SEC Denies Expert Market – For Now
As the compliance date for the new 15c2-11 rules looms near, on August 2, 2021, in a very short statement, the SEC shot down any near-term hope for an OTC Markets operated “expert market.” The SEC short statement indicated that a review of the proposed exemptive order that would allow the expert market is not on its agenda in the short term. The SEC continued that “[A]ccordingly, on September 28, 2021, the compliance date for the amendments to Rule 15c2-11, we expect that broker-dealers will no longer be able to publish proprietary quotations for the securities of any issuer for which there is no current and publicly available information, unless an existing exception to Rule 15c2-11 applies.”
The statement acts as a great segue for a review as to just what those exceptions may be. In addition, this blog will discuss the OTC Markets proposed expert market and finish with a broader refresher on the new 211 rules including the current public information requirements for each class of issuer. For an in-depth discussion of the amended rules, see HERE.
Also, importantly, even for companies that believe they are current in their OTC Markets Alternative Reporting requirements, OTC Markets requires that the company profile be verified through the OTCIQ system as part of the 211 compliance process. OTC Markets has indicated that profiles must be updated by August 9 to ensure their compliance team has sufficient time to confirm the availability of current public information and update company information prior to the rule’s September effective date.
As more fully described below, current information works on a 180-day timeline from the date of the end of a reporting period. Since most companies have a calendar year reporting period, the SEC picked September 28th as the compliance deadline because that is exactly 181 days from March 31st. Assuming a report is filed for the March 31st quarter end, the company will remain piggyback qualified from April 1st through September 27th inclusive. If the Company does not file its June 30th report, it will lose qualification on September 28th (the compliance date) because the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.
Adding pressure to the thousands of companies that will be impacted by the new rules, on July 20, TD Ameritrade published a 162-page list of over 6,000 companies that do not have current public information, for which it will accept liquidating orders only, beginning mid-August. That list was reduced to 3,500 companies by August 2nd and as of today, TD Ameritrade has suspended its plans to cease trading for the time being as companies continue to get up.
15c2-11 Exceptions
- Piggyback Exception
Under the new rules, the SEC is requiring that a company’s current publicly available information be timely filed or filed within 180 calendar days from a specified date, depending on the category of company, for a broker-dealer to rely on the piggyback exemption to publish quotations. The chart below summarizes the filing requirements. The 180-day period begins on the date that a reporting period ends. Accordingly, for example, if a SEC reporting issuer has a December 31 year-end and filed a report for that period, quotations for the period January 1 – June 29 inclusive, would be covered by the piggyback exception. If the same issuer filed its quarterly reports for March 31, June 30 and September 30, the 180-day period would extend from each of those dates (until April 30 of the following year). However, if the same issuer failed to file its September 30 10Q, it would no longer be able to rely on the piggyback exception beginning December 28 (180 days following June 30) because following that date, the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.
In making the calculation for an alternative reporting (catch-all) company, a broker-dealer must ensure that current information is dated within 12 months of the publication of the quotation and that the balance sheet is less than 16 months old. Accordingly, for example, if the alternative reporting company has a December 31 year-end, and filed its annual report for December 31, 2020 including all the required information (with a balance sheet dated after September 1, 2019 and a profit and loss for the 12 months preceding that period), a broker-dealer could continue to rely on the piggyback exception until December 31, 2021.
Of course, maintaining current information requires more than just financial statements. As further discussed below, where SEC or other regulatory requirements prescribe the information that must be reported (such as for a foreign private issuer), Rule 15c2-11 does not require different information. The Rule, however, does prescribe the information required by a catch-all company. The OTC Markets has updated its current information reporting requirements to encompass all of the information and requirements in the new Rule.
The amended rule adds a 15-day conditional grace period from the date of a publicly available determination that a company no longer has current information within the 180-day specified period as set forth in the chart below, for a broker-dealer to continue to quote the particular security. The purpose of the grace period is to give the markets notice that the company is in danger of no longer being quoted and provide investors with an opportunity to liquidate positions. In order to use the grace period, three conditions must be met: (i) OTC Markets or FINRA must make a public determination that current public information is no longer available within 4 business days of the information no longer being available (i.e., expiration of the time periods in the chart); this could be by, for example, a tag on the quote page or added letter to the ticker symbol; (ii) all other conditions for reliance on the piggyback exception must be effective (such as a one way quote); and (iii) the grace period ended on the earliest of the company once again making current information publicly available or the 14th calendar day after OTC Markets or FINRA makes the public determination in (i) above. I note that once OTC Markets has made a publicly available determination that a broker-dealer may rely on the piggyback exception, it has an affirmative duty to make a publicly available determination that the same company no longer has publicly available current information as required by the rule.
The SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggyback exception; rather, the amended rule provides for a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations. A broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period. Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter-end. Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility. Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility.
To reduce some of the added burdens of the rule change, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the piggyback exception have been met. To be able to properly keep track of piggyback exception eligibility, OTC Markets will need to establish, maintain, and enforce reasonably designed written policies and procedures to determine, on an ongoing basis, whether the documents and information are, depending on the type of company, filed within the prescribed time periods.
The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:
| Category of Company | 15c2-11 Current Information |
| Exchange Act reporting company | Filed within 180 days following end of a reporting period. |
| Regulation A reporting company | Filed within 120 days of fiscal year-end and 90 days of semi-annual period end |
| Regulation Crowdfunding filer | Filed within 120 days of fiscal year-end. |
| Foreign Private Issuer | Since first day of most recent completed fiscal year, has filed information required to be filed by the laws of home country or principal exchange traded on. |
| Catch-all company | Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet.
Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e., approximately 2 years and 2 months). A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date. |
In addition to the current publicly available information requirement, to rely on the piggyback exception, the new rules require: (i) at least a one-way priced quotation at a specified price (either bid or ask); and (ii) that no more than 4 days in succession have elapsed without a quotation (frequency of quotation requirement). Although the priced quotation must be at a specified price, there is no minimum threshold (for example, it does not have to be above $0.01). For a broker-dealer to rely on the piggyback exception, a quoted OTC security of an issuer would need to be the subject of a bid or offer quotation, at a specified price, with no more than four business days in succession without such a quotation.
The initial rule proposal contained a provision that would have eliminated the piggyback exception altogether for shell companies. This provision received significant pushback and would have had a huge chilling effect on reverse merger transactions in the OTC Markets. In response to the pushback, the final rule allows for broker-dealers to rely on the piggyback exception to publish quotations for shell companies for a period of 18 months following the initial priced quotation on OTC Markets. In essence, a shell company is being granted 18 months to complete a reverse merger with an operating business, or in the alternative, to organically begin operations itself. The amended rules only allow the piggyback exception for a period of 18 months following the initial quotation. The first 18-month period for a shell company will begin on September 18, the compliance date for the new rules. If a company remains a shell at the end of the 18-month period, it will lose piggyback eligibility and a new 211 compliance review would be necessary.
The rule adopts a definition of shell company that tracks Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2, but also adds a “reasonable basis” qualifier to help broker-dealers and OTC Markets make determinations. A shell company is defined as any issuer, other than a business combination related shell company as defined in Rule 405 or asset backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents. A company will not be considered a shell simply because it is a start-up or has limited operating history. To have a reasonable basis for its shell company determination, a broker-dealer or the OTC Markets can review public filings, financial statements, business descriptions, etc.
In addition, a broker-dealer may not rely on the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act.
Understanding the dramatic change and impact the new rules will have on the OTC Market place, the SEC will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule. In a request for relief, the SEC will consider all facts and circumstances including whether based on information provided, the issuer or securities are less susceptible to fraud or manipulation. The SEC may consider securities that have an established prior history of regular quoting and trading activity; companies that do not have an adverse regulatory history; companies that have complied with any applicable state or local disclosure regulations that require that the company provide its financial information to its shareholders on a regular basis, such as annually; companies that have complied with any tax obligations as of the most recent tax year; companies that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors. At the time of the rule release, the SEC suggested that requests for relief be submitted as soon as possible to prevent a quotation interruption prior to the rule’s implementation. At the time of publication of this blog, I am unsure if the SEC could entertain such a request prior to the September 28 deadline.
- Unsolicited Quotation Exception
Rule 15c2-11 has an unsolicited quotation exception. That is, a broker-dealer may issue a quote where such quotation represents unsolicited customer orders. The Rule requires a broker-dealer that is presented with an unsolicited quotation to determine whether there is current publicly available information. If no current available information exists, the unsolicited quotation exception is not available for company insiders or affiliates. The Rule defines “affiliate” using the same language as Rule 144 and in particular “[A]n affiliate of an issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.” This definition encompasses officers and directors and presumptively covers shareholders owning 10% or more of the outstanding securities.
A broker-dealer may rely on a written representation from a customer’s broker that such customer is not a company insider or an affiliate. The written representation must be received before and on the day of a quotation. Also, the broker-dealer must have a reasonable basis for believing the customer’s broker is a reliable source including, for example, obtaining information on what due diligence the broker conducted. Like the piggyback exception, a broker-dealer will be able to rely on a qualified IDQS (OTC Markets) or a national securities association (FINRA) determination that there is current publicly available information.
- ADTV and Asset Test Exception
Rule 15c2-11 has an ADTV and asset test exception for securities that are considered lower-risk. To rely on this exception, the security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”).
The ADTV test requires that the security have a worldwide reported ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation. To satisfy the final ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade)
The asset test requires that the company have at least $50 million in total assets and stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end. This would cover both domestic and foreign issuers.
The rule also creates an exception for a company who has another security concurrently being quoted on a national securities exchange. For example, some companies quote their warrants or rights on OTC Markets following a unit IPO offering onto a national exchange.
Like the piggyback exception, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the ADTV and asset test or the exchange-traded security exception have been met. Conversely, if OTC Markets or FINRA is publishing the availability of an exception, they will also need to publish when such exception is no longer available.
- Underwritten Offering Exception
The Rule has an exception to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This change may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation. This exception requires that the broker-dealer have the 211 current information in its possession and have a reasonable basis for believing the information is accurate and the sources of information are reliable.
OTC Markets Request for Exemptive Order for Expert Market
OTC Markets requested an exemptive order with the SEC to permit broker-dealers to publish or submit proprietary quotations for securities, on a continuous basis, in a market where the distribution of such quotations is restricted to sophisticated or professional investors, without complying with the information review and recordkeeping requirements of amended Rule 15c2-11. The SEC published the proposed exemptive order and requested public comment.
OTC Markets currently maintains an expert market which allows broker-dealer subscribers to, among other things, find price transparency in certain securities that may not be eligible or suitable for retail investors. The request for exemptive relief would modify that expert market to provide greater access to certain retail investors. An expanded expert market is intended to provide a marketplace, limited to sophisticated or professional investors, for grey market securities or small companies seeking growth opportunities that might prefer to be quoted in a more limited market.
Under the proposed conditional exemptive order, OTC Markets Group would authorize market data distributors, including Subscribers, to be eligible to receive quotations published or submitted on the Expert Market and to distribute such data to Subscribers who comply with certain obligations and restrictions on data access set forth in a Market Data Distribution Agreement (“MDDA”). The MDDA would, among other things, restrict end users and the distribution to any third parties that do not qualify as a permitted recipient, and would require that the distributor or subscriber report all end users to OTC Markets.
Permitted recipients (“Qualified Experts”) or expert market users would include: (i) any qualified institutional buyer as defined in Rule 144A (generally must own and invest $100 million in securities); (ii) any accredited investor as defined in Rule 501(a) (see HERE); and (iii) any qualified purchaser as defined in Section 2 of the Investment Company Act of 1940 (generally have $5 million or more in securities).
Qualified securities on the expert market would include: (i) companies that are currently quoted under the piggyback exception and lose qualification on the compliance date for the amended rules (September 28); (ii) companies that lose 211 compliance in the future due to a lack of current public information, shell status or failure to meet the frequency of quotation requirement; and (iii) any security that is issued in conjunction with a Chapter 11 bankruptcy plan under Section 1145 of the Bankruptcy Code. Securities that had been subject to a registration revocation or defunct companies would not be able to be quoted.
In operating the expert market under the proposed exemptive relief, OTC Markets would establish, maintain, and enforce written policies and procedures that are reasonably designed to allow only permitted recipients to view, and to prevent the general public from viewing, quotations published or submitted on the expert market. OTC Markets would also establish procedures to surveil the use of the expert market to ensure compliance with the MDDA.
As noted at the beginning of this blog, the SEC has taken any action on this Order off the table, at least in the near term.
More on Amended Rule 15c2-11
Amended Rule 15c2-11: (i) requires that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limits certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduces regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allows OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamlines the rule and eliminate obsolete provisions.
The amended Rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The rule release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. The only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA. However, if new IDQS platforms or national securities associations develop, they would also be covered by the Rule.
A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review. Keeping the rule’s current 3-business-day requirement, a broker-dealer’s quotation must be published or submitted within 3 business days after the qualified IDQS (OTC Markets) makes a publicly available determination.
Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies to file Forms 211 with FINRA. I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews.
Current Public Information Requirements
The amended Rule (i) requires that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permits additional market participants to perform the required review (i.e., OTC Markets); and (iii) expands some categories of information required to be reviewed.
To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation. The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation.
The catch-all category encompasses companies that alternatively report on OTC Markets, as well as companies that are delinquent in their SEC reporting obligations – provided, however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggyback exception.
For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence. The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet.
Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied. In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension. The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggyback exception, for continued quotations.
Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.
The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.
Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements.
Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer. The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.
Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame as laid out in the chart above. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.
The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation. A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet.
The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officers, and directors. In addition, records must be reviewed, and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder. As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10%-or-greater shareholders unless the company has current publicly available information.
The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review, the broker-dealer, upon confirming that the 211 information is current and publicly available, is excepted from performing a separate review and can proceed to quote that security.
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SEC Spring 2021 Regulatory Agenda
The first version of the SEC’s semiannual regulatory agenda and plans for rulemaking under the current administration has been published in the federal register. The Spring 2021 Agenda (“Agenda”) is current through April 2021 and contains many notable pivots from the previous SEC regime’s focus. The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.
The Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame jumped up to 45 items since Fall, which had only 32 items. Some of the new items are a revisit of previously passed rule changes. Although a big jump from Fall 2020, 45 is in line with prior years. The Spring 2019 Agenda had 42 and the Fall 2019 had 47 on the list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.
Four items appear in the pre-rule stage including prohibition against fraud, manipulation, and deception in connection with security-based swaps which was also on the Fall Agenda. Added to the list are exempt offerings, third-party service providers and gamification. Third-party service providers refer to the asset management industry and includes services such as index and model providers. Under the gamification category, the SEC is considering seeking public comment on potential rules gamification, behavioral prompts, predictive analytics, and differential marketing. Gary Gensler talked about gamification issues in a recent speech – see HERE
Interestingly, the SEC HERE; offering communications (HERE); amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (HERE); Regulation A (HERE); and Regulation CF (HERE).
The Agenda indicates that the SEC is now planning on seeking public comment on ways to further updated the SEC rules for exempt offerings “to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.” All of these were points of contention during the rule amendment process. Also in August 2020, the SEC updated the definition of an accredited investor and specifically decided not to increase the financial thresholds (see HERE). Seems we could be going back to the beginning in this whole process. As a practitioner I am frustrated by the idea that the SEC’s rulemaking could be so partisan-driven. Historically, that was not the case. Certainly, we have seen a different focus with new administrations but not a seesaw of rulemaking.
Thirty-six items are included in the proposed rule stage, up from just 16 on the Fall 2020 list, and include plenty of brand-new interesting topics. New to the proposed rule list are ESG related items including climate change and human capital disclosure. In addition to many public announcements on the topic of climate change, in March, the SEC issued a statement requesting public input on climate change disclosure with a focus on enhancing and updating the prior 2010 guidance (see HERE), it is now considering rule amendments to further enhance the disclosure requirements. Further proposed items in the ESG category are rules related to investment companies and investments advisors addressing environmental, social and governance factors.
Also new to the list is special purpose acquisition companies (SPACs) which could include a plethora of potential rule changes such as specific exclusion from the protections of Private Securities Litigation Reform Act (PSLRA), enhanced disclosure requirements, amendments to Exchange listing requirements and changes to accounting treatment, among others (see HERE). Rule 10b5-1 and in particular, a review of affirmative defenses available for insider trading cases, has been added to the proposed rule list. This is a topic Gary Gensler and the current SEC top brass have been vocal about in public speeches. Similarly, potential changes to Section 10 liability provisions surrounding loans or the borrowing of securities now appear on the proposed rule list.
Another hot topic amongst the SEC and marketplace has been share repurchase programs by public companies, including the potential they unfairly benefit insiders selling into the upmarket created by the repurchase programs. Share repurchase disclosure modernization has been added to the proposed rule list. Likewise, market structure reform including related to payment for order flow, best execution and market concentration are new to the Agenda in the proposed rule category. Gary Gensler gave a heads-up that this was a priority in his May 6, 2021 speech to the House Financial Services Committee (see HERE). Keeping in the market structure category, the SEC is considering amending the rules to shorten the standard settlement cycle. The historical t+3 was shortened to t+2 back in March 2017 (see HERE) and many believe that technology can currently handle t+1 with a goal of reaching simultaneous settlement (t+0).
Rounding out new items on the Agenda appearing on the proposed rule list include disclosure regarding beneficial ownership of swaps including interests in security-based swaps; cybersecurity risk governance which could enhance company disclosure requirements regarding cybersecurity risk; electronic submission of applicators for orders under the Advisors Act, confidential treatment requests for filings on Form 13F, and ADV-NR; open-end fund liquidity and dilution management; incentive-based compensation arrangements at certain financial institutions that have $1 billion or more in total assets; and portfolio margining of uncleared swaps and non-cleared security-based swaps.
Many items remain on the proposed list including mandated electronic filings increasing the number of filings that are required to be made electronically; potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and records to be preserved by certain exchange members, brokers and dealers.
Amendments to the transfer agent rules still remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). Former SEC top brass suggested that it would finally be pushed over the finish line last year, but so far it remains stalled (see, for example, HERE).
Another controversial item still appearing on the proposed rule stage list is enhanced listing standards for access to audit work papers and improvements to the rules related to access to audit work papers and co-audit standards. In June 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market” (see HERE).
Bolstering Nasdaq’s position, the Division of Trading and Markets and the Office of the Chief Accountant are considering jointly recommending (i) amendments to Rule 2-01(a) of Regulation S-X to provide that only U.S. registered public accounting firms will be recognized by the SEC as a qualified auditor of an issuer incorporated or domiciled in non-cooperating jurisdictions for purposes of the federal securities laws, and (ii) rule amendments to enhance listing standards of U.S. national securities exchanges to prohibit the initial and continued listing of issuers that fail to timely file with the SEC all required reports and other documents, or file a report or document with a material deficiency, which includes financial statements not prepared by a U.S. registered public accounting firm recognized by the SEC as a qualified auditor.
It is not just the pre-rule stage that reflects a re-do of recently enacted rules. The disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE and finalized in December 2020 (see HERE) is now on the proposed rule list to determine if additional amendments might be appropriate. Keeping with a seeming willingness to subject the marketplace to continued regulatory uncertainty, back on the proposed list is amendments to the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8. After years of discussion and debate, the SEC adopted much-needed rule changes in September 2020 (see HERE) which are now apparently back on the table. The complete proxy advisory rule changes (see HERE) are also back in play on the proposed rule list. Finally, amendments to the whistleblower program which had dropped off the list as completed, are now back on for further review.
Several items have moved from long term actions to the proposed rule stage. Executive compensation clawback (see HERE), which had been on the proposed rule list in Spring 2020 and then moved to long-term action, is back on the proposed list. Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification. This topic has been batting around since 2015. Also, clawbacks of incentive compensation at financial institutions moved from long-term to proposed.
Also moved up from long-term action to proposed is corporate board diversity (although nothing has been proposed, it is a hot topic); reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); amendments to the custody rules for investment advisors (which was moved from proposed to long term and now back to proposed); money market fund reforms; registration and regulation of security-based swap execution facilities; prohibitions of conflicts of interest relating to certain securitizations; broker-dealer liquidity stress testing, early warning, and account transfer requirements; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and short sale disclosure reforms.
Bouncing back to the proposed list from the long-term list in Fall after spending one semi-annual period on the proposed rule list are amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons.
Nine items are included in the final rule stage, down from 14 on the Fall Agenda, none of which are new to the Agenda. Implementation of Dodd-Frank’s pay for performance jumped from the long-term list where it had sat for years, to the final rule stage (see HERE). Establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC also jumped from a long-term action item to the proposed rule list. Likewise, amendments to the NMS Plan for the consolidated audit trail data security have been added.
Investment company summary shareholder report and modernization of certain investment company disclosures moved from the proposed to final rule stage, as did amendments to Regulation ATS for the registration of and reporting by alternative trading systems (ATS) for government securities.
Moving quickly from the proposed rule stage to final rule stage are the controversial amendments to the Rule 144 holding period and Form 144 filings. In December 2020, the SEC surprised the marketplace by proposing amendment to Rule 144, which would prohibit the tacking of a holding period upon the conversion of variably priced securities (see HERE. The responsive comments have been overwhelmingly opposed to the change, with only a small few in support and those few work together in plaintiff’s litigation against many variably priced investors. Many of the opposition comment letters are very well thought out and illustrate that the proposed change by the SEC may have been a knee-jerk reaction to a perceived problem in the penny stock marketplace. I wholly oppose the rule change and hope the SEC does not move forward. For more on my thoughts on the damage this change can cause, see HERE.
Still listed in the final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility. The SEC re-opened comments on the rule proposal in April 2021 (see HERE). Although things can change, final action is currently slated for October 2021.
Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); and an amendment to the definition of clearing agency for certain activities of security-based swaps dealers.
Seventeen items are listed as long-term actions, down from the 32 that were on the Fall list, including many that have been sitting on the list for years and one that is new. Although the already implemented amendments to the proxy process and rules are under new review as discussed above, additional proxy process amendments dropped from the proposed list to a long-term action item. New to the list in long-term action is investment company securities lending arrangements.
Continuing their tenure on the long-term list is conflict minerals amendments; stress testing for large asset managers; custody rules for investment companies; requests for comments on fund names; amendments to improve fund proxy systems; end user exception to mandatory clearing of security-based swaps; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.
Several items have dropped off the Agenda as they have now been implemented and completed, including amendments to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation; use of derivatives by registered investment companies and business development companies; market data infrastructure, including market data distribution and market access; and amendments to the SEC’s Rules of Practice.
Moved from the proposed rule stage to a long-term action item are proposed changes to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies). In May 2018, SEC amended the rules and issued a concept release (see HERE and HERE). In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy. This no longer seems to be a priority.
Dropped from the Agenda are amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years. Surprisingly, the proposal was met with overwhelming pushback from market participants. There were 2,238 comment letters opposing the change and only 24 in support. Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other, more pressing matters.
Other items dropped from the Agenda without action include amendments to asset-backed securities disclosures (last amended in 2014); earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020 back down to long-term in Fall 2020 and now has been dropped altogether. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority.
Also dropped without action is amendments to Guide 5 on real estate offerings and Form S-11 (though some changes were made in relation to the acquisition of businesses by blind pools); and amendments to the family office rule (though I expect this will be partly covered by the item on the proposed list related to disclosure regarding beneficial ownership of swaps including interests in security-based swaps).
Disappointingly still not on the Agenda is Regulation Finders. Although the SEC proposed a conditional exemption for finders (see HERE), it does not go far enough, and again is not a priority.
The Author
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SEC Rules Requiring Disclosures for Resource Extraction Companies
As required by the Dodd-Frank Act, in December 2020, the SEC adopted final rules requiring require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals. The last version of the proposed rules were published in December 2019 (see HERE )The rules have an interesting history. In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court. In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress. In December 2019, the SEC took its third pass at the rules that were ultimately adopted.
The final rules require resource extraction companies that are required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) to disclose payments made by it or any of its subsidiaries or controlled entities, to the U.S. federal government or foreign governments for the commercial development of oil, natural gas, or minerals.
FINAL RULES
The Dodd-Frank Act added Section 13(q) to the Exchange Act directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.
As noted above, the first two passes at the rules by the SEC were rejected. The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects. In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors. The rules were also thought to exceed the SEC authority.
The final rules make many significant changes to the rejected 2016 rules. In particular, the final rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) amend the definition of “not de minimis” to mean any payment or series of related payments that equals or exceeds $100,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made but require disclosure of aggregated amounts for each subnational government payee and identify each subnational government payee; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.
The rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q). Under the rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F. Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered. Moreover, smaller reporting companies and emerging growth companies are exempted. However, if the SRC or EGC is subject to disclosure requirements by an alternative reporting regime will have to report on a scaled basis.
The rules define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity. The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development. The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.
Likewise, the definitions of “extraction” and “processing” are narrowly defined and do not include downstream activities such as refining or smelting. “Export” is defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource. Companies that provide transportation services, without an ownership interest in the resource, are not covered.
Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits. The rules define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure. Furthermore, an anti-evasion provision is included such that the rules require disclosure with respect to an activity or payment that, although not within the categories included in the rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).
A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place. A resource extraction issuer will have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral. The disclosure would be at the broad level without the need to drill down further on the type of resource. The second prong requires a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining. Again, additional details are not required. The third prong requires an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.
Under the rules, a “foreign government” is defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” includes a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government. On the other hand, “federal government” refers to the government of the U.S. and does not include subnational governments such as states or municipalities.
The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate. Under the rules, Form SD expressly states that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited. The report covers the company’s fiscal year and needs to be filed no later than nine months following the fiscal year-end. The Form SD must include XBRL tagging.
As noted above, the rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts. In addition, the rules contain a targeted exemption for payment related to exploratory activities. Under this targeted exemption, companies will not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year. The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.
Finally, the rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO. When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year. Similarly, companies that complete an IPO do not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.
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SEC Announces It Will Not Enforce Amended Rules Governing Proxy Advisors
On June 1, 2021, SEC Chair Gary Gensler and the SEC Division of Corporation Finance issued statements making it clear that the SEC would not be enforcing the 2020 amendments to certain rules governing proxy advisory firms or the SEC guidance on the new rules.
In particular, in July 2020 the SEC adopted amendments to change the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provide additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amended Rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules. On the same day, the SEC issued updated guidance on the new rules. See HERE for a discussion on the new rules and related guidance.
Like all rules and guidance related to the proxy process, the amendments were controversial with views generally falling along partisan lines. On June 1, 2021, Chair Gary Gensler issued an extremely brief public statement, as follows:
I am now directing the staff to consider whether to recommend further regulatory action regarding proxy voting advice. In particular, the staff should consider whether to recommend that the Commission revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments, among other matters.
On the same day, the SEC Division of Corporation Finance issued a public statement that CorpFin is following Chair Gensler’s direction and revisiting the rules and guidance. CorpFin stated that, in light of the new direction, it will not recommend enforcement action based on the 2019 Interpretation and Guidance or the 2020 Rule Amendments during the period in which the SEC is considering further regulatory action in this area. Moreover, even if the new rules are left in place, CorpFin will not recommend enforcement for a reasonable period of time thereafter, including until current litigation related to the rule changes have been addressed.
Refresher on Amended Rules and Guidance
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. The rules apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures. Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.
The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.”
The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.
On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request. For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts. The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).
The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.
The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9). A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions. In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters). The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.
New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021. Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while, at the same time, working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.
The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship. The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.
Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects. The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended. Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended. Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible. This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms, such as ISS and Glass Lewis, voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice. The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.
The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses. The time for review was set as a number of days based on the date of filing of the definitive proxy statement. However, commenters pushed back and the SEC listened.
The final rules allow proxy advisory businesses to take matters into their own hands. In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).
As adopted, the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible. Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.
New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule. In particular:
(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.
(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).
The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company. Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice. Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.
It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule. The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does, in fact, meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Supplemental Guidance for Investment Advisors
On the same day as enacting the amended rules, the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE. The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.
The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline. The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.
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SEC Re-Opens Comments On The Use Of Universal Proxy Cards
On April 16, 2021, the SEC voted to reopen the comment period on the proposed rules for the use of Universal proxy cards in all non-exempt solicitations for contested director elections. The original rules were proposed on October 16, 2016 (see HERE) with no activity since. However, it is not surprising that the comment period re-opened, and it is not as a result of the new administration. The SEC’s Spring and Fall 2020 semi-annual regulatory agendas and plans for rulemaking both included universal proxies as action items in the final rule stage. Prior to that, the topic had sat in the long-term action category for years.
In light of the several years since the original proposing release, change in corporate governance environment, proliferation of virtual shareholder meetings, and rule amendments related to proxy advisory firms (see HERE) and shareholder proposals in the proxy process (see HERE), the SEC believed it prudent to re-open a public comment period. In addition, the SEC including additional questions for public input in its re-opening release.
Background
Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Companies subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies.
Currently where there is a contested election of directors, shareholders are likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e., all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned, the second would cancel out and replace the first under state corporate law.
Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally, in a contested election the opposing candidates will not agree, presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.
Shareholders can always appear in person, or in today’s world – virtually in person, and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. Besides other impediments, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years, some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition. To provide the same voting rights to shareholders utilizing a proxy card as they would have in person, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.
In 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First, it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e., those prepared by the company) to get those names.
In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card, and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. As a response, the SEC issued the rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.
SEC Proposed Rule
On October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. In particular, the proposed rule would:
- Create new Rule 14a-19 to require the use of universal proxy cards in all non-exempt solicitations in connection with contested director elections. The universal proxy card would not be required where the election of directors is uncontested. There may be cases where shareholder proposals are contested by a company, in which case a shareholder would still receive two proxy cards; however, in such case, all director nominees must be included in each groups proxy cards;
- Revise the consent required of a bona fide director nominee such that a consent for nomination will include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
- Eliminate the short slate rule;
- Prescribe certain filing, notice, and solicitation requirements of companies and dissidents when using universal proxy cards;
- Require dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
- Require dissidents in a contested election subject to new Rule 14a-19 to solicit holders of at least a majority of the voting power of shares entitled to vote on the election of directors;
- Provide for a filing deadline for the dissidents’ definitive proxy statement; and
- Prescribe formatting and other requirements for the universal proxy cards.
The Proposed Rules also include other improvements to the proxy voting process, such as mandating that proxy cards include an “against” voting option when permitted under state laws and requiring disclosure about the effect of a “withhold” vote in an election.
The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:
| Due Date | Action Required |
| No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [proposed Rule 14a-19(b)(1)] | Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees. |
| No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [proposed Rule 14a- 19(d)] | Registrant must notify the dissident of the names of the registrant’s nominees. |
| No later than 20 business days before the record date for the meeting. [current Rule 14a-13] | Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners. |
| By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [proposed Rule 14a-19(a)(2)] | Dissident must file its definitive proxy statement with the Commission. |
The proposed new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.
In its rule release, the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”
Companies have a concern that dissident board representation can be counterproductive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve. The SEC rule release solicits comments on this point.
Moreover, there is a concern that shareholders could be confused as to which candidates are endorsed by whom, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.
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ESG Matters – What a Difference A Year Makes
What a difference a year makes – or should I say – what a difference an administration makes! Back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s disclosure based regulatory regime. Enter Chair Allison Herron Lee and in a slew of activity over the past few weeks, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; Corp Fin has called for public comment on ESG disclosures and suggested a framework for discussion on the matter; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and the SEC issued a statement calling for public comment on climate related disclosures including a detailed list of questions to consider.
The ESG activity coming out of the SEC is so constant, I had to go back and add to this blog three times after I thought it was finished.
It seems that the SEC must answer the call from investors for valuable ESG disclosures. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
Net zero refers to operating such that global warming is limited to below 2o Celsius with net zero greenhouse gas emissions by 2050. But like all things ESG, there is a lot of disagreement on the best path forward. On March 10, 2021, the UK’s Institutional Investors Group on Climate Change, representing $35 trillion Euro in assets under management, published a Net Zero Investment Framework 1.0 specifically discouraging the use of carbon market offsets in achieving net zero goals. The problem is that many large companies use carbon offsets as an integral part of their stated net zero plans. Disclosure of plans may satisfy the SEC, but it is no guarantee that investors or stakeholders will approve of any course of action.
Back in 2010 the SEC issued guidance to public companies regarding disclosure requirements as they apply to climate change matters. Reviewing compliance with these guidelines is top of list for both Corp Fin and the Enforcement Taskforce. The Enforcement Task Force is also focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
In a series of blogs I will discuss ESG related matters including this first blog, which is focused on the climate change initiatives, a second discussing ESG investing, ratings and the role of a Chief Sustainability Officer and a third on ESG disclosures in general.
SEC Recent Climate Related Disclosure Initiative
As indicated, in the past 6 weeks, the SEC has issued a slew of statements and started numerous initiatives related to climate disclosures and environmental matters. Climate change is a top priority for the Biden administration. On February 1, 2021, the SEC announced that Satyan Khanna was named its first ever Senior Policy Advisor for Climate and ESG. Mr. Khanna was a former agency attorney and ex-adviser to Biden.
On February 24, 2021, acting SEC Chair Allison Herren Lee directed the Division of Corporation Finance to enhance its focus on climate related disclosures in public company filings. In her announcement, Chair Lee indicated that Corp Fin will review the extent to which public companies address the topics identified in the SEC’s 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The SEC staff has been directed to also update the 2010 guidance for present day efficacy. Then on March 15, 2021 the SEC solicited public comment on climate change disclosures with specific questions to consider.
The directive is not surprising as Chair Lee has always been vocal about her desire for increased climate and environment related disclosures. Stepping up initiatives for climate disclosure regulations, in March, Chair Lee, speaking at a virtual conference, stated that the SEC wants to implement a global framework for climate disclosures working in collaboration with global stakeholders and climate authorities. Certainly our markets are global and the SEC has made other recent disclosure changes to align with global practices, such as mining disclosure requirements (see HERE. New Corp Fin Director John Coates is fully on board. He is a former Harvard Law School professor who has pushed the SEC to update is corporate disclosures requirements on climate change and ESG matters.
On March 4, 2021, the SEC announced the creation of a Division of Enforcement Climate and ESG Task Force made up of 22 members from various offices. The task force will be focused on “ESG-related misconduct” including reviewing compliance with the 2010 climate disclosure guidelines and focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
I would also think that the Task Force will spend time reviewing the numerous ESG related financial products including high-yield debt instruments that have flooded the market. As one Wachtell Lipton memo pointed out, “[M]assive inflows into ESG-oriented investment funds and seemingly insatiable demand for ESG-related issuances have led to ‘greenium’ pricing (i.e., a lower cost of capital for issuers) of many ESG-related issuances. Moreover, credit rating agencies are increasingly factoring ESG risks – including related regulatory risks – into their ratings, as are credit committees at banks into their determinations.”
Also, on March 4, SECers Hester M. Peirce and Elad L. Roisman issued a joint statement questioning the practical meaning of the SEC’s climate and ESG related activities. As noted in the statement, Corp Fin has been reviewing companies’ disclosures, assessing their compliance with disclosure requirements under the federal securities laws, and engaging with them on climate change and a variety of issues that fall under the ESG umbrella, for decades. The concern is that the new initiative should be limited to reviewing public disclosures against the existing backdrop of regulation and not suddenly holding companies to a new undisclosed standard. The commissioners also questioned the timing of the enforcement task force, pointing out that it would be more prudent to wait until Corp Fin had completed its assessment on existing rules and until the Division of Examinations has completed this examination cycle. With that said, the statement concludes with a supportive call for adequate guidelines and rules resulting from input from SEC staff, investors, issuers and practitioners.
Request for Public Input on Climate Change Disclosure
On March 15, 2021, SEC Chair Allison Herren Lee issued a statement requesting public input on climate change disclosures. On the same day Ms. Lee gave a speech to the Center of American Progress outlining the SEC’s initiative on climate change matters. The request for public comment outlined specific questions for consideration and in particular:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant)? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)?[7] Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
SEC 2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures. In 2010 and the few years prior, climate change was not only a global topic of discussion, but a regulatory hotspot as well. The EPA passed regulations requiring the reporting of and reduction of greenhouse gases by the largest pollutants; internationally the Kyoto Protocol was passed; the European Union Emissions Trading System became effective; international climate change conferences became the norm; official and un-official groups banded together on the subject; and the insurance industry revamped its actuarial and risk assessment system to account for climate change.
For some public companies, the regulatory changes could have a significant impact on operating and financial decisions including capital expenditures to reduce emissions and compliance with new laws, including those requiring reporting. Also, companies not directly impacted by the changes could be indirectly impacted by changes in costs for goods and services and impacts on their supply chain. The SEC release also notes that changes in weather patterns, increased storm intensity, sea level rise, melting of permafrost and temperature extremes at facilities could affect operations and financial disclosures. Likewise, changes in the availability or quality of water or other natural resources can have impacts on machinery, equipment and operations. Climate can also impact consumer demand such as reduced demand for heating fuels and warm clothing in warmer temperatures.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures HERE. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading).
The 2010 release delineated areas that could require such disclosure.
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business both historically and intended (see HERE for recent amendments to Item 101 including the addition of ESG related human capital disclosures). Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Legal Proceedings
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Like Item 101, Item 103 has recently been amended – see HERE.
Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Risk Factors
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 503 has also been amended – see HERE. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A- is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. Like the others, MD&A has been amended since 2010 – see HERE.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate related information.
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SEC Final Rule Changes For Exempt Offerings – Part 4
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this fourth blog discussing the changes to Regulation A. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE.
Background; Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation A
The current two-tier Regulation A offering process went into effect on June 19, 2015, as part of the JOBS Act. Since its inception there has been one rule modification opening up the offering to SEC reporting companies (see HERE) and multiple SEC guidance publications including through C&DI on the Regulation A process. For a recent summary of Regulation A, see HERE. In reviewing the rules, the SEC found a few areas where compliance with Regulation A is more complex or difficult than for registered offerings, including the rules regarding the redaction of confidential information in material contracts, making draft offering statements public on EDGAR, incorporation by reference, and the abandonment of a post-qualification amendment. The new rules address these points.
The SEC has simplified the requirements for Regulation A and established greater consistency between Regulation A and registered offerings by permitting Regulation A issuers to: (i) file certain redacted exhibits using the process previously adopted for registered offerings (see HERE); (ii) make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements (see HERE); (iii) incorporate financial statement information by reference to other documents filed on EDGAR and generally allow incorporation by reference to the same degree as a registered offering (see HERE); and (iv) to have post-qualification amendments declared abandoned.
In addition, as has been discussed for several years now, the new rules increase the Tier 2 offering limit. Moreover, the new rules add an eligibility standard such that an Exchange Act reporting company which is delinquent in such reports, will not qualify to rely on Regulation A.
Increase in Offering Limit
The new rules increase the maximum Regulation A Tier 2 offering from $50 Million to $75 million in any 12-month period. As such, the 30% offering limit for secondary sales has increased from $15 million to $22.5 million. Tier 1 offering limits remain unchanged.
Redaction of Confidential Information in Certain Exhibits
In March 2019, the SEC amended parts of Regulation S-K to allow companies to mark their exhibit index to indicate that portions of the exhibit or exhibits have been omitted. Under the rules, a company must include a prominent statement on the first page of the redacted exhibit stating that certain identified information has been excluded from the exhibit because it is both not material and would be competitively harmful if publicly disclosed. A company must also indicate with brackets where the information has been omitted from the filed version of the exhibit. At the time the Regulation A rules were not changed such that Regulation A filers were still compelled to submit an application for confidential treatment in order to redact immaterial confidential information from material contracts and plans of acquisition, reorganization, arrangement, liquidation, or succession.
The new rules have aligned the Regulation A requirements with those for registered offerings. The SEC has added a new instruction to the Form 1-A that allows companies to redact exhibits using the same procedure as for registered offerings. SEC staff will continue to review Forms 1-A filed in connection with Regulation A offerings and selectively assess whether redactions from exhibits appear to be limited to information that meets the appropriate standard. Upon request, companies are expected to promptly provide supplemental materials to the SEC similar to those currently required by Exchange Act reporting companies. The information that the SEC could request includes an unredacted copy of the exhibit and an analysis of why the redacted information is both not material and the type of information that the company customarily and actually treats as private and confidential. The new rules follow the updated definition of “confidential” which does not include the “competitive harm” factor in the analysis. See HERE.
Regulation A Companies are also still able to request confidentiality under Rule 83. For more on confidential treatment in SEC filings, see HERE.
Confidential Offering Statement
Companies that are conducting Regulation A offerings are permitted to submit non-public draft offering statements and amendments for review by the SEC if they have not previously sold securities pursuant to (i) a qualified offering statement under Regulation A or (ii) an effective Securities Act registration statement. Prior to the rule amendments, confidential submittals had to be filed as an exhibit to a public filing at least 21 days prior to the qualification of the offering statement, which adds time and expense to the process. Aligning with confidential treatment for registered offerings, the SEC has amended the rules to allow a company to make draft offering statements and related correspondence available to the public via EDGAR by changing the previous submission selection from “confidential” to “public.”
Incorporation by Reference
The ability to incorporate financial statements by reference to Exchange Act reports filed before the effective date of a registration statement is permitted on Form S-1, subject to certain conditions. Aligning Regulation A with the S-1 provisions, the new rules will allow previously filed financial statements to be incorporated by reference into a Regulation A offering circular. To avail itself of the ability to incorporate by reference companies that have a reporting obligation under Rule 257, or the Exchange Act must be current in their reporting obligations. In addition, companies must make incorporated financial statements readily available and accessible on a website maintained by or for the company and disclose in the offering statement that such financial statements will be provided upon request. Companies conducting ongoing offerings still need to file an annual post-qualification amendment with updated financial statements.
Abandonment of an Offering
Prior to the rule amendment, Regulation A permitted the SEC to declare an offering statement abandoned but did not provide the same authority for post-qualification amendments. The new rules now specifically allow for the SEC to declare a post-qualification filing abandoned.
Ineligibility for Delinquent Exchange Act Reporting Companies
Regulation A includes an eligibility requirement that company conducting a Regulation A offering must have filed all reports, with the SEC, required to be filed, if any, pursuant to Rule 257 during the two years before the filing of the offering statement (or for such shorter period that the issuer was required to file such reports). When the SEC amended Regulation A to allow Exchange Act reporting companies to rely on the rule, it did not amend the provision related to delinquent filings. Accordingly, since Exchange Act companies are not required to file reports pursuant to Rule 257, a company could technically be delinquent and eligible to use Regulation A. In actuality, the SEC generally commented and pushed back on such companies, but the new rules close this loophole. In particular, companies that do not file all the reports required to have been filed by Sections 13 or 15(d) of the Exchange Act in the two-year period preceding the filing of an offering statement are ineligible to conduct a Regulation A offering.
« SEC Final Rule Changes For Exempt Offerings – Part 3 Caremark Eroded – Director Liability In Delaware »
SEC Final Rule Changes For Exempt Offerings – Part 2
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters. The first blog in the series discussed the new integration rules (see HERE).
Background
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.
Effective September 2013, in accordance with the JOBS Act, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) and new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly, in the Rule 506 context, determining whether solicitation or advertising has been utilized is extremely important.
Other private offerings also allow for solicitation and advertising. In particular, Regulation A, Regulation Crowdfunding, Rule 147 and 147A, and Rule 504 all allow for solicitation and advertising. For more information on Rule 504, Rule 147 and 147A, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. Part 1 of this blog series talked about issues with integration, including between offerings that allow and don’t allow solicitation, but equally important is determining what constitutes solicitation in the first place.
Prior to the JOBS Act, general solicitation and advertising was prohibited in most exempt offerings and “testing the waters” was not yet a mainstream term of art in the capital markets. Following the JOBS Act creation of Rule 506(c), Regulation Crowdfunding and the new Regulation A/A+ structure, offering solicitation and pre-offering testing the waters became the norm. Recognizing the benefits of additional offering communications, and testing the waters prior to launching an offering, the SEC has included expanded offering communications and testing the waters provision in its modernized exempt offering rules.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
The Securities Act defines the term “offer” very broadly and includes any publication of information or communication in advance of a financing that would have the effect of arousing interest in the securities being offered. Likewise, general solicitation and advertising have been interpreted very broadly. Although Rule 502(c) lists some examples, the SEC has expanded upon those examples over the years, including information posted on an unrestricted website as a general solicitation.
Rule 502(c) lists the following examples of solicitation or advertising:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; provided, however,that publication by a company of a notice in accordance with Rule 135c or filing with the SEC of a Form D shall not be deemed to constitute general solicitation or general advertising; and provided further that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the U.S., to meetings with companies or selling security holder representatives conducted outside of the U.S., or to written press-related materials released outside the U.S., at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising.
Generally, testing the waters through contacting potential investors in advance of an exempt offering to gauge interest in the future offering, could be deemed solicitation. In 2015 the SEC issued several C&DI to address when communications would be deemed a solicitation or advertisement, including factual business communications in advance of an offering and demo days or venture fairs.
At that time, the SEC indicated that participation in a demo day or venture fair does not automatically constitute general solicitation or advertising under Regulation D. If a company’s presentation does not involve the offer of securities at all, no solicitation is involved. If the attendees of the event are limited to persons with whom either the company or the event organizer have a pre-existing, substantive relationship, or have been contacted through a pre-screened group of accredited, sophisticated investors (such as an angel group), it will not be deemed a general solicitation. However, if invitations to the event are sent out via general solicitation to individuals and groups with no established relationship and no pre-screening as to accreditation, any presentation involving the offer of securities would be deemed to involve a general solicitation under Regulation D. For more on a pre-existing substantive relationship, see HERE.
The amended rules specifically exempt “demo days” from the definition of general solicitation and advertising for all offerings; allow companies to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue; and add test-the-waters provisions to Regulation Crowdfunding.
Demo Days; New Rule 148
“Demo days” and similar events are generally organized by a group or entity that invites issuers to present their businesses to potential investors, with the aim of securing an investment.
New Rule 148 provides that certain demo day communications will not be deemed to be a general solicitation or advertising. Specifically, a company will not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting sponsored by a college, university, or other institution of higher education, a local government, a state government, instrumentalities of state and local governments, a nonprofit organization, or an angel investor group, incubator, or accelerator and in which more than one company participates. Rule 148 excludes broker-dealers and investment advisors from the scope of the exemption.
Rule 148 requires that “angel investor groups” maintain defined processes and procedures for making investment decisions, though the rule does not require that the processes be memorialized in writing.
Sponsors of events are not permitted to: (i) make investment recommendations or provide investment advice to attendees of the event; (ii) engage in any investment negotiations between the company and investors attending the event; (iii) charge attendees fees beyond a reasonable administrative fee; (iv) receive compensation for making introductions; or (v) receive any compensation with respect to the event that would require registration as a broker-dealer or investment advisor.
Advertising for the event is also limited and may not reference any specific offering of securities by a participating company. To address concerns that communications for demo day events will encompass a large number of non-accredited investors especially in light of the increase in virtual events, the new rule limits online participation for an event to: (i) individuals who are members of, or otherwise associated with the sponsor organization; (b) individuals that the sponsor reasonably believes are accredited investors; or (iii) individuals who have been invited to the event by the sponsor based on industry or investment related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.
Rule 148 also regulates the information a presenting company can convey to: (i) notification that the company is in the process of an offering or planning an offering of securities; (ii) the type and amount of securities being offered; (iii) use of proceeds; and (iv) the remaining unsubscribed amount of an offering.
Rule 148 is a non-exclusive method of communicating with potential investors. Companies may continue to rely on previously issued guidance to attend events where the participation is limited to individuals or groups of individuals with whom the company or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals. In those events, the information provided by the company is not limited.
Solicitations of Interest; New Rule 241
Prior to the JOBS Act, almost no exempt offerings (except intrastate offerings when allowed by the state) allowed for advertising or soliciting, including solicitations of interest or testing the waters. The JOBS Act created the current Regulation A, which allows for testing the waters subject to certain SEC filing requirements and the inclusion of specific legends on the offering materials. For a discussion on Regulation A test-the-waters provisions, see HERE.
The SEC recognizes the benefits of testing the waters prior to incurring the costs associated with an offering. As such, the SEC is adopting new Rule 241, which exempts companies from the registration requirements for generic pre-offering communications that are made in compliance with the rule. Rule 241 allows companies to solicit indications of interest in an exempt offering, either orally or in writing, prior to determining which exemption they will rely upon, even if the ultimate exemption does not allow for general solicitation or advertising. Rule 241 is an exemption from the registration requirements for “offers” but not “sales,” but since communications under the rule are considered “offers,” they are subject to the antifraud provisions under the federal securities laws.
Rule 241 is similar to existing Rule 255 of Regulation A. Rule 241 communications require a legend or disclaimer stating that: (i) the company is considering an exempt offering but has not determined the specific exemption it will rely on; (ii) no money or other consideration is being solicited, and if sent, will not be accepted; (iii) no sales will be made or commitments to purchase accepted until the company determines the exemption to be relied upon and where the exemption includes filing, disclosure, or qualification requirements, all such requirements are met; and (iv) a prospective purchaser’s indication of interest is non-binding.
Once a company determines which type of offering it intends to pursue, it would no longer be able to rely on Rule 241 but would need to comply with the rules associated with that particular offering type, including its solicitation of interest and advertising rules. Moreover, since the solicitation of interest would likely be a general solicitation, if the chosen offering does not allow general solicitation or advertising, the company would need to conduct an integration analysis to make sure that there would be no integration between the solicitation of interest and the offering. Under the new rules, that would generally require the company to wait 30 days between the solicitation of interest and the offering (see Part 1 of this blog series HERE). I say “would likely be a general solicitation” because a company may still indicate interest from persons that it has a prior business relationship with, without triggering a general solicitation, as they can now under the current rules.
If a company elects to proceed with a Regulation A or Regulation Crowdfunding offering, it will need to file the Rule 241 test-the-waters materials if the Rule 241 solicitation is within 30 days of the ultimate offering, as such solicitation of interest would integrate with the following offering. If more than 30 days pass, the Rule 241 communications would not need to be filed, but any Rule 255 communication would need to be filed in a Regulation A offering and new Rule 206 communications would need to be filed in a Regulation Crowdfunding offering.
Although new Rule 241 does not limit the type of investor that can be solicited (accredited or non-accredited), under the new rules, if a company determines to proceed with a Rule 506(b) offering within 30 days of obtaining indications of interest, it must provide the non-accredited investors, if any, with a copy of any written solicitation of interest materials that were used.
New Rule 241 does not pre-empt state securities laws. Accordingly, if a company ultimately proceeds with an offering that does not pre-empt state law, it will need to consider whether it has met the state law requirements, including whether each state allows for solicitations of interest prior to an offering. This provision will likely be a large impediment to a company that is considering an offering that does not pre-empt state law.
Regulation Crowdfunding; New Rule 206; Amended Rule 204
Prior to the amendments, a company could not solicit potential investors until their Form C is filed with the SEC. New Rule 206 will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. Under Rule 206, companies are permitted to test the waters with all potential investors.
The testing-the-waters materials will be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test-the-waters communications will need to contain a legend including: (i) no money or other consideration is being solicited, and if sent, will not be accepted; (ii) no sales will be made or commitments to purchase accepted until the Form C is filed with the SEC and only through an intermediary’s platform; and (iii) a prospective purchaser’s indication of interest is non-binding. Any test-the-waters materials will need to be filed with the SEC as an exhibit to the Form C.
Unlike Regulation A, Rule 206 only allows for testing the waters prior to the filing of a Form C with the SEC. Once the Form C is filed, any offering communications are required to comply with the terms of Regulation Crowdfunding, including the Rule 204 advertising restrictions.
However, the SEC has also amended Rule 204 to permit oral communications with prospective investors once the Form C is filed. The SEC has also expanded upon the allowed categories of advertised information that can be provided under Rule 204. Rule 204 generally allows a company to advertise a Regulation Crowdfunding offering by directing potential investors to the intermediary’s platform. Rule 204 allows such advertisements to include limited information about the offering. The SEC has added: (i) a brief description of the planned use of proceeds of the offering; and (ii) information on the company’s progress towards meeting its funding goals, to the already allowable: (a) statement that the company is conducting an offering under Regulation Crowdfunding; (b) the name of the intermediary and a link to the intermediary’s platform; (c) the terms of the offering; and (d) factual information about the legal identity and business location of the company including its full name, address, phone number, web site address, email of a representative and a brief description of the business.
The SEC has further amended Rule 204 to specify that a company may provide information about the terms of an offering under Regulation Crowdfunding in the offering materials for a concurrent offering, such as in an offering statement on Form 1-A for a concurrent Regulation A offering or a Securities Act registration statement filed with the SEC, without violating Rule 204. To do so, the information provided about the Regulation Crowdfunding offering must be in compliance with Rule 204, including the requirement to include a link directing the potential investor to the intermediary’s platform. However, since SEC rules prohibit live links to locations outside the EDGAR system, the link in such a filing could not be a live hyperlink.
Further Background Reading
Prior to the rule changes, the SEC issued a concept release and request for public comment on the subject in June 2019 (see HERE). Also, for my five-part blog series on the proposed rules, see HERE, HERE , HERE, HERE, and HERE.
« SEC Final Rule Changes For Exempt Offerings – Part 1 SEC Final Rule Changes For Exempt Offerings – Part 3 »
SEC Final Rule Changes For Exempt Offerings – Part 1
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). For my five-part blog series on the proposed rules, see HERE, HERE, HERE, HERE and HERE. The new rules go into effect on March 14, 2021.
The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I will break it down over a series of blogs, with this first blog focusing on integration.
Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they can make informed investment and voting decisions.
In recent years, the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors. The Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and to Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Section 4(a)(2) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the offering exemptions, incorporating the new rule changes.
Rule Changes
The rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; set clear and consistent rules that increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Integration; new Rule 152
Current Integration Structure
Prior to the amendments, the Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. That is, where two or more offerings are integrated, there is a danger that the exemptions for one or both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
Prior to the amendments, Securities Act Rule 502(a) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis. The five-factor test has been completely eliminated in the new regulatory structure.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, considering whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
New Rule 152(a) – General Integration Principal
The amended rules completely overhaul the integration concept, creating a new Rule 152(a) setting forth a general integration concept and new Rule 152(b) containing four safe harbors applicable to all securities offerings whether registered or exempt. Where a safe harbor exists under Rule 152(b), that safe harbor may be relied upon.
Where a safe harbor does not exist, offers and sales will not be integrated if, based on the particular facts and circumstances, the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Where solicitation is prohibited, the company must have a reasonable belief that each purchaser in the offering that does not allow for solicitation, was either not solicited or that such investor had a pre-existing substantive relationship with the company prior to commencement of the offering.
A “pre-existing” relationship is one that the company has formed with an offeree prior to the commencement of the offering or, that was established through another person, such as a registered broker-dealer or investment adviser, prior to that person’s participation in the offering. A substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication, and has established accreditation. A substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
In a huge change from the prior structure, under the new integration principle in Rule 152(a), a company may conduct concurrent Rule 506(c) and Rule 506(b) offerings, or any other combination of concurrent offerings, involving an offering prohibiting general solicitation and another offering permitting general solicitation, without integration concerns, so long as the provisions of Rule 152(a)(1) and all other conditions of the applicable exemptions are satisfied. That is, if the company can establish that the purchasers in the 506(b) offering were not solicited using general solicitation or that there was a substantive relationship with that purchaser prior to the commencement of the 506(b) offering, the exemption would survive.
Rule 152(a) specifically provides that where two or more concurrent offerings are being completed which allow general solicitation, care must be given to ensuring that all offerings comply with each of the exemptions including any disclosures or regulatory legends required for such offering. For example, if a company is conducting a concurrent Rule 506(c) and Regulation A offering and discusses the terms of the Regulation A offering in its Rule 506(c) general solicitation material, all of the requirements in Regulation A must be met.
New Rule 152(a) contains introductory language that the provisions of either Rule 152(a) or (b) will not have the effect of avoiding integration for any transaction or series of transactions that, although in technical compliance with the rule, is part of a plan or scheme to evade the registration requirements of the Securities Act.
New Rule 152(b) – Statutory Safe Harbors
New Rule 152(b) sets forth four new non-exclusive safe harbors from integration, including:
(i) Any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation applying the principals in Rule 152(a) (this 30-day test would replace the six-month test across the board);
(ii) Offerings under Rule 701, pursuant to an employee benefit plan, or in compliance with Regulation S will not integrate with other offerings;
(iii) A registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering for which general solicitation is permitted that terminated or completed more than 30 calendar days prior to the commencement of the registered offering; and
(iv) Offers and sales that allow for general solicitation will not integrate with a prior completed or terminated offering. In particular, offerings under Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504, Rule 506(b), Rule 506(c), Section 4(a)(2) and registered offerings will not integrate with a subsequent Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504 or Rule 506(c) offering.
New Rules 152(c) and 152(d) – Commencement, Termination and Completion of Offerings
New Rules 152(c) and 152(d) provide a non-exclusive set of factors to consider when determining when an offer has commenced, terminated or been completed. New Rule 152(c) provides a non-exclusive list of factors to consider in determining when an offering will be deemed to be commenced. Regardless of the type of offering, it will be commenced at the time of the first offer of securities in the offering by the issuer or its agents. The Rule also includes a list of factors that should be considered in determining when an offering is commenced, including:
(i) On the date the company first makes a generic offer soliciting interest in a contemplated offering where the company has not yet determined the exemption it will rely upon (new Rule 241 covering generic solicitations of interest will be discussed in Part 2 of this blog series);
(ii) For Section 4(a)(2), Regulation D or Rule 147 or 147A, on the date the company first made an offer of its securities in reliance on these exemptions;
(iii) For Regulation A, on the earlier of the first day of testing the waters or the public filing of a Form 1-A;
(iv) For Regulation Crowdfunding, on the earlier of the first day of testing the waters or the public filing of a Form C;
(v) For registered offerings – for a continuous offering on the date of the initial filing with the SEC or for a delayed offering, on the earliest of which the company or its agents commence public efforts to offer and sell which could be evidenced by the earlier of the filing of a prospectus supplement or use of public disclosure such as a press release.
New Rule 152(d) provides a non-exclusive list of factors to consider in determining whether an offering is terminated or completed. Regardless of the type of offering, termination or completion of an offering is likely to occur when the company and its agents cease efforts to make further offers to sell the issuer’s securities under such offering. The Rule also includes a list of factors that should be considered including:
(i) For a Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering, the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities;
(ii) For a Regulation A offering, when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering;
(iii) For Regulation Crowdfunding, upon the deadline of the offering set forth in the offering materials or as indicated in any notice to investors by the intermediary;
(iv) For registered offerings, on the date of withdrawal of the registration statement, the filing of a prospectus supplement or amendment disclosing the offering termination, a declaration of abandonment is made by the SEC, the third anniversary after effectiveness of the initial registration statement, or any other evidence of abandonment or termination of the offering such as the filing of a Form 8-K or a press release.
An offering may also be effectively terminated. For example, if a company commences a Rule 506(b) offering and then begins to solicit under Rule 506(c) and relies exclusively on Rule 506(c) once it commences solicitation, the Rule 506(b) offering will be deemed to be terminated.
As will be discussed in this blog series, Rule 506(b) has been amended such that a company may sell to 35 unaccredited investors within any 90 calendar days. This provision alleviates concerns that a company would engage in consecutive 506(b) offerings every 30 days selling to 35 accredited investors each time.
Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions), and Rule 500(g) have been amended to cross reference the new Rule 152. Other rules including Rules 255(e), 147(h), 147A(h) and Rule 155 (related to abandoned offerings) have been eliminated as the provisions are covered in Rule 152.
Exemption Overview Chart
The following chart is includes the most commonly used offering exemptions as updated by the amended rules:
| Type of Offering | Offering Limit within 12- month Period | General Solicitation/Manner of Offering | Issuer Requirements | Offeree and Investor Requirements | SEC Filing and Information Requirements | Restrictions on Resale | Preemption of State Registration and Qualification |
| Section 4(a)(2) | None | No general solicitation. | None | Transactions by an issuer not involving any public offering. See SEC v. Ralston Purina Co.Offerees and purchasers must be sophisticated and be given access to information. | None | Yes. Restricted securities | No preemption. Must qualify in each state |
| Rule 506(b) of Regulation D | None | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors
Up to 35 sophisticated but non-accredited investors in any 90 day period but must provide certain financial and non-financial disclosures |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement for accredited investor except disclosure of resale restrictions and investors must be given access to information if requested.
For any non-accredited investors: (A) if 1934 Act reporting company, certain reports or filings or (B) if non-reporting company, (1) Regulation A narrative information for eligible issuers and otherwise narrative information required by Part I of applicable registration form and (2) Regulation A financials that may be unaudited if offering $20,000,000 or less and audited if more |
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Rule 506(c) of Regulation D | None | General solicitation permitted if all purchasers are verified accredited investors. Non-exclusive safe harbors available for verification of natural persons and previous investors who self-certify within 5 years. | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors. No non-accredited investors.
Issuer must take reasonable steps to verify that all purchasers are accredited investors |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement except disclosure of resale restrictions and investors must be given access to information if requested.
|
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Regulation A: Tier 1 | $20 million but no more than $6,000,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Reg A offering and any Reg A offerings in 12 months | Permitted; before qualification, testing the waters permitted before and after the offering statement is filed.
No sales or direct or indirect commitments for sales until after qualified with SEC.
General solicitation permitted after qualified with SEC. |
U.S. or Canadian issuersExcludes blank check companies, registered investment companies, business development companies, issuers of certain securities, and certain issuers subject to a Section 12(j) order; and Regulation A Exchange Act reporting companies that have failed to file certain required reports
“Bad actor” disqualifications apply No asset-backed securities. |
None | Form 1-A, including two years of unaudited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Exit report on Form 1-Z within 30 days of offering completion. |
No | No preemption. Must qualify in each state. |
| Regulation A: Tier 2 | $75 million but no more than $22,500,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Tier 2 offering and any Reg A offerings in 12 months | Non-accredited investors are subject to investment limits of 10% of the greater of annual income and net worth, unless securities will be listed on a national securities exchange | Form 1-A, including two years of audited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Annual, semi-annual, current, and exit reports |
No | Exempt as “covered security,” subject to state fees and notice filings. | ||
| Rule 504 of Regulation D | $10 million including all Section 3(b)(1) sales and sales in violation of Section 5 | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually. Generic testing the waters permitted.General solicitation permitted if registered in state requiring use of substantive disclosure document or under exemption in state for sales to accredited investors | Excludes blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | None | Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.
Can register in a state based on state disclosure requirements for issuance of unrestricted securities. |
Yes. Restricted securities unless registered in a state requiring use of a substantive disclosure document or sold under state exemption for sale to accredited investors with general solicitation | Need to comply with state blue sky law by registration (Form U-7 may be available) or state exemption. State crowdfunding may be available |
| Intrastate: Section 3(a)(11) | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult. | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Securities must come to rest with in-state residents.Generally states require a one year hold. | No preemption. Must qualify in state. |
| Intrastate: Rule 147 | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult.Testing the waters is permitted | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Intrastate: Rule 147A | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all purchasers must be in- state residents.
Testing the waters is permitted |
In-state residents and “doing business” in-state; excludes registered investment companies | Offerees and Purchasers must be in- state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Regulation Crowdfunding; Section 4(a)(6) | $5 million | Testing the waters permitted before Form C is filed.Solicitation permitted with limits on advertising after Form C is filed
Offering must be conducted on an internet platform through a registered intermediary |
Excludes non-U.S. issuers, blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | No investment limits for accredited investors.Non-accredited investors investment limits in any 12-month period through crowdfunding of (i) the greater of $2,200 or 5% of the greater of annual income or net worth if either is less than $107,000, or (ii) 10% of the greater of annual income or net worth, but not more than $107,000, if both are at least $107,000. | Form C, including two years of financial statements that are certified, reviewed or audited, as required based on offering amount. Must file test the waters materials with Form C.Up to $107,000 – latest tax return and financials certified by officers; from $107,000 to $535,000 – financials reviewed by public accountant; above $535,000, audited financials but may be reviewed for first-time issuer up to $1,070,000.
Progress and annual reports |
12-month resale limitations | Exempt as “covered security,” subject to state notice filing with primary state. State antifraud rules apply. |
It is extremely difficult for small and emerging companies to raise capital, and any changes to the rules that will assist these companies is a positive step. Small businesses are job creators, generators of economic opportunity, and fundamental to the growth of the country. Small businesses account for the majority of net new jobs since the recession ended and are critical to the health and vitality of our country. In the absence of access to funding, small businesses cannot create new jobs, foster innovation, and develop into the next generation of publicly traded companies whose growth fuels capital markets investors’ retirement accounts.
I am very interested to see the new administration’s regulatory and general policies and agendas that impact small business capital raising efforts.
« Audit Committees – NYSE American SEC Final Rule Changes For Exempt Offerings – Part 2 »
SEC Amendments To Rules Governing Proxy Advisory Firms
In a year of numerous regulatory amendments and proposals, Covid, newsworthy capital markets events, and endless related topics, and with only one blog a week, this one is a little behind, but with proxy season looming, it is timely nonetheless. In July 2020, the SEC adopted controversial final amendments to the rules governing proxy advisory firms. The proposed rules were published in November 2019 (see HERE). The final rules modified the proposed rules quite a bit to add more flexibility for proxy advisory businesses in complying with the underlying objectives of the rules.
The final rules, together with the amendments to Rule 14a-8 governing shareholder proposals in the proxy process, which were adopted in September 2020 (see HERE), will see a change in the landscape of this year’s proxy season for the first time in decades. However, certain aspects of the new rules are not required to be complied with until December 1, 2021.
The SEC has been considering the need for rule changes related to proxy advisors for years as retail investors increasingly invest through funds and investment advisors, in which the asset managers rely on the advice, services and reports of proxy voting advice businesses. It is estimated that between 70% and 80% of the market value of U.S. public companies is held by institutional investors, the majority of which use proxy advisory firms to manage the decision making and logistics of voting for thousands of proposals within a concentrated period of a few months. Proxy voting advice businesses provide a variety of services including research and analysis on matters to be voted upon; general voting guidelines that clients can adopt; giving specific voting recommendations on specific matters subject to a shareholder vote; and handling the administrative process of returning proxies and casting votes. The administrative tasks are usually electronic and, at times, can involve an automated completion of a ballot based on programed voting instructions.
The final vote was divided with the SEC Commissioners voting 3-1 in favor of the new rules. On the same day the SEC Commissioners, also in a 3-1 divided vote, endorsed guidance to investment advisors related to the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE.
In essence, the amendments condition the availability of two exemptions from the information and filing requirements of the federal proxy rules, which are often used by proxy voting advice businesses, on compliance with tailored and comprehensive conflicts of interest disclosure requirements. In addition, the exemptions are conditioned on the requirements that (i) companies that are the subject of proxy voting advice have that advice made available to them in a timely manner; and (ii) clients of proxy advice businesses are made aware of a company’s response to the advice in a timely manner.
The amendments codify the SEC’s longstanding view that proxy advice constitutes a solicitation under the proxy rules and is thus subject to the anti-fraud provisions. In particular, the amendment changes the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provides additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amends rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. The rules apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures. Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.
The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.“
The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.
On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request. For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts. The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).
The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.
The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9). A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions. In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters). The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.
New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021. Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while at the same time working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.
The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship. The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.
Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects. The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended. Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended. Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible. This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms such as ISS and Glass Lewis voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice. The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.
The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses. The time for review was set as a number of days based on the date of filing of the definitive proxy statement. However, commenters pushed back and the SEC listened.
The final rules allow proxy advisory businesses to take matters into their own hands. In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).
As adopted the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible. Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.
New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule. In particular:
(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.
(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).
The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company. Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice. Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.
It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule. The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does in fact meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Supplemental Guidance for Investment Advisors
On the same day as enacting the amended rules the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE. The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.
The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline. The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.
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