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Mergers And Acquisitions: Types Of Transactions

Posted by Securities Attorney Laura Anthony | April 5, 2016 Tags: Merger Types, OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities

As merger and acquisition (M&A) transactions completed its most active year since the financial crisis, it is helpful to go back to basics. Activity has been prevalent in all market sectors, including large, mid and small cap and across all industries, including biotech, financial services, technology, consumer goods and services, food and beverage and healthcare, among others.

Although I’ve written about M&A transactions multiple times, this will be the first time I’ve given a broad overview of the forms that an M&A transaction can take.

Types of Mergers and Acquisitions

A merger or acquisition transaction is the combination of two companies into one resulting in either one corporate entity or a parent-holding and subsidiary company structure. Mergers can categorized by the competitive relationship between the parties and by the legal structure of the transaction. Related to competitive relationship, there are three types of mergers: horizontal, vertical and conglomerate. In a horizontal merger, one company acquires another that is in the identical or substantially similar industry eliminating a competitor. In a vertical merger, one company acquires a customer or supplier. A conglomerate merger covers all other transactions where there is no direct competitive or vertical relationship between the merging parties. The result is generally the creation of a conglomerate – thus the name.

From a legal structure perspective, an M&A transaction can be an asset purchase, a stock purchase, a forward merger or a forward or reverse triangular merger. In an asset purchase, stock acquisition, forward merger or forward triangular merger, the acquiring company remains in control. In a reverse merger or a reverse triangular merger, the target company shareholders and management gain control of the acquiring company.

In an asset purchase transaction, the acquirer can pick and choose the assets that it is purchasing, and likewise the liabilities it is assuming. An asset purchase can be complex and requires careful drafting to ensure that the desired assets are included, including all tangible and intangible rights thereto, and that only the specified liabilities are legally assumed. Third-party consents are often required to achieve the result.

In a stock acquisition, the acquiring company purchases the stock from the target company shareholders. A stock acquisition can result in a forward or reverse acquisition depending on the control of the target company shareholders at the closing of the transaction. In a stock acquisition transaction, the operations, assets and liabilities of the target remain unchanged; it just has different ownership. Complexities arise if some of the target company shareholders refuse to participate in the transaction, leaving unfriendly minority shareholders. Oftentimes a stock acquisition is structured such that a closing is contingent upon a certain percentage participation, such as 90% or even 100%.

In a forward merger or a forward or reverse triangular merger, two companies combine into one, resulting in either one corporate entity or a parent-holding and subsidiary company structure. The shareholders of the target company receive either stock of the acquirer, cash or a combination of both. All assets and liabilities are included in the M&A transaction. A triangular merger is one in which a new acquisition subsidiary is formed to complete the transaction and results in a parent-subsidiary structure.

As mentioned above, a reverse merger results in a change of control of the acquirer. In particular, in a reverse or reverse triangular merger the shareholders of the target company exchange their shares for either new or existing shares of the acquiring company so that at the end of the transaction, the shareholders of the target company own a majority of the acquiring company and the target company has become a wholly owned subsidiary of the acquiring company or has merged into a newly formed acquisition subsidiary. A reverse merger is often used as a private to public transaction for a target company where the acquiring company is a public entity.

The specific form of the transaction should be determined considering the relevant tax, accounting and business objectives of the overall transaction.

Refresher on Other Aspects of the Transaction

An Outline of the Transaction Documents

Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent followed by the merger agreement itself. In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information, including allowable disclosure both internally and to third parties. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality, such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

A letter of intent (“LOI”) is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with the “who do” identification.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. A “window shop” provision allows for some level of third-party negotiation. For example, a window shop provision may allow for the consideration of unsolicited proposals.

Much different from a no shop or window shop provision is a “go shop” provision. To address a board of directors’ fiduciary duty and, in some instances, to maximize dollar value for its shareholders, a potential acquirer may request that the target “go shop” for a better deal up front to avoid wasted time and expense. A go shop provision is more controlled than an auction and allows both target and acquiring entities to test the market prior to expending resources. A go shop provision is common where it is evident that the board of directors’ “Revlon Duties” have been triggered.

A standstill provision prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning off subsidiaries, hiring or firing management teams and the like. Many companies also protect their interests in the LOI stage by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The Merger Agreement

In a nutshell, the merger agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being purchased and provides for rights and remedies in the event that this description proves to be materially inaccurate. The merger agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.

The main components of the merger agreement and a brief description of each are as follows:

Representations and warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. Both parties represent as to the accuracy of public filings, financial statements, material contract, tax matters and organization and structure of the entity.
Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing. All covenants require good faith in completion.
Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
Deal protections – Like the LOI, the merger agreement itself will contain deal protection terms. These deal protection terms can include no shop or window shop provisions, requirements as to business operations by the parties prior to the closing, breakup fees, voting agreements and the like.
Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the merger agreement may contain due diligence provisions. Due diligence refers to the legal, business and financial investigation of a business prior to entering into a transaction. Although the due diligence process can vary depending on the nature of a transaction (a relatively small acquisition vs. a going public reverse merger), it is arguably the most important component of a transaction (or at least equal with documentation).

Board of Directors’ Fiduciary Duties in the Merger Process

State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Generally a court will not second-guess directors’ decisions as long as the board has conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases, including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).

However, in certain instances, such as in a merger and acquisition transaction, where a board may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) and Unocal vs. Mesa Petroleum, 493 A.2d 946 (Del. 1985).

A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving directors and/or shareholders such as where directors are on both sides of the transaction. Under the entire fairness standard, the directors must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms.

In all matters, directors’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director to provide complete and materially accurate information to a corporation.

As with many aspects of the law, a director’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors is reduced and only the basic business judgment rule will apply. For example, in instances where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers.

Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective of maximizing the return to shareholders though social interests and considerations (such as the loss of jobs) may also be considered in the process.

The law focuses on the process, steps and considerations made by the board of directors, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors in the face of scrutiny. Courts will consider facts such as attendance at meetings, the number and frequency of meetings, knowledge of the subject matter, time spent deliberating, advice and counsel sought by third-party experts, requests for information from management, and requests for and review of documents and contracts.

In the performance of their obligations and fiduciary responsibilities, a board of directors may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction.

Dissenter and Appraisal Rights

Unless they are a party to the transaction itself, such as in the case of a share-for-share exchange agreement, shareholders of a company in a merger transaction generally have what is referred to as “dissenters” or “appraisal rights.” An appraisal right is the statutory right by shareholders that dissent from a particular transaction, to receive the fair value of their stock ownership. Generally such fair value may be determined in a judicial or court proceeding or by an independent valuation. Appraisal rights and valuations are the subject of extensive litigation in merger and acquisition transactions.

Although the details and appraisal rights process vary from state to state (often meaningfully), as with other state corporate law matters, Delaware is the leading statutory example and the Delaware Chancery Court is the leader in judicial precedence in this area of law. More than half of U.S. public companies and more than two-thirds of Fortune 500 companies are domiciled in Delaware.

As is consistent with all states, the Delaware General Corporation Law (“DGCL”) Section 262 providing for appraisal rights requires both petitioning stockholders and the company to comply with strict procedural requirements. Section 262 of the DGCL gives any stockholder of a Delaware corporation who (i) is the record holder of shares of stock on the date of making an appraisal rights demand, (ii) continuously holds such shares through the effective date of the merger, (iii) complies with the procedures set forth in Section 262, and (iv) has neither voted in favor of nor consented in writing to the merger, to seek an appraisal by the Court of Chancery of the fair value of their shares of stock.

Generally there are four recurring valuation techniques used in an appraisal rights proceeding: (i) the discounted cash flow (DCF) analysis; (ii) a comparable company’s analysis and review; (iii) a comparable transactions analysis and review; and (iv) the merger price itself. Merger price is usually reached through the reality of a transaction process, as opposed to the academic and subjective valuation processes used in litigation challenging such price.

In a recent line of cases, the Delaware court has upheld the merger price as the most reliable indicator of fair value where the merger price was reached after a fair and adequate process in an arm’s-length transaction. Where there is a question as to the process resulting in the final merger price, Delaware courts generally look to the DCF analysis as the next best indicator of fair value.

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.

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

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« Responding To SEC Comments Regulation SCI »

Responding To SEC Comments

Posted by Securities Attorney Laura Anthony | March 29, 2016 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities, responding to sec comments, SEC, sec comment 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 to enhance such disclosures as to each particular issuer. CorpFin will also be cognizant of the anti-fraud provisions of the federal securities laws and may refer a matter to the Division of Enforcement where material concerns arise over the adequacy and accuracy of reported information or other securities law violations, including violations of the Section 5 registration requirements. CorpFin has an Office of Enforcement Liason in that regard.

CorpFin’s review and responsibilities can be described with one word: disclosure!

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. Forms 8-K reporting a change of auditor, a material acquisition, or a change in financial statements are almost always reviewed. Moreover, the Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. 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.

CorpFin does not publicly disclose the criteria it uses to identify companies and filings for review. Essentially, a publicly reporting company’s filings may be reviewed at any time and periodic comment letters are a standard part of being a public company.

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 eleven 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.

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. The company should carefully consider its responses to comments that could open the door to additional review and comments. Comments related to accounting treatment and the flow-through to MD&A can be especially tricky and open the door to further review and changes.

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. 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, explain how the company is burdened and how the alternative provided by the company will provide adequate disclosure for investors. The argument that technical compliance is overly burdensome rarely succeeds with CorpFin, but at times a middle ground can be reached if the company is convincing enough in its analysis.

The comment and response process continues until the staff has resolved all comments. CorpFin may request that the reasoning behind a disclosure be added to the SEC report itself, and so the company should consider whether it wants particular language included in public filings when drafting a response letter to a comment.

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.

Comment letters and responses are posted on the EDGAR database by CorpFin no earlier than 20 days after it has finished the review process.

The SEC generally requires an affirmative statement from the company acknowledging that the company cannot use the SEC’s comment process as a defense in any securities-related litigation. This language is referred to as a “Tandy” letter. The Tandy portion of a response must be agreed to by the company itself, so if the response letter is on attorney letterhead, a signature line must be provided for the company or the company can submit a separate letter. The Tandy language for an Exchange Act filing is generally as follows:

The company acknowledges that:

the company is responsible for the adequacy and accuracy of the disclosure in the filing;

staff comments or changes to disclosure in response to staff comments do not foreclose the Commission from taking any action with respect to the filing; and

the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.

Tandy language for a Securities Act registration statement is generally as follows:

The company acknowledges the following:

should the Commission or the staff, acting pursuant to delegated authority, declare the filing effective, it does not preclude the Commission from taking any action with respect to the filing;

the action of the Commission or the staff, acting pursuant to delegated authority, in declaring the filing effective does not relieve the company from its full responsibility for the adequacy and accuracy of the disclosure in the filing; and

the company may not assert staff comments and the declaration of effectiveness as a defense in any proceeding initated by the Commission or any person under the federal securities laws of the United States.

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. As CorpFin is only reviewing information provided by, or publicly available related to, a company, the completion of a review is not a guarantee as to the accuracy or adequacy of the information in the filing and cannot be used as a defense to claims of fraud or misrepresentations.

Although a full discussion of confidential treatment and requests are 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 Rule 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. In a future blog I will discuss confidential treatment requests and SEC review policies.

Conclusion

The very best way to handle comments and responses is to have a competent team in place that submits high-quality SEC reports in the first place and that is able to communicate with the SEC and understand the legal disclosure and accounting requirements, including interpretative changes over time. The topic of disclosures and disclosure requirements is in the forefront these days, and changes are being reviewed and considered by the SEC (see, HERE for example). Understanding the disclosure requirements for your particular company and industry will save substantial time and effort for a public company.

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.

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.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

« SEC Advisory Committee On Small And Emerging Companies Reviews Capital Formation Mergers And Acquisitions: Types Of Transactions »

OTC Markets Amends Listing Standards For The OTCQX

Posted by Securities Attorney Laura Anthony | December 30, 2015 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities

OTC Markets has unveiled changes to the quotations rule and standards for the OTCQX, which changes become effective January 1, 2016. The amended listing standards increase the quantitative criteria for listing and add additional qualitative requirements continuing to align the OTCQX with standards associated with a national stock exchange. Companies already listed on the OTCQX as of December 31, 2015 will have until January 2017 to meet the new ongoing eligibility requirements.

As part of the rule changes, OTC Markets has renamed its U.S. Designated Advisor for Disclosure (DAD) to an OTCQX Advisor. All U.S. companies that are quoted on the OTCQX must have either an attorney or an Investment Bank OTCQX Advisor. A company may appoint a new OTCQX Advisor at any time, provided that the company retains an approved OTCQX Advisor at all times.

All International companies that are quoted on the OTCQX must have either an Attorney Principal American Liaison (“PAL”) or an Investment Bank PAL – provided however, if the company’s OTCQX traded security is an ADR, the international company may have an ADR/PAL. All PAL’s must be approved by OTC Markets Group. A company may appoint a new PAL at any time provided they maintain a PAL at all times.

All OTCQX Advisors and PALs must be approved by OTCQX after submitting an application. Eligibility to act as an OTCQX Advisor or PAL is limited to experienced and qualified securities attorneys or qualified FINRA member investment banking firms. I am an approved OTCQX Advisor and PAL.

The primary roles of an OTCQX Advisor and PAL include (i) to provide advice and guidance to a company in meeting its OTCQX obligations; (ii) to provide professional guidance to the issuer on creating investor demand as they build long-term relationships with management; (iii) to assist companies in discerning the information that is material to the market and should be disclosed to investors; and (iv) to provide a professional review of the company’s disclosure. The OTCQX puts a great deal of onus on the OTCQX Advisor/PAL to be responsible for the company in which it sponsors, emphasizing the negative impact on the OTCQX Advisor’s reputation for sponsoring companies that are not of acceptable quality. In addition to providing advice and counsel to a company, an OTCQX Advisor/PAL is required to conduct investigations to confirm disclosures. An OTCQX Advisor/PAL must submit a Letter of Introduction and subsequent annual letters confirming their duties and the attesting to the disclosures made by the company.

Summary of Changes

The OTCQX has increased its quantitative initial and ongoing listing standards for U.S. companies including: (i) increase of initial bid price requirement from $0.10 to $0.25 for initial qualification and to $0.10 for ongoing eligibility; (ii) addition of initial minimum market capitalization requirement of $10 million; (iii) addition of continued listing minimum market capitalization requirement of $5 million; (iv) minimum of two market makers with priced quoted on OTC Markets within 90 days of joining; and (v) expands the requirement that the company remain qualified for a penny stock exemption under Rule 3a51-1 or be removed.

The OTCQX has also increased its quantitative initial and ongoing listing standards for international companies including: (i) increase of initial bid price requirement from $0.10 to $0.25 for initial qualification and to $0.10 for ongoing eligibility; (ii) addition of initial minimum market capitalization requirement of $10 million; (iii) addition of continued listing minimum market capitalization requirement of $5 million; and (iv) minimum of two market makers with priced quoted on OTC Markets within 90 days of joining.

The OTCQX has added new qualitative corporate governance requirements for U.S. issuers as well. In particular to list on OTCQX, U.S. companies will be required to (i) have a minimum of 2 independent board members; (ii) have an audit committee comprised of a majority of independent directors; and (iii) conduct an annual shareholders meeting and submit annual financial reports to shareholders at least 15 calendar days prior to such meeting.

The standards for the OTCQX U.S. and International Premier tiers have also increased. The U.S. Premier increases are meant to align such companies with the financial standards recognized by most states for issuer state blue sky exemptions. In particular U.S. Premier companies will require (i) a minimum bid price of $4 for initial qualification and $1 on an ongoing basis; (ii) a minimum market capitalization of $10 million for initial qualification and $5 million on an ongoing basis for companies with a public float of at least $15 million or a minimum market capitalization of $50 million for initial qualification and $35 million on an ongoing basis for companies with a public float of at least $1 million and $750,000 in net income as of the most recent fiscal year end; (iii) stockholders’ equity of $4 million for initial qualification and $1 million for ongoing eligibility; (iv) minimum of 4 market makers with prices quoted on OTC Markets within 90 days of joining; and (v) a minimum of 3 years’ operating history.

The International Premier standards have increased to align with the margin eligibility standards set by the Federal Reserve and SEC. In particular International Premier Companies must have: (i) a global market capitalization of $1 billion for initial qualification and $500 million for ongoing eligibility; (ii) a minimum 5 years’ operating history; (iii) average weekly share volume of 200,000 shares or $1 million for initial qualification and 100,000 shares or $500,000 for ongoing eligibility; and (iv) minimum of 4 market makers with prices quoted on OTC Markets within 90 days of joining.

The annual fee for all companies on the OTCQX has been raised to $20,000.

As part of the changes, the term “OTCQX Advisor” has replaced the current Designated Advisor for Disclosure (DAD) for U.S. companies. I am a qualified approved OTCQX Advisor.

OTCQX

The following is a complete summary of the OTCQX listing standards as they will be in effect on January 1, 2016.

The OTCQX divides its listing criteria between U.S. companies and international companies, though they are very similar. The OTCQX has two tiers of quotation for U.S. companies: (i) OTCQX U.S. Premier (also eligible to quote on a national exchange); and (ii) OTCQX U.S. and two tiers for international companies: (i) OTCQX International Premier; and (ii) OTCQX International. Quotation is available for American Depository Receipts (ADR’s) or foreign ordinary securities of companies traded on a Qualifying Foreign Stock Exchange, and an expedited application process is available for such companies.

Issuers on the OTCQX must meet specified eligibility requirements. Moreover, OTC Markets have the discretionary authority to allow quotation to substantially capitalized acquisition entities that are analogous to SPAC’s.

OTCQX – Requirements for Admission

To be eligible to be quoted on the OTCQX U.S., companies must:

Have $2 million in total assets as of the most recent annual or quarter end;

As of the most recent fiscal year end, have at least one of the following: (i) $2 million in revenues; (ii) $1 million in net tangible assets; (iii) $500,000 in net income; or (iv) $5 million in market value of publicly traded securities;

Have a market capitalization of at least $10 million on each of the 30 consecutive calendar days immediately preceding the company’s application;

Meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application and as of the most recent fiscal year end have at least one of the following: (w) net income of $500,000; (x) net tangible assets of $1,000,000; (y) revenues of $2,000,000; or (z) total assets of $5,000,000; or (ii) have net tangible assets of $2 million if the company has been in continuous operation for at least three years, or $5,000,000 if the company has been in continuous operation for less than three years which qualification can be satisfied as of the end of a fiscal period or as a result of an interim capital raise; or (iii) have average revenue of at least $6,000,000 for the last three years;

Not be a blank check or shell company as defined by the Securities Act of 1933 (“Securities Act”);

Not be in bankruptcy or reorganization proceedings;

Be in good standing in its state of incorporation and in each state in which it conducts business;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Be quoted by at least one market maker on the OTC Link;

Have a minimum bid price of $0.25 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX. If (i) there has been no prior public market for the company’s securities in the U.S. and (ii) FINRA has approved a Form 211, then the company may apply to OTC Markets for an exemption from the minimum bid price requirements, which exemption is at the sole discretion of OTC Markets. In the event that the company is a Seasoned Public Issuer (i.e., has been in operation and quoted on either OTC Link, the OTCBB or an exchange for at least one year) that completed a reverse stock split within 6 months prior to applying for admission to OTCQX U.S., the company must have a minimum bid price of $0.25 per share for its common stock as of the close of business on each of the 5 consecutive trading days immediately preceding the company’s application for OTCQX, after the reverse split;

Have GAAP compliant (i) audited balance sheets as of the end of each of the two most recent fiscal years, or as of a date within 135 days if the company has been in existence for less than two fiscal years, and audited statements of income, cash flows and changes in stockholders’ equity for each of the fiscal years immediately preceding the date of each such audited balance sheet (or such shorter period as the company has been in existence), and must include all going concern disclosures including plans for mitigation; and GAAP compliant (ii) unaudited interim financial reports, including a balance sheet as of the end of the company’s most recent fiscal quarter, and income statements, statements of changes in stockholders’ equity and statements of cash flows for the interim period up to the date of such balance sheet and the comparable period of the preceding fiscal year;

Be included in a Recognized Securities Manual or be subject to the reporting requirements of the Exchange Act; and

Have an OTCQX Advisor.

To be eligible to be quoted on the OTCQX U.S. Premier, companies must:

Satisfy all of the eligibility requirements for OTCQX U.S. set forth above;

Meet one of the following: (i) Market Value Standard – have at least (a) $15 million in public float and (b) a market capitalization of at least $50 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; or (ii) Net Income Standard – have at least (a) $1 million in public float; and (b) a market capitalization of at least $10 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; and (c) $750,000 in net income as of the company’s most recent fiscal year end;

Have at least 500,000 publicly held shares;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Have a minimum of 100 beneficial shareholders owning at least one round lot (100 shares) each;

Have a minimum bid price of $4.00 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX. If (i) there has been no prior public market for the company’s securities in the U.S. and (ii) FINRA has approved a Form 211 and (iii) the bid price is equal to or greater than $1.00, then the company may apply to OTC Markets for an exemption from the 30-day minimum bid price requirements, which exemption is at the sole discretion of OTC Markets. In the event that the company is a Seasoned Public Issuer (i.e., has been in operation and quoted on either OTC Link, the OTCBB or an exchange for at least one year) that completed a reverse stock split within 6 months prior to applying for admission to OTCQX U.S., the company must have a minimum bid price of $4.00 per share for its common stock as of the close of business on each of the 5 consecutive trading days immediately preceding the company’s application for OTCQX, after the reverse split;

Have at least $4 million in stockholder’s equity;

Have a 3-year operating history; and

Conduct annual shareholders’ meetings and submit annual financial reports to its shareholders at least 15 calendar days prior to such meetings.

To be eligible to be quoted as an OTCQX U.S. Acquisition Company, companies must:

Satisfy all of the eligibility requirements for OTCQX U.S. set forth above;

Have a minimum bid price of $5.00 per share for its common stock as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX; and

Be subject to the reporting requirements of the Exchange Act.

Corporate Governance Requirements for all OTCQX U.S., U.S. Premier and U.S. Acquisition Companies:

Have at least 2 independent board members on the board of directors;

Have an audit committee comprised of a majority of independent directors; and

Conduct annual shareholders’ meetings and submit annual financial reports to its shareholders at least 15 calendar days prior to such meetings.

To be eligible to be quoted on the OTCQX International, companies must:

Have U.S. $2 million in total assets as of the most recent annual or quarter end;

As of the most recent fiscal year end, have at least one of the following: (i) U.S. $2 million in revenues; (ii) U.S. $1 million in net tangible assets; (iii) U.S. $500,000 in net income; or (iv) U.S. $5 million in global market capitalization;

Meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application and as of the most recent fiscal year end have at least one of the following (w) net income of $500,000; (x) net tangible assets of $1,000,000; (y) revenues of $2,000,000 or (z) total assets of $5,000,000; or (ii) have net tangible assets of U.S. $2 million if the company has been in continuous operation for at least three years, or U.S. $5,000,000 if the company has been in continuous operation for less than three years; or (iii) have average revenue of at least U.S. $6,000,000 for the last three years;

Be quoted by at least one market maker on the OTC Link (which requires a 15c2-11 application if the company is not already quoted on a lower tier of OTC Markets);

Not be a shell company or blank check company;

Not be in bankruptcy or reorganization proceedings;

Have a minimum of 50 beneficial shareholders owning at least one round lot (100 shares) each;

Be included in a Recognized Securities Manual or be subject to the reporting requirements of the Exchange Act;

Have its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days – provided, however, that in the event the company’s securities are listed on a non-U.S. exchange that is not a Qualified Foreign Stock Exchange, then at the company’s request and subsequent to the company providing OTC Markets Group with personal information forms for each executive officer, director, and beneficial owner of 10% or more of a class of the company’s securities and such other materials as OTC Markets Group deems necessary to make an informed determination of eligibility, OTC Markets Group may, upon its sole and absolute discretion, consider the company’s eligibility for OTCQX International;

Have a global market capitalization of at least $10 million on each of the 30 consecutive calendar days immediately preceding its application day;

Meet one of the following conditions: (i) be eligible to rely on the registration exemption found in Exchange Act Rule 12g-2(b) and be current and compliant in such requirements; or (ii) have a class of securities registered under Section 12(g) of the Exchange Act and be current in its SEC reporting requirements; or (iii) if such company is not eligible to rely on the exemption from registration provided by Exchange Act Rule 12g3-2(b) because it does not (A) meet the definition of “foreign private issuer” as that term is used in Exchange Act Rule 12g3-2(b) or (B) maintain a primary trading market in a foreign jurisdiction as set forth in Exchange Act Rule 12g3-2(b)(ii), and is not otherwise required to register under Section 12(g), be otherwise current and fully compliant with the obligations of a company relying on the exemption from registration provided by Exchange Act Rule 12g3-2(b); and

Have Principal American Liaison (PAL).

Explanation of Exchange Act Rule 12g3-2(b):

Exchange Act Rule 12g3-2(b) permits foreign private issuers to have their equity securities traded on the U.S. over-the-counter market without registration under Section 12 of the Exchange Act (and therefore without being subject to the Exchange Act reporting requirements). The rule is automatic for foreign issuers that meet its requirements. A foreign issuer may not rely on the rule if it is otherwise subject to the Exchange Act reporting requirements.

The rule provides that an issuer is not required to be subject to the Exchange Act reporting requirements if: (i) the issuer currently maintains a listing of its securities on one or more exchanges in a foreign jurisdiction which is the primary trading market for such securities; and (ii) the issuer has published, in English, on its website or through an electronic information delivery system generally available to the public in its primary trading market (such as the OTC Market Group website), information that, since the first day of its most recently completed fiscal year, it (a) has made public or been required to make public pursuant to the laws of its country of domicile; (b) has filed or been required to file with the principal stock exchange in its primary trading market and which has been made public by that exchange; and (c) has distributed or been required to distribute to its security holders.

Primary Trading Market means that at least 55 percent of the trading in the subject class of securities on a worldwide basis took place in, on or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer’s most recently completed fiscal year.

In order to maintain the Rule 12g3-2(b) exemption, the issuer must continue to publish the required information on an ongoing basis and for each fiscal year.

The information required to be published electronically under paragraph (b) of this section is information that is material to an investment decision regarding the subject securities, such as information concerning: (i) Results of operations or financial condition; (ii) Changes in business; (iii) Acquisitions or dispositions of assets; (iv) The issuance, redemption or acquisition of securities; (v) Changes in management or control; (vi) The granting of options or the payment of other remuneration to directors or officers; and (vii) Transactions with directors, officers or principal security holders.

At a minimum, a foreign private issuer shall electronically publish English translations of the following documents: (i) Its annual report, including or accompanied by annual financial statements; (ii) Interim reports that include financial statements; (iii) Press releases; and (iv) All other communications and documents distributed directly to security holders of each class of securities to which the exemption relates.

To be eligible to be quoted on the OTCQX International Premier, companies must:

Satisfy all of the eligibility requirements for OTCQX International set forth above;

Have a global market capitalization of at least $1 billion on each of the 30 consecutive calendar days immediately preceding its application day; and

Have one of the following over the prior 6 months: (i) average weekly trading volume of at least 200,000 shares; or (ii) average weekly trading volume of at least $1 million.

Application to the OTCQX

All U.S. companies that are quoted on the OTCQX must submit an application and pay an application fee. The application consists of (i) the application with information related to the company; (ii) the contractual agreement with OTCQX for quotation; (iii) personal information for each executive officer, director and beneficial owner of 5% or more of the securities, except for companies already traded on a foreign exchange or moving from a recognized U.S. exchange; (iv) designation of the OTCQX Advisor; (v) appointment form for the OTCQX Advisor; and (vi) a digital company logo.

All international companies that are quoted on the OTCQX must submit an application and pay an application fee. The application consists of (i) OTCQX application for international companies; (ii) the contractual agreement with OTCQX for international companies; (ii) the OTCQX application fee; (iv) the OTCQX Agreement for international companies; (v) an application for the international company’s desired PAL if such PAL is not already pre-qualified; (vi) an appointment form for the PAL; and (vii) a copy of the company’s logo in encapsulated postscript (EPS) format.

The application is subject to review and comment by OTC Markets. OTC Markets may require additional conditions or undertakings prior to admission. Moreover, the application may be denied if, in the opinion of OTC Markets, trading would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.

Initial Disclosure Obligations

A company must post its initial disclosure documents on the OTC Markets website as a precondition to acceptance of an application for quotation, and such posting must be confirmed with a letter by the company OTCQX ADVISOR/PAL.

Initial disclosure documents include: (i) SEC reports if the company is subject to the Exchange Act reporting requirements; (ii) current information in accordance with OTC Markets disclosure guidelines including financial statements; (iii) if the company is a Regulation A reporting company, it must be current in such reporting requirements; (iii) if the company was an SEC Reporting Company immediately prior to joining OTCQX and has a current 10-K on file with the SEC, or was a Regulation A Reporting Company immediately prior to joining OTCQX and has a current 1-K on file with the SEC, the company is not required to post an information statement through the OTC Markets, but subsequent to joining OTCQX must post all annual, quarterly, interim and current reports required pursuant to the Disclosure Guidelines; and (iv) for international companies not subject to the SEC reporting requirements, all information required to be made public pursuant to Exchange Act Rule 12g3-2(b) for the preceding 24 months, which information must be posted in English.

A company must supplement and update any changes to the initial disclosure within 30 days of acceptance of its application for quotation. International companies must follow initial disclosure with a PAL Letter of Introduction.

Requirements for Ongoing Qualification for Quotation on the OTCQX

The following is a summary of the ongoing responsibilities for U.S. OTCQX quoted securities:

Compliance with Rules – OTCQX quoted companies must maintain compliance with the OTCQX rules including disclosure requirements. The company’s OTCQX ADVISOR/PAL is responsible for reporting their/its potential conflicts of interest;

Compliance with Laws – OTCQX quoted companies must maintain compliance with state and federal securities laws and must cooperate with any securities regulators, including self-regulatory organizations;

Blue Sky Manual Exemption – Companies must either properly qualify for a blue sky manual exemption or be subject to and current in their Exchange Act reporting requirements;

Retention and Advice of OTCQX ADVISOR – Companies must have an OTCQX ADVISOR at all times and are required to seek the advice of such OTCQX ADVISOR as to their OTCQX obligations;

Duty to Inform OTCQX ADVISOR – As part of its duty to seek advice from its OTCQX ADVISOR, a company has an obligation to provide disclosure and information to the OTCQX ADVISOR, including “complete access to information regarding the company, including confidential and propriety information”; access to personnel; updated personal information forms; and timely responses to requests for information or documents;

Notification of Resignation or Dismissal of OTCQX ADVISOR – A company must immediately notify OTC Markets in writing of the resignation or dismissal of the OTCQX ADVISOR for any reason;

Payment of Fees – a company must pay its annual fees to OTC Markets;

Sales of Company Securities by Affiliates – Prior to transacting in the company’s securities through a broker-dealer, each officer, director or other affiliate of the company shall make its status as an affiliate of the company known to the broker-dealer;

Distribution and Publication of Proxy Statements – The company shall solicit proxies for all meetings of shareholders. If the company is a Regulation A Reporting Company, the company shall publish, on EDGAR through SEC Form 1-U, copies of all proxies, proxy statements and all other material mailed by the company to its shareholders with respect thereto, within 15 days of the mailing of such material. If the company is not an SEC Reporting Company or a Regulation A Reporting Company, the company shall publish, through the OTC Markets, copies of all proxies, proxy statements and all other material mailed by the company to its shareholders with respect thereto, within 15 days of the mailing of such material;

Redemption Requirements – All redemptions must be either by lot or pro rata and require 15 days’ notice;Changes in Form or Nature of Securities – All changes in form, nature or rights associated with securities quoted on the OTCQX require 20 days’ advance notice to OTC Markets;

Transfer Agent – Companies are required to use the services of a registered transfer agent and authorize such transfer agent to share information with OTC Markets;

Accounting Methods – Any change in accounting methods requires advance notice of such change and its impact, to OTC Markets;

Change in Auditors – All changes in auditor requires prompt notification and a letter from such auditor analogous to Form 8-K requirements;

Responding to OTC Markets Group Requests – OTCQX quoted companies are required to respond to OTC Markets comments and amend filings as necessary in response thereto;

Ongoing Disclosure Obligations – (i) Companies subject to the Exchange Act reporting requirements must remain current in such reports; (ii) Companies not subject to the Exchange Act reporting requirements must remain current with the annual, quarterly and current reporting requirements of OTC Markets, including posting annual audited financial statements prepared in accordance with GAAP and audited by a PCAOB auditor; (iii) Regulation A reporting companies shall maintain current compliance with their Regulation A reporting requirements and within 45 days of the end of the first and third fiscal quarters shall file quarterly disclosure including all information required in a semi-annual report (i.e., the company shall file quarterly and not just semi-annual reports); (iv) file a notification of late filing when necessary; (v) quickly release disclosure of material news and recent developments, whether positive or negative, through a press release on the OTC Markets website (in addition to SEC filings); (vi) an OTCQX company should also act promptly to dispel unfounded rumors which result in unusual market activity or price variations;

General requirements regarding integrity – OTCQX quoted companies are expected to act professionally and uphold the OTC Markets standards for “high quality,” and to release news and reports that are prepared factually and accurately with neither excessive puffery or conservatism; companies must not report or act in a way that could be misleading; must not inundate with non-material releases; and must not make misleading premature announcements;

Maintain Company Updated Profile – OTCQX quoted companies are required to maintain updated accurate information on their profile page and to verify same every six months;

OTCQX ADVISOR Letter – Within 120 days of each fiscal year end and after the posting of the company’s annual report, every company must submit an annual OTCQX ADVISOR letter;

To remain eligible for trading on the OTCQX U.S. tier, the company’s common stock must have a minimum bid price of $0.10 per share as of the close of business for at least one of every thirty consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $0.10 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $0.10 for ten consecutive trading days;

To remain eligible for trading on the OTCQX U.S. tier, the company must maintain a market capitalization of at least $5 million for at least one of every 30 consecutive calendar days;

To remain eligible for trading on the OTCQX U.S. tier, the company must have at least 2 market makers quote the stock;

To remain eligible for trading on the OTCQX U.S. Premier tier, the company’s common stock must have a minimum bid price of $1.00 per share as of the close of business for at least one of every thirty consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $1.00 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $1.00 for ten consecutive trading days. In the event that the company’s common stock does not regain compliance during the grace period, the company shall have a fast-track option to have its securities traded on the OTCQX U.S. tier.

To remain eligible for trading on the OTCQX U.S. Premier tier, the company must meet one of the following standards: (i) Market Value Standard – have at least (a) $15 million in public float and (b) a market capitalization of at least $35 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; or (ii) Net Income Standard – have at least (a) $1 million in public float; and (b) a market capitalization of at least $5 million, each as of the close of business on each of the 30 consecutive days immediately preceding the company’s application; and (c) $500,000 in net income as of the company’s most recent fiscal year end;

To remain eligible for trading on the OTCQX U.S. Premier tier, the company must have at least $1 million in stockholders’ equity;

To remain eligible for trading on the OTCQX U.S. Premier tier, the company must have at least 4 market makers quoting the stock;

All U.S. companies, whether U.S. standard or U.S. Premier, must maintain corporate governance standards including independent director and audit committee requirements. A company must notify OTC Markets immediately of a disqualification and must regain compliance by its next annual shareholder meeting or one year from the date of non-compliance.

The following is a summary of the ongoing responsibilities for OTCQX International quoted securities:

Eligibility Criteria – The international company must meet the above eligibility requirements as of the end of each most recent fiscal year;

Compliance with Rules – OTCQX quoted companies must maintain compliance with the OTCQX rules, including disclosure requirements. Officers and directors of the company are responsible for compliance and are solely responsible for the content of information;

Compliance with Laws – OTCQX quoted companies must maintain compliance with applicable securities laws of their country of domicile and applicable U.S. federal and state securities laws. The company must comply with Exchange Act Rule 10b-17 and FINRA rule 6490 regarding notification and processing of corporate actions (such as name changes, splits and dividends). The company must cooperate with any securities regulators, whether in their country of domicile or in the U.S., including self-regulatory organizations;

Blue Sky Manual Exemption – Companies must either properly qualify for a blue sky manual exemption or be subject to and current in their Exchange Act reporting requirements;

Retention and Advice of PAL – Companies must have a PAL at all times and are required to seek the advice of such PAL as to their OTCQX obligations;

Notification of Resignation or Dismissal of PAL – A company must immediately notify OTC Markets in writing of the resignation or dismissal of the PAL for any reason;

Payment of Fees – A company must pay its annual fees to OTC Markets;

Responding to OTC Markets Group Requests – OTCQX quoted companies are required to respond to OTC Markets comments and amend filings as necessary in response thereto;

To remain eligible for OTCQX International, the company must maintain a minimum bid price of $0.10 as of the close of business for at least one of every 30 consecutive calendar days. In the event that the minimum bid price for the company’s common stock falls below $0.10 per share at the close of business for thirty consecutive calendar days, a grace period of 180 calendar days to regain compliance shall begin, during which the minimum bid price for the company’s common stock at the close of business must be $0.10 for ten consecutive trading days;

To remain eligible for OTCQX International, the company must maintain a market capitalization of at least $5 million for at least one of every 30 consecutive calendar days;

To remain eligible for OTCQX International, the company must maintain at least 2 market makers;

Ongoing Disclosure Obligations – (i) Companies subject to the Exchange Act reporting requirements must remain current in such reports; (ii) A company that is not an SEC Reporting Company must remain current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and in any event shall, on an ongoing basis, post in English through the OTC Disclosure & News Service or an Integrated Newswire, the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b); (iii) provide a letter to its PAL at least once a year, no later than 210 days after the fiscal year end, which states that the company (y) continues to satisfy the OTCQX quotation requirements; and (z) is current and compliant in its obligations under Exchange Act Rule 12g3-2(b) and that the information required under such rule is posted, in English, on the OTC Markets website or that the company is subject to the SEC reporting requirements and is current in such reporting requirements;

PAL Letter – Within 225 days of each fiscal year end and after the posting of the company’s annual report, every company must submit an annual PAL letter; and

To remain eligible for the OTCQX International Premier, the company must have (i) a global market capitalization of at least $500 million for at least one of every 30 consecutive calendar days; (ii) of one following over the prior 6 months (a) an average weekly trading volume of at least 100,000 shares or (b) an average weekly trading dollar volume of at least $500,000; and (iii) at least 4 market makers.

Removal from OTCQX International

A company may be removed from the OTCQX if, at any time, it fails to meet the eligibility and continued quotation requirements subject to a 30-day notice and opportunity to address them. In addition, OTC Markets Group may remove the company’s securities from trading on OTCQX immediately and at any time, without notice, if OTC Markets Group, upon its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors. In addition, OTC Markets can temporarily suspend trading on the OTCQX pending investigation or further due diligence review.

A company may voluntarily withdraw from the OTCQX with 24 hours’ notice.

Fees

Upon application for quotation on the OTCQX, companies must pay an initial non-refundable fee of $5,000. In addition, companies must pay an annual non-refundable fee of $20,000. The annual fee is based on the calendar year and is due by December 1st each year.

OTCQX Advisor (formerly known as Designated Advisors for Disclosure (“DAD”)) and Principal American Liaison (“PAL”) Requirements

All International companies that are quoted on the OTCQX must have either an Attorney Principal American Liaison (“PAL”) or an Investment Bank PAL – provided however, if the company’s OTCQX traded security is an ADR, the international company may have an ADR PAL. All PAL’s must be approved by OTC Markets Group. A company may appoint a new PAL at any time provided they maintain a PAL at all times.

The primary roles of an OTCQX Advisor and PAL include (i) to provide advice and guidance to a company in meeting its OTCQX obligations; (ii) to provide professional guidance to the issuer on creating investor demand as they build long-term relationships with management; (iii) to assist companies in discerning the information that is material to the market and should be disclosed to investors; and (iv) to provide a professional review of the company’s disclosure. The OTCQX puts a great deal of onus on the OTCQX Advisor/PAL to be responsible for the company which it sponsors, emphasizing the negative impact on the OTCQX Advisor’s reputation for sponsoring companies that are not of acceptable quality. In addition to providing advice and counsel to a company, an OTCQX Advisor/PAL is required to conduct investigations to confirm disclosures. An OTCQX Advisor/PAL must submit a Letter of Introduction and subsequent annual letters confirming their duties and the attesting to the disclosures made by the company.

The Author

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

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SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies

Posted by Securities Attorney Laura Anthony | July 29, 2015 Tags: Going public attorneys-2, LawCast-2, OTC Attorneys, OTC Law Firm, OTC Law firm-2, OTC Law Firms, OTC Lawyers, OTC Market Attorneys, OTC Markets Attorneys, otc markets attorneys-2, OTC Securities Attorneys, OTC Securities Attorneys-2, Reverse Merger Attorneys, Reverse merger attorneys-2, Reverse Mergers Attorneys, Securities Attorneys

On May 6, 2015 the SEC approved a two-year pilot program with FINRA and the national securities exchanges that will widen the minimum quoting and trading increments, commonly referred to as tick sizes, for the stocks of smaller public companies. The goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks.

The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. The other side of the coin is that larger spreads and more profit for the traders equates to increased costs to the investors whose accounts are being traded.

The tick size program includes companies that meet the following $3 billion or less in market capitalization, an average trading volume of one million shares or less, and a volume weighted average price of at least $2.00 for every trading day. The pilot study group includes a control group of 1400 securities and three test groups with 400 securities in each. Notably, the tick size program will not include micro-cap securities with a weighted average price of less than $2.00 per day.

During the pilot the control group will be quoted at the current tick size increment of $.01 per share and will trade at the currently permitted increments. The first test group will be quoted in increments of $.05 but will continue to trade at any price increment that is currently permitted. The second test group will be quoted in increments of $.05 and will also trade at $.05 minimum increments subject to certain exceptions. The third test group will be quoted in increments of $.05 and will be subject to an additional “trade at” requirement to prevent price matching. The third test group will have the same exceptions as the second and an additional block size exception.

Background and Reasoning for the Program

Since the inception of decimalization in 2001 and minimum price variation of one penny for exchange-traded companies, there has been a significant change in the nature of trading and role of market participants. Many market participants believe that underwriters and market makers have lost their incentive to make markets and produce research for micro-, small- and mid-capitalization companies.

The JOBS Act directed the SEC to conduct a study and report to Congress on how decimalization affected the number of IPO’s and the liquidity and trading of stock in smaller public companies. The JOBS Act also gives the SEC the authority to designate a minimum increment for the trading of emerging growth companies that is more than $.01 but less than $.10. In July 2012 the SEC submitted the “Decimalization Report” to Congress, failing to reach a firm conclusion and instead realizing further research was needed, including by pursuing a pilot program to study the impact of wider tick sizes. The SEC believes that the current approved tick size pilot program will provide the necessary information to determine whether to permanently change tick sizes for these smaller companies.

As mentioned, the goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks. The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. Moreover, additional market makers may enter the market as they see an opportunity to earn value. Additional market makers will equate to additional liquidity, which in turn attract more investors.

Issuers benefit from increased liquidity and market activity and quality in several ways. More trading activity and increased investor awareness could reduce the company’s cost of capital and improve opportunities to attract capital. That is, more investors will be willing to invest directly into the company, through PIPE transactions, registered secondary offerings, equity lines and the like as they will see a strong exit strategy. Moreover, with higher liquidity and market value, the ultimate exit by these investors will have less of a downward impact on trading price. Where the investment instrument was convertible (such as convertible debt, warrants and options) using a market price formula, less downward pressure on trading price will mean fewer shares will need to be issued in the conversion and the existing shareholders will suffer less dilution.

In addition, one of the main purposes of going public is to use capital stock as currency in making acquisitions and attracting key executives. Where the company has an active trading market, market maker support and strong liquidity, the value of the capital stock is likewise higher. Not only will the capital cost of making stock-based acquisitions and attracting and retaining high-quality key executives be reduced but for some issuers, it will make the difference of being able to utilize this benefit of being public at all.

Although there is no doubt that improved liquidity, market activity and market maker and underwriter support is extremely beneficial to all public companies, and in serious need for improvement for smaller public companies, it is not known whether the increased tick size will have the desired outcome.

The other side of the coin is that larger spreads and more profit for the traders with the increased tick size equates to increased costs to the investors whose accounts are being traded. Moreover, the program itself will be complex and costly to implement for market participants. Market participants have stringent rules to follow for each test group to ensure a valid test result. Each participant must adopt written policies and procedures and monitor and report results.

Conclusion

It is important that the SEC and market participants actively seek to improve the market quality for smaller public companies, and this is just one measure in that wheelhouse. However, it is a two-year program. I’m anxious to see more timely efforts in this arena, such as through the launch of venture exchanges.

The Author

Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony 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 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 host of LawCast.com, the securities law network.

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

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« The ECOS Matter; When Is A Reverse Split Effective? OTC Markets Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156 »

The ECOS Matter; When Is A Reverse Split Effective?

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Duty of Care, Finra, Going Public Attorneys, OTC Attorneys, OTC Marketplace, OTC Markets Attorneys, Reverse Merger Attorneys, Reverse Mergers Attorneys, Reverse split, Rule 10b-17, Rule 6490

In what was presumably an unintended consequence, the application of an SEC- approved FINRA regulation has resulted in a conflict between state and federal corporate law for a small publicly traded company.

On September 16, 2014, Ecolocap Solutions, Inc. (“ECOS”) filed a Form 8-K in which it disclosed that FINRA had refused to process its 1-for-2,000 reverse split. At the time of the FINRA refusal, ECOS had already received board and shareholder approval and had filed the necessary amended articles with the State of Nevada, legally effectuating the reverse split in accordance with state law. Moreover, ECOS is subject to the reporting requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and had filed a preliminary and then definitive 14C information statement with the SEC, reporting the shareholder approval of the split.

The ECOS 8-K attached a copy of the FINRA denial letter, which can be viewed HERE. In support of its denial of the reverse split, FINRA relied upon its discretion under FINRA Rule 6490 and the existence of a previous SEC action against an individual who is the principal of an entity that is a convertible note holder of ECOS. In particular, FINRA cited an SEC order issued on November 25, 2013 against Curt Kramer, Mazuma Corporation, Mazuma Funding Corporation and Mazuma Holding Corporation involving violations of Section 5 of the Securities Act of 1933 and Rule 504. FINRA cited that Curt Kramer is a principal of Asher Enterprises and that Asher Enterprises, in turn, is a convertible note holder in ECOS and therefore FINRA was refusing to process the reverse split.

In its 8-K filing, ECOS took a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate. In support of their position, ECOS sets forth that the subject reverse split was already legally effective in accordance with state law and therefore FINRA’s refusal to reflect such capital change in ECOS trading quotation results in public misinformation regarding the company’s capitalization. ECOS also objected to FINRA’s application of Rule 6490 in this case by denying that either Mr. Kramer or Asher Enterprises is “connected” with the company as contemplated by the Rule. Furthermore, they stated that the subject SEC action was completely unrelated to ECOS or the reverse split.

Although FINRA has not issued a responsive statement, one of its mandates is to protect investors and maintain fair and orderly markets. In this instance, the Company’s stock is actively trading at $.0001 per share. The Company’s total outstanding shares increased from 893,615,983 one year ago to 6,865,010,372 as of April 2014. ECOS has been in the development stage since January 1, 2007 and has not reported any revenues since September, 2010. The overwhelming majority of the increase in outstanding stock is the result of the conversion of convertible debt, and most of funds received by the company from the note holders was used for salaries, as well as interest on the convertible debt and fees for staying a publicly-traded company (such as satisfying reporting obligations). Although the information in the Company’s filings as to its business operations is sparse, it has been in the same business with the same management since 2007, without any financial success. As of June 30, 2014, the Company had approximately $664,000 in convertible outstanding notes payable. The Company intends to complete a 1:2000 reverse split, which will reduce the total outstanding shares to 3.9 million and presumably increase the share price to $.20.

However, the Company’s new, higher share price will likely be temporary due to the lack of any underlying business success to create support for a higher market valuation. In addition, FINRA realizes that in all probability, upon enactment of the inflated share price, existing note holders have an increased incentive to convert their debt into freely tradable shares and may begin selling these shares in the market. Should such selling pressure occur, and the new share price decrease, any shareholder that purchased at $.20 will most likely suffer a loss. Should the cycle of selling continue, the outstanding shares will increase, potentially into the billions, until the share price is once again $.0001. Taking this into account, FINRA’s concerns are self-evident.

There clearly exists a fundamental conflict between federal and state law and the ability to regulate corporate actions. It raises the basic question of “When is a reverse split effective?” If pursued, this action opens the door for court interpretation of FINRA’s authority under Rule 6490 in general.

Rule 6490

Effective September 27, 2010, the SEC approved FINRA Rule 6490 (Processing of Company Related Actions). Rule 6490 requires that corporations whose securities are trading on the over-the-counter market (OTCQX, OTCQB, OTCBB or pinksheets) timely notify FINRA of certain corporate actions, such as dividends, forward or reverse splits, rights or subscription offerings, and name changes. The Rule grants FINRA discretionary power when processing documents related to the announcements.

Rule 6490 works in conjunction with Exchange Act Rule 10b-17. Rule 10b-17 provides that “it shall constitute a manipulative or deceptive device or contrivance as used in section 10(b) of the Act for any issuer of a class of securities publicly traded… to fail to give notice in accordance with paragraph (b) of this section of the following actions relating to such class of securities: (1) a dividend or other distribution in cash or in kind… (2) a stock split or reverse split; or (3) a rights or other subscription offering.” Section (b) requires that notice be given to FINRA “no later than 10 days prior to the record date involved.”

FINRA also issues trading symbols to over-the-counter traded issuers and maintains a database of trading symbols for issuers. When FINRA completes the processing of a corporate action, OTC marketplace is notified of such changes and actions. Most commonly, changes and actions include the re-pricing of securities after a forward or reverse split and the issuance of a new trading symbol following a name change or merger.

Prior to 2010, FINRA’s role has been predominantly ministerial due to their limited jurisdictional ability to impose informational or other regulatory requirements, and fundamental lack of power to reject requested changes. However, since the SEC began expressing concern that entities were using FINRA to assist in fraudulent activities, Rule 6490 was created.

The Rule codifies FINRA’s authority to conduct in-depth reviews of company-related actions and equips the staff with discretion to refuse the processing of such actions in situations when the information or requisite forms are incomplete or when certain indicators of potential fraud exist. FINRA staff now possesses broad discretion to request additional documents and supporting evidence to verify the accuracy of submitted information.

Rule 6490(d)(3) provides:

(3) Deficiency Determination

In circumstances where an SEA Rule 10b-17 Action or Other Company-Related Action is deemed deficient, the Department may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets, that documentation related to such SEA Rule 10b-17 Action or Other Company-Related Action will not be processed. In instances where the Department makes such a deficiency determination, the request to process documentation related to the SEA Rule 10b-17 Action or Other Company-Related Action, as applicable, will be closed, subject to paragraphs (d)(4) and (e) of this Rule. The Department shall make such deficiency determinations solely on the basis of one or more of the following factors: (1) FINRA staff reasonably believes the forms and all supporting documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements, if applicable, to the SEC or other regulatory authority; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security. (emphasis added)

Exchange Act Rule 10b-17 appears to be limited to notice and allows the SEC to pursue an enforcement action for the failure to give such notice in a timely manner. Rule 6490 goes further, stating a corporation action “will not be processed” if FINRA makes a “deficiency determination.” Clearly subsections (3) and (4) give broad discretionary authority to FINRA to render such a deficiency determination and refuse to process an action.

Further exacerbating the existing conflict between the application of state and federal law is the fact that FINRA requires that a Company submit the file-stamped amendments to its corporate charter as part of their review process. Simply stated, the FINRA corporate action process requires that a Company legally completes the corporate action (reverse split, name change, etc.) on the state level prior to issuing a determination as to whether it will process the already-completed change with the marketplace.

State vs. Federal Regulation of Corporate Law

Historically the regulation of corporate law has been firmly within the power and authority of the states. However, over the past few decades the federal government has become increasingly active in matters of corporate governance. In waves, typically following a period of scandal in business or financial markets, the federal government has enacted regulation either directly or indirectly imposing upon state corporate regulations. The predominant method of federal regulation of corporate governance is through the enactment of mandatory terms that either reverse or preempt state law rules on the same point.

State corporation law is generally based on the Delaware and Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances. The traditional fiduciary duties that govern state corporations laws include the duties of care and loyalty and are tempered by the business judgment rule.

The duty of care requires that directors exercise the same level of care that would be expected from an ordinarily prudent person in the conduct of his or her own affairs. This includes making an informed decision, seeking the advice of experts when necessary, and considering both the positive and negative impacts of a decision. The duty of loyalty is essentially a proscription against conflict of interest and self-dealing. The business judgment rule basically says that if a director follows both his duty of loyalty and duty of care, then the decision should be deferred to.

Director actions that result in a fraud upon shareholders and investors is actionable under federal (and state) securities laws. Both the state and federal securities regulators are charged with preventing fraud on the markets and protecting the integrity of the trading markets in general.

Conclusion

The ECOS matter has raised heated debate on whether FINRA fairly applied its authority in this case and as to the meaning of “connected.” Publicly traded companies, by nature, have ever-evolving shareholders and investors, the identities of which are often not in the power or control of the company itself. Stock is personal property that generally may be freely transferred by its owners (which should not be confused with suggesting that such transferred stock is always freely tradable on a public market). Debt instruments are negotiable instruments and generally transferrable by the debt holder. The sale and transfer of such debt instruments is common. In the small cap world, changes in management and control are fairly commonplace, as is the change in the business direction of a company.

Regulators are tasked with the job of supporting these changes in the small and micro-cap space and giving every entrepreneur a fair shot while preventing abuses in the system and what such as in this case, they ultimately see, as crossing the line.

Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux. What is the capitalization of ECOS? In accordance with state law, the company has approximately 3.4 million shares issued and outstanding; however, according to the over-the-counter marketplace, the company has approximately 6.8 billion shares outstanding. Legally it seems that the company has 3.4 million shares of stock outstanding at a trading price of $.0001 and that FINRA’s refusal to process relates solely to a refusal to re-price the stock as a result of the reverse split and not a broader refusal to recognize the validly of the share reduction itself.

However, many people in the industry are debating the impact and meaning of the decision with divergent views and conclusions, including the legal effect of the reverse split.

A discussion of federal law pre-emption is beyond the scope of this blog. However, even if I did include a treatise on the subject, the answer would be difficult. As an attorney I could write a very good argument that state law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply), and I could also write a very good argument that federal law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply except where there is a competing strong federal policy – such as the regulation of public markets). I could argue that the federal government has no right to stop a corporation from effectuating a name change or reverse split but only the power to prosecute the failure to provide adequate notice of same. I could also argue that the federal government has the right to take actions that may prevent fraud being committed on public markets, including by refusing to allow a name change or reverse split.

The Author

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

Contact Legal & Compliance LLC. Inquiries of a technical nature are always encouraged.

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