused on the fraud and misuse that has consumed this space recently.

Current Regulations and Needed Change

While the agencies investigate and review needed changes to the regulatory environment, both maintain that current regulations can be relied upon to address the current state of the market. On the SEC side, Chair Clayton walked the Banking Committee through previous SEC statements and the DAO Section 21(a) report issued in July 2017. He again confirmed that the Howey Test remains the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. The current registration and exemption requirements are also appropriate for ICO offerings. An issuer can either register an offering, or rely on exemptions such as Regulation D for any capital-raising transaction, including those involving tokens.

Conversely, the current regulatory framework related to exchange traded fund products (ETF’s) needs some work before a virtual currency product could be approved. Issues remain surrounding liquidity, valuation, custody of holdings, creation, redemption and arbitrage. In that regard, in a coming blog, I will review an SEC letter dated January 18, 2018 entitled “Engaging on Fund Innovation and Cryptocurrency-related Holdings” outlining why a crypto-related ETF would not be approved at this time. Senator Mark Warner was quick to point out that there seems to be a regulatory disconnect where an SEC governed ETF is not approved, but a CFTC-governed Bitcoin future is allowed.

The current federal broker-dealer registration requirements remain the best test to determine if an exchange or other offering participant is required to be registered and a member of FINRA. Chair Clayton repeats his warning shot to gatekeepers such as attorneys and accountants that are involved in ICO’s and the crypto marketplace as a whole. Chair Clayton expresses concern that crypto markets often look similar to regulated securities markets and even are called “exchanges”; however, “investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems (ATSs), such as best execution, prohibitions on front running, short sale restrictions, and custody and capital requirements.”

CFTC Chair Giancarlo reiterated that current regulations related to futures, options, and derivatives contracts, and the registration (or lack thereof through self-certification) of spot currency exchanges are being utilized in the virtual currency market. However, the part of the regulatory system that completely defers to state law may need change. In particular, check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC, and both agencies expressed concern about this jurisdictional gap.

Giancarlo was especially critical of this state-by-state approach and suggested new federal legislation, including legislation related to data reporting, capital requirements, cybersecurity standards, measures to prevent fraud, price manipulation, anti-money laundering, and “know your customer” protections. “To be clear, the CFTC does not regulate the dozens of virtual currency trading platforms here and abroad,” Giancarlo said, clarifying that the CFTC can’t require cyber-protections, platform safeguards and other things that consumers might expect from traditional marketplaces.

Chair Clayton expressed the same concerns, especially the lack of protections for Main Street investors. Chair Clayton stated, “I think our Main Street investors look at these virtual currency platforms and assume they are regulated in the same way that a stock is regulated and, as I said, it’s far from that and I think we should address that.”

I am always an advocate of federal oversight of capital markets matters that cross state lines. A state-by-state approach is always inconsistent, expensive, and inefficient for market participants.

Both agencies are clear that regardless of the technology and nomenclature, they are and will continue to actively pursue cases of fraud and misconduct. Current regulations or questions related to needed changes do not affect this role. However, Chair Clayton did impress upon the Banking Committee that the current hiring freeze and budgetary restraints are an impediment. The SEC specifically needs more attorneys in their enforcement and trading and markets divisions.

Further Reading on DLT/Blockchain and ICO’s

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 summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

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

The Author

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