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SEC Issues New C&DI On Abbreviated Debt Tender And Debt Exchange Offers

Posted by Securities Attorney Laura Anthony | January 31, 2017 Tags: C&DI, Five-Day Tender Offer, SEC, Should I accept a Tender Offer, Tender Offer Example, Tender Offer Private Company, Tender Offer Process, Tender Offer Rules, Tender Offer vs Merger, What does it mean to tender shares, What is a Tender Offer?

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The SEC has been issuing a slew of new Compliance and Disclosure Interpretations (“C&DI”) on numerous topics in the past few months. On November 18, 2016, the SEC issued seven new C&DI providing guidance on tender offers in general as well as on abbreviated debt tender and debt exchange offers, known as the Five-Day Tender Offer. The guidance related to the Five-Day Tender Offer clarifies a previously issued January 2015 no-action letter on the subject. As I have not written on the subject of tender offers previously, I include a very high-level summary of tender offers in general and together with specific discussion on the new C&DI.

What Is a Tender Offer?

A tender offer is not statutorily defined, but from a high level is a broad solicitation made by a company or a third party to purchase a substantial portion of the outstanding debt or equity of a company. A tender offer is set for a specific period of time and at a specific price. The purchase offer can be for cash or for equity in either the same or another company (an exchange offer). Where a tender offer is an exchange offer, the offeror must either register the securities being offered for exchange or there must be an available exemption from registration such as under Section 4(a)(2) or Rule 506 of Regulation D.

A tender offer must be made at a fixed price and can include conditions to a closing, such as receiving a certain minimum percentage of accepted tenders. If the person making the tender may own more than 5% of the company’s securities after the tender offer is completed, they must file a Schedule TO with the SEC, including certain delineated disclosures.

Where a tender offer is being made by a company or its management, it is often in association with a going private transaction. Where it is being made by a third party, it is generally for the purpose of acquiring control over the target company and can be either a friendly or hostile takeover attempt.

As mentioned, a tender offer is not statutorily defined but rather can be applied to a broad array of transactions that include the change of ownership of securities. Over the years, a judicially established eight-factor test is used to determine whether the tender offer rules have been implicated and need to be complied with. In particular, in Wellman v. Dickinson, 475 F. Supp. 783 (S.D,N.Y. 1979) the court listed the following eight factors in determining whether a transaction is a tender offer:

An active and widespread solicitation of public shareholders for the shares of a company is made;
A solicitation is made for a substantial percentage of the company’s securities;
The offer to purchase is made at a premium to prevailing market price;
The terms of the offer are firm rather than negotiable;
The offer is contingent on the tender of a fixed number of minimum shares and may be subject to a fixed maximum;
The offer is open for a limited period of time;
The offeree is subjected to pressure to sell their securities; and
Public announcements are made regarding the offer.

Not all factors need be present for a transaction to be considered a tender offer, but rather all facts and circumstances must be considered. The SEC has historically focused on whether an investor is being asked to make an investment decision and whether there is pressure to sell. Once it is determined that a transaction involves a tender offer, the tender offer rules and regulations must be complied with.

Tender offers are governed by the Williams Act, which added Sections 13(d), 13(e), 14(d) and 14(e) to the Securities Exchange Act of 1934. The principle behind the regulatory framework is to ensure proper disclosures to, and equal treatment of, all offerees and to prevent unfair selling pressure. Section 14(d) and Regulation 14D govern tender offers by third parties. Section 14(d) and Regulation 14D set forth the SEC filing requirements and information that must be delivered to those being solicited in association with a tender offer, including the requirement to file a Schedule TO with the SEC.

As with any disclosure document relating to the solicitation or sale of securities, a Schedule TO is comprehensive and includes:

(i) A summary term sheet;

(ii) Information about the issuer;

(iii) The identity and background of the filing persons;

(iv) The terms of the transactions;

(v) Any past contacts, transactions and negotiations involving the filing person and the target company and offerees;

(vi) The purposes of the transactions and plans or proposals;

(vii) The source and amount of funds or other consideration for the tender offer;

(viii) Interests in the subject securities, including direct and indirect ownership;

(ix) Persons/assets retained, employed, compensated or used in the tender process. In its November 18, 2016 C&DI the SEC clarifies that the terms of employment and compensation to financial advisors engaged by an issuer’s board or independent committee to provide financial advice, would need to be disclosed in this section even if such financial advisor is not soliciting or making recommendations to shareholders. In addition, another of the new C&DI clarifies the specificity needed related to compensatory disclosure for financial advisors that are active in soliciting or making recommendations to shareholders. Such disclosure may not always need to include the exact dollar figure of the fees paid or payable to the financial advisor but must include a detailed discussion of the types of fees (such as independence fees, sale or success fees, advisory fees, discretionary fees, bonuses, etc.), when and how such fees will be paid, including any contingencies and any other information that would reasonably be material for a shareholder to judge the merits and objectivity of the financial advisor’s recommendations.

(x) Financial Statements;

(xi) Additional information as appropriate; and

(xii) Exhibits.

Section 14(e) and Regulation 14E contain the antifraud provisions associated with tender offers and apply to all tender offers, whether by insiders or third parties, for cash or an exchange, and whether full or mini offers. Section 14(e) prohibits an offeror from making any untrue statement of a material fact, or omitting to state any material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Section 14(e) also prohibits any fraudulent, deceptive or manipulative acts in connection with a tender offer.

Regulation 14E contains certain requirements designed to prevent fraudulent conduct and must be complied with in all tender offers. Regulation 14E requires:

(i) A tender offer must be open for at least 20 days;

(ii) The percentage of the class of securities being sought and the consideration offered cannot change unless the offer remains open for at least an additional 10 business days following notice of such change;

(iii) The offeror must promptly make full payment, or return the tendered securities, upon the termination, withdrawal or closing of the offering. Prompt payment is generally considered to be within 3 days;

(iv) Public notice must be made of any extension of an offer, and such notice must disclose the amount of any securities already tendered. Public notice is usually made via a press release in a widely disseminated publication such as the Wall Street Journal;

(v) The company subject to a tender offer must disclose its position on the tender offer (for, against, or expresses no opinion) to its shareholders. The disclosure must be made within 10 days of notice of the tender offer being provided to the target shareholders;

(vi) All parties must be mindful of insider trading rules and avoid trading when in possession of information related to the launch of a tender offer. Where the company is tendering for its own shares, it must be extra careful and cannot conduct a tender while in possession of insider information;

(vii) Tendering persons must have a net long position in the subject security at the time of tendering and at the end of the proration period in connection with partial tender offers (and not engage in short-tendering and hedged tendering in connection with their tenders); and

(viii) Subject to certain exceptions, no covered person can purchase or arrange to purchase any of the subject securities from the time of announcement of the tender until its completion through closing, termination or expiration. A covered person is broadly defined to include the offeror and its affiliates, including its dealer-manager and advisors.

Section 13(e) governs the information delivery requirements for the repurchase of equity securities by an issuer company and its affiliates. Rule 13e-4 sets forth disclosure, filing and procedural requirements for a company tendering for its own equity securities, including the filing of a Schedule TO with the SEC. An equity security is broadly defined and includes securities convertible into equity securities such as options, warrants and convertible debt but does not include non-convertible debt. Companies often use the SEC no-action letter process for relief as to whether a particular security is an equity security invoking Rule 13e-4 or similar enough to debt as to not require compliance with the rule.

In addition to an initial Schedule TO, which must be filed with the SEC on the commencement date of the offer, under Rule 13e-4, a company must file any of its written communications related to the tender offer, an amendment to the Schedule TO reporting any material changes, and a final amendment to the Schedule TO reporting the results of the tender offer. Moreover, a company must further disseminate information through either mail or widely distributed newspaper publications or both.

Where a company or affiliate is the offeror, Rule 13e-4 requires that such offeror allow a tendering shareholder the right to withdraw their tender at any time while the tender offer remains open. The tender offer must be made to all holders of the subject class of securities and where an offer is oversubscribed, the company must accept tenders up to its disclosed limit on a pro rata basis.

There are several exemptions from the Section 13(e) and Rule 13e-4 requirements. Also, careful consideration should be given when a company embarks on a stock repurchase program under Rule 10b-18 to ensure that such program does not actually result in a tender offer necessitating compliance with the tender offer rules. For a summary of Rule 10b-18, see my blog HERE.

Where the target company remains public, upon acquiring 5% or more of the outstanding securities, Section 13(d) requires that a Schedule 13D must be filed by the acquirer. For more information on Schedule 13D disclosure requirements, see my blog HERE.

Mini-tenders

Many provisions of the Williams Act, including Sections 13(d), 13(e), 14(d) and Regulation 14D do not have to be complied with for a tender offer that will result in less than 5% ownership (“mini-tender”); however, the antifraud provisions still apply. Mini-tenders are really just a bid for the purchase of stock, usually through a purchase order with a broker, which bid must remain open for a minimum of 20 days. A mini-tender bidder must make payment in full promptly upon a closing. Bidders in a mini-tender do not have to file documents with the SEC or provide the delineated disclosures required by a full tender offer.

Key differences between a mini-tender and full tender offer include: (i) a mini-tender is not required to file a Schedule TO with the SEC, and thus a target company is not given the opportunity to file a responsive Schedule 14d-9; (ii) a mini-tender bidder is not required to treat all offerees equally; (iii) a mini-tender bidder is not required to carve back offerees on a pro rata basis if oversubscribed; (iv) a mini-tender is not required to allow investors to change their minds and withdraw shares prior to a full closing; (v) a mini-tender deadline can be extended indefinitely.

Mini-tenders tend to be at or below market price, whereas full tenders tend to be at a premium to market price, reflecting the increased value in obtaining a control position over the target company. As a result of the lack of investor protections, and that mini-tenders are generally below market price, they are considered predatory and have a high level of negative stigma. The primary criticism against a mini-tender is that target shareholders are likely confused about the distinctions between the mini and full tender and do not realize that the offer is below market, irrevocable, and does not require equal and fair treatment for all shareholders, although all of this information would be required to be disclosed under the still applicable tender offer antifraud provisions.

There does not appear to be a rational reason as to why an investor in a liquid market would choose to sell to a bidder below market price unless there is confusion as to the terms of the offer being presented. The SEC even has a warning page on mini-tenders urging investors to carefully review all terms and conditions. Where a market is not liquid, a mini-tender could be a viable exit strategy, though in practice, mini-tenders are largely launched for the purchase of larger, highly liquid securities.

Abbreviated Debt Tender Offers (Five Business Day Tender Offer)

As discussed above, Section 14(e) of the Exchange Act and Regulation 14E set forth certain requirements for all tender offers designed to prevent fraud and manipulative acts and practices. One of those requirements is that a tender offer be open for a minimum of 20 business days and remain open for at least an additional 10 business days after notice of any change in the consideration offered.

Beginning in 1986, the SEC began issuing a series of no-action letters providing relief from the 20-day rule for certain non-convertible, investment-grade debt tender offers. The SEC recognized that tender offers in a straight debt transaction are often effectuated to refinance debt at a lower interest rate or to extend looming maturity dates. The tender is often at a small premium to the prevailing market or pay-off price and does not include any equity upside or kicker considerations. All parties to a debt tender offer are motivated to move quickly and without the equity considerations; the SEC recognized that the same investor protections are not necessary as in an equity tender offer.

The SEC relief generally required that the debt tender remain open for 7-10 days. In January 2015, in response to a request from numerous top industry law firms, the SEC granted further no-action relief establishing a Five Business Day Tender Offer for non-convertible debt securities, which meets certain delineated terms and conditions.

The conditions to a Five Business Day Tender Offer include:

(i) Immediate Widespread Dissemination – the debt tender must begin with immediate (prior to 12:00 noon on the first day of the offer) widespread dissemination of the offer including by press release and Form 8-K containing certain disclosures and including a hyperlink to an Internet address where the offeree can effectuate the tender. The November 18, 2016 C&DI clarifies that a foreign private issuer may satisfy this requirement by filing a Form 6-K instead of Form 8-K.

(ii) Be made for non-convertible debt securities only;

(iii) Only be initiated by the issuer of the debt securities or a direct or indirect wholly owned subsidiary or parent company;

(iv) Be made solely for cash consideration or an exchange for Qualified Debt Securities. Qualified Debt Securities means non-convertible debt securities that are identical in all material respects (including issuer, guarantor, collateral, priority, and terms and covenants) to the debt securities that are the subject of the tender offer except for the maturity date, interest payment and record dates, redemption provisions and interest rate, and provided further that to be Qualified Debt Securities, all interest payments must be solely in cash (no equity) and the weighted average life to maturity must be longer than the debt that is subject to the offer.

(v) Be open to all record and beneficial holders of the debt securities, provided that in an exchange offer, the exchange offer can be limited to Qualified Institutional Buyers as defined in Rule 144A and/or non-U.S. persons as defined in Regulation S under the Securities Act, and as long as all other record and beneficial holders are offered cash with a value reasonably equal to the value of the exchange securities being offered to those qualified to receive such exchange. The November 18, 2016 C&DI clarifies that although the offer has to be made equally to all holders, like other tender offers, it can have conditions to closing such as that a minimum number of debt holders accept the tender.

(vi) The November 18, 2016 C&DI clarifies that where the offer includes an exchange of Qualified Debt Securities to Qualified Institutional Buyers as defined in Rule 144A of the Securities Act, the cash consideration to the other record holders can be calculated by reference to a benchmark as long as it is the same benchmark used to calculate the value of the Qualified Debt Securities.

(vii) Not be made in connection with the solicitation of consents to amend the outstanding debt securities;

(viii) Not be made if a default exists with respect to the subject tender, or any other, material credit agreement to which the company is a party;

(ix) Not be made if at the time of the offer the company is in bankruptcy or insolvency proceedings;

(x) Not be financed with the proceeds of a Senior Indebtedness;

(xi) Permits tender procedures through a certificate as long as the actual debt security is delivered within 2 business days of closing;

(xii) Provide for certain withdrawal rights until the expiration of the offer or any extension;

(xiii) Provide that consideration will be promptly paid for the tendered debt securities; and

(xiv) Not be made in connection with a change of control, merger or other extraordinary transaction involving the company and not be commenced within ten business days of an announcement of the purchase, sale or transfer of a material subsidiary or amount of assets. The November 18, 2016 C&DI clarifies that a company could announce a plan to conduct a Five Business Day Tender Offer but could not commence the offer until the ten-business-day period had passed.

The Author

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

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

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SEC Issues New C&DI On Rule 701

Posted by Securities Attorney Laura Anthony | November 1, 2016 Tags: C&DI, Rule 701

On June 23, 2016, the SEC issued seven new Compliance and Disclosure Interpretations (“C&DI”) related to Rule 701 of the Securities Act of 1933, as amended (“Securities Act”). On October 19, 2016, the SEC issued an additional three C&DI. The majority of the new C&DI focus on the effect on Rule 701 issuances following a merger or acquisition and clarify financial statement requirements under Rule 701. Two of the new C&DI address restricted stock awards including the disclosure requirements are triggered and when the holding period begins under Rule 144.

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

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

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

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

The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

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

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

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

New C&DI

On June 23, 2016, the SEC issued seven new C&DI and on October 19, 2016 an additional three new C&DI all related to Rule 701. The majority of the new C&DI focus on merger and acquisition transactions, including reverse mergers. In addition, the new C&DI clarify financial statement requirements under Rule 701. A summary of the new C&DI follows.

In a merger transaction where the acquirer assumes derivative securities of the target (such as options and warrants) and, as such, they become economically equivalent derivative securities of the acquirer, no exemption need be relied upon for the assumption and transfer of the obligation to the acquirer as long as the derivative securities (again, such as employee options and warrants) were properly issued under Rule 701 and the transfer to the acquirer does not require the consent of the holders of the derivative securities.

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

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

As a reminder from above, the amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption.

The new C&DI clarifies when disclosure delivery requirements are triggered when aggregate sales of a restricted stock award (commonly referred to as a restrictive stock unit or RSU) in a 12 month period exceeds the $5 million threshold. When a company grants a restricted stock award, the date of sale is the date of grant of the award and thus the disclosure must be provided a reasonable time before the date of grant. Unlike an option or warrant, the employee does not need to take additional action to convert or exercise a restricted stock award, rather the award vests and the stock becomes irrevocably granted to the employee by the satisfaction of conditions (such as time of employment). Accordingly, Rule 7(e)(6) requiring disclosure be delivered prior to the exercise of an option or warrant would not apply.

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

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

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

On May 3, 2016, the SEC issued final amendments to revise the rules related to the thresholds for registrations, termination of registration, and suspension of reporting under Section 12(g) of the Securities Exchange Act of 1934. The amendments revise the Section 12(g) and 15(d) rules to reflect the new, higher shareholder thresholds for triggering registration requirements and for allowing the voluntary termination of registration or suspension of reporting obligations.

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

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

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

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

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

held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or

held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

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

The Author

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

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

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SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1

Posted by Securities Attorney Laura Anthony | May 24, 2016 Tags: C&DI, Non-GAAP Measures, Regulation G, SEC Issues New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

The new C&DI follows a period of controversy, press and speeches on the subject. In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.

In recent years management has used MD&A and other areas of its disclosure to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.

However, where EBITDA may not be controversial, the SEC has seen a slippery slope in the use of these non-GAAP measures. The comments letters, and objections by the SEC, relate to failure to abide by Regulation G in providing non-GAAP information, disclosures related to why non-GAAP measures are useful, and cherry-picking of adjustments within a non-GAAP measure. Corp Fin has expressed a particular concern regarding “the use of individually tailored accounting principles to calculate non-GAAP earnings; providing per share data for non-GAAP performance measures that look like liquidity measures; and non-GAAP tax expense.”

The “non-GAAP earnings” issue is really revenue recognition. Public companies are under constant pressure to increase revenues and have become creative in figuring out ways that GAAP revenue recognition standards can be adjusted to increase revenues. Where the elimination of a non-cash GAAP expense item, such as depreciation or derivative liability, seems relatively harmless, and in fact is presented in the statement of cash flows, the inclusion of unearned revenue is much more questionable. Another controversial item affecting revenue is the couching of recurring cash expenses as non-recurring to justify eliminating that item in a non-GAAP presentation. Many of the new C&DI focus on revenue recognition.

Although I understand the SEC concern, I wonder about the continued and increasing proliferation of non-GAAP measures precipitating the controversy. If 90% of companies use non-GAAP numbers to explain their financial operations, perhaps the GAAP rules themselves needs some adjustment. If, on the other hand, the increase is due to greater economic factors, such as the fact that the US economy has been stagnant for six straight years with zero or near-zero interest rates and no real “boom” following the recession “bust” of 2008, then the SEC may be right in its recent hard-line stance. The pressure on public companies to display consistent growth and improved performance continues regardless of the state of the economy. More on that topic another day.

In this two-part blog I will start with the new and circle back to the old. Part I will summarize the new C&DI, and Part II will review Regulation G and Item 10(e) of Regulation S-K.

New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. Some of the C&DI are brand-new and some are revisions of existing guidance. Prior to this, the last published C&DI on non-GAAP financial measures was in July 2011.

Related to Revenue Recognition

The SEC issued four brand-new C&DI related to revenue recognition and, going directly to the issue of “misleading” information, the underpinning of fraud claims.

Question (100.01): Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.

Question (100.02): Can a non-GAAP measure be misleading if it is presented inconsistently between periods?

Answer: Yes. For example, a non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.

Question (100.03): Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?

Answer: Yes. For example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.

Question (100.04): A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.

To be sure the point is being made that adjustments may violate rules and be considered misleading and thus add risk of enforcement proceedings, the SEC has added a reference to new Question 100.01 to an existing C&DI allowing adjustments. In particular:

Question (102.03): Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?

Answer: The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. See Question 100.01.

Three of the C&DI are amendments related to the use of “funds from operations” or “FFO” as defined by the National Association of Real Estate Investment Trusts (NAREIT). The SEC accepts the NAREIT’s definition of FFO and allows the presentation of FFO as a performance measure including FFO on a per share basis. However, the amended C&DI clarify that any adjustments to the standard FFO as defined by NAREIT must comply with Regulation G and that such adjustments “may trigger the prohibition on presenting this measure.” In other words, any adjustments will be scrutinized as possibly being misleading.

Related to earnings per share and liquidity measures

Further related to per share measures of performance, the SEC reiterates the rule that non-GAAP measures may not be used to present liquidity on a per share basis. In particular:

Question (102.05): While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?

Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission, consistent with Accounting Series Release No. 142. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.

Similarly, the SEC adds a clarification to an existing C&DI (Question 102.07) to confirm that “free cash flow” is a liquidity measure that must not be presented on a per share basis.

The SEC also confirms that the generally non-controversial EBITDA may not be presented on a per share basis (Question 103.02).

Related to presentation including reconciliation and prominence

The new C&DI add completely new language, amend prior guidance and eliminate and replace other prior guidance. The new guidance provides:

Question (102.10): Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;

Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;

Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;

A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);

Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;

Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;

Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and

Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.

Question (102.11): How should income tax effects related to adjustments to arrive at a non-GAAP measure be calculated and presented?

Answer: A registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures. If a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained.

The Author

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

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