SEC Proposed Rule Changes For Exempt Offerings – Part 5
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this fifth and final blog focusing on amendments to Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see HERE. To review the third blog in this series which focused on Regulation D, Rule 504 and the bad actor rules, see HERE. To review the fourth blog in this series related to changes to Regulation A, see HERE.
Background; 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 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) and Section 4(a)(6) known as Regulation Crowdfunding. For more background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
Regulation Crowdfunding
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
Increase in Offering Limit
The proposed amendments would increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding would become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The proposed amendments would increase the investment limit by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits would only apply to non-accredited investors whereas currently they apply to all investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The proposed amendments would allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles would be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding issuer and would not have a separate business purpose. Investors in the crowdfunding vehicle would have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying crowdfunding issuer in an offering made under Regulation Crowdfunding.
The proposed rule would benefit companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders, which can make these companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle would also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle may constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available it is required to register, if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Security Types
The proposed amendments would narrow the types of securities eligible under Regulation Crowdfunding to debt securities, equity securities, and debt securities convertible or exchangeable into equity securities, including guarantees of such securities, to harmonize the provisions of Regulation Crowdfunding regarding eligible security types with those of Regulation A. Other types of securities would be excluded from eligibility under the proposed 260 amendments. For example, Simple Agreements for Future Equity (SAFE) securities would no longer be eligible under Regulation Crowdfunding.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements
The SEC has issued FAQ on Covid-19 issues, including the impact on S-3 shelf registration statements. The SEC issued 4 questions and answers consisting of one question related to disclosure and three questions related to S-3 shelf registrations.
SEC FAQ
Disclosure
Confirming prior guidance, the SEC FAQ sets forth the required disclosures in the Form 8-K or 6-K filed by a company to take advantage of a Covid-19 extension for the filing of periodic reports. In particular, in the Form 8-K or Form 6-K, the company must disclose (i) that it is relying on the COVID-19 Order (for more information on the Order, see HERE); (ii) a brief description of the reasons why the company could not file the subject report, schedule or form on a timely basis; (iii) the estimated date by which the report, schedule or form is expected to be filed; and (iv) a company-specific risk factor or factors explaining the impact, if material, of COVID-19 on the company’s business. Also, if the reason the report cannot be filed timely relates to the inability of any person, other than the company, to furnish any required opinion, report or certification, the company must also attach, as an exhibit to the Form 8-K or Form 6-K, a statement signed by such person stating the specific reasons why the person is unable to furnish the required opinion, report or certification. The Form 8-K or 6-K must be filed with the SEC on or before the original due date of such report.
Furthermore, when the delayed report is filed it must contain disclosures that it was delayed based on the Covid-19 Order and reiterate the reasons it could not timely file the report.
Effect on Form S-3
S-3 eligibility and the ability to take down periodic offerings from an effective S-3 registration statement is often the lifeblood for publicly traded companies, especially during times of financial hardship. For a detailed review of S-3 eligibility, see HERE.
Generally speaking, a company must be current in its SEC reporting requirements in order to file or utilize an existing S-3 shelf. Moreover, a company must re-assess its eligibility to continue to use the shelf each time it files an update to the registration statement, which could be through a post-effective amendment or a Form 10-K which is automatically incorporated by reference and acts as a prospectus update.
The SEC has issued three question-and-answer FAQs related to the ability to use or file an S-3 shelf registration statement while relying on the Order allowing for an extension of the filing of periodic reports due to Covid-19.
The first question confirms that a company can continue to conduct takedowns using an already effective registration statement while relying on the Covid-19 Order for an extension to the filing date of a report, including a Form 10-K. However, in order to continue to use an existing S-3, the company must make a determination that the prospectus, as it exists at that time, complies with Section 10(a) of the Securities Act. This is no different than at any other time a shelf is used – that is, it is always incumbent upon a company to believe that its prospectus complies with Section 10(a). Section 10(a)(3) requires that when a prospectus is used more than nine months after the effective date of the registration statement, the information contained in the prospectus cannot be older than 16 months.
However, Section 10(a)(3) has a qualifier that information must be updated at 16 months “so far as such information is known to the user of such prospectus or can be furnished by such user without unreasonable effort or expense.” The new SEC FAQ provides that “[A]lthough Section 10(a)(3) may permit registrants relying on the COVID-19 Order to conduct a takedown using a prospectus that contains information older than sixteen months in the event that updated information cannot be furnished without unreasonable effort or expense, registrants and their legal advisers will need to determine when it is appropriate to update the prospectus. Registrants are responsible for the accuracy and completeness of their disclosure.”
In addition, shelf offerings pursuant to Rule 415 require a company to file a post-effective amendment (which could be via a Form 10-K that is forward incorporated by reference) to reflect any facts or events arising after the effective date which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. In other words, if the information in the prospectus is materially inaccurate, it cannot be used.
The second question confirms that a company must re-assess its eligibility to continue to use Form S-3 at the time of the filing of its Form 10-K. In general, each time a company files a post-effective amendment to its Form S-3, including through the filing of a Form 10-K, the company must assess its eligibility to continue to use the Form. For example, to continue to be eligible the company must have timely filed all of its periodic reports (with some limited Form 8-K exceptions) for a period of at least 12 calendar months. For a complete and detailed list of eligibility requirements, see HERE. Where the company has relied on the Covid-19 Order to extend the filing deadline for that Form 10-K, it can make its eligibility assessment at the time of filing under the new deadline.
The third question confirms that a company may file a new s-3 registration statement between the original due date of a required filing and the due date as extended by the COVID-19 Order, even if the company has not yet filed the required periodic report. The SEC will consider a company current and timely in its Exchange Act reports as long as it timely filed the Form 8-K for an extension of the deadline for a particular report such as a Form 10-Q or 10-K. However, although the company can file a new Form S-3, the SEC will not likely accelerate its effectiveness until the delayed periodic report has been filed. The company will no longer be considered current and timely, and will lose eligibility to file new registration statements on Form S-3, if it fails to file the required report by the due date as extended by the COVID-19 Order.
« SEC Enacts Temporary Expedited Crowdfunding Rules NASDAQ Provides Additional Relief To Shareholder Approval Requirements For Companies Affected By Covid-19 »
SEC Enacts Temporary Expedited Crowdfunding Rules
Following the April 2, 2020 virtual meeting of the SEC Small Business Capital Formation Advisory Committee in which the Committee urged the SEC to ease crowdfunding restrictions to allow established small businesses to quickly access potential investors (see HERE), the SEC has provided temporary, conditional expedited crowdfunding access to small businesses. The temporary rules are intended to expedite the offering process for smaller, previously established companies directly or indirectly affected by Covid-19 that are seeking to meet their funding needs through the offer and sale of securities pursuant to Regulation Crowdfunding.
The temporary rules will provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief will apply to offerings launched between May 4, 2020 and August 31, 2020.
TEMPORARY RULES
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1,070,000 (as adjusted for inflation in 2017) in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
In March 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework including Regulation Crowdfunding. The proposed rules would increase the offering limit to $5 million; increase the investment limit by altering the formula to be based on the greater of, rather than lower of, an investor’s annual income or net worth; remove investment limits on accredited investors; allow the use of special purpose vehicles and reduce the types of securities that can be sold in a Regulation Crowdfunding offering. However, the timing for implementation of the proposed rules, either as proposed or with changes, is uncertain.
As noted, the temporary rules are intended to provide existing eligible smaller businesses with quick access to capital by reaching out to the “crowd” which may include local investors, customers, vendors, etc., that are willing to support small businesses. This table, which was included in the SEC press release announcing the temporary rules, and to which I have provided explanatory and further detailed information, is a very good summary of the temporary rules.
| Requirement | Existing Regulation Crowdfunding | Temporary Amendment |
| Eligibility | The exemption is not available to:
|
To rely on the temporary rules, issuers must meet the existing eligibility criteria PLUS:
|
| Offers permitted | After filing of offering statement (including financial statements) | After filing of offering statement, but financial statements may be initially omitted (if not otherwise available) |
| Investment commitments accepted | After filing of offering statement on Form C (including financial statements) | After filing of offering statement on Form C that includes financial statements or amended offering statement that includes financial statements.That is, the temporary rule allows a test-the-waters period by allowing the company to file a Form C and post offering information on a funding platform, gathering indications of interest, prior to filing financial statements. If the offering does not garner interest, the company may determine to abandon or delay the offering and would not have occurred the expense of financial statement preparation.
Certain disclosures will need to be added if no financial statements are included and no investment commitments can be accepted until the financial statements have been provided. |
| Financial statements required when issuer is offering more than $107,000 and not more than $250,000 in a 12-month period | Financial statements of the issuer reviewed by a public accountant that is independent of the issuer | Financial statements of the issuer and certain information from the issuer’s federal income tax returns, both certified by the principal executive officer.Must also provide a statement that financial information certified by the principal executive officer has been provided instead of financial statements reviewed by an independent public accountant. |
| Sales permitted | After the information in an offering statement is publicly available for at least 21 days | As soon as an issuer has received binding investment commitments covering the target offering amount (note: commitments are not binding until 48 hours after they are given) |
| Early closing permitted | Once target amount is reached if:
|
As soon as binding commitments are received reaching target amount if:
|
| Cancellations of investment commitments permitted | For any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. Thereafter, an investor is not able to cancel any investment commitments made within the final 48 hours of the offering (except in the event of a material change to the offering). | For any reason for 48 hours from the time of the investor’s investment commitment (or such later period as the issuer may designate). After such 48-hour period, an investment commitment may not be cancelled unless there is a material change to the offering. |
e Crowdfunding Professional Association (C
« SEC Proposed Rule Changes for Exempt Offerings – Part 2 SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements »
SEC Proposed Rule Changes for Exempt Offerings – Part 2
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with the second blog in the series which focuses on offering communications, the new demo day exemption, and testing the waters provisions. The first in this series centered on the offering integration concept and can be read HERE.
Background; 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 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.
For more background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering, from the Act’s registration requirements. The Supreme Court case of SEC v. Ralston Purina Co. and its progeny Doran v. Petroleum Management Corp. and Hill York Corp. v. American Int’l Franchises, Inc. together with Securities Act Release No. 4552 set out the criteria for determining whether an offering is public or private and therefore the availability of Section 4(a)(2). In order to qualify as a private placement, the persons to whom the offer is made must be sophisticated and able to fend for themselves without the protection of the Securities Act and must be given access to the type of information normally provided in a prospectus.
All facts and circumstances must be considered including the relationship between the offerees and the issuer, and the nature, scope, size, type, and manner of the offering. 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). That is, if all of the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with. An issuer can rely directly on Section 4(a)(2) without regard to Rule 506; however, Section 4(a)(2) alone does not pre-empt state law and thus requires blue sky compliance.
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) 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, are 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 this adds a burden of verifying such accredited status to the issuing company. 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.
Likewise, other offerings 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.
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 day 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 proposed rule would expand test-the-waters for all companies to be able to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue. Also, Regulation Crowdfunding would allow for test-the-waters much the same as Regulation A. Furthermore, a new “demo day” will be allowed for all offerings which would be exempted from the definition of general solicitation or advertising.
The SEC considered but determined not to add a rule that statutorily defines a substantive pre-existing relationship or to add to or expand on the examples of solicitation and advertising currently contained in Rule 502(c). As a reminder, 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; 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.
Demo Days; New Rule 148
New Rule 148 would provide that certain demo day communications would not be deemed general solicitation or advertising. Specifically, as proposed, a company would not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting by a college, university, or other institution of higher education, a local government, a nonprofit organization, or an angel investor group, incubator, or accelerator sponsoring the seminar or meeting.
Sponsors of events would not be permitted to make investment recommendations or provide investment advice to attendees of the event, nor to engage in any investment negotiations between the company and investors attending the event. The sponsor would not be able to charge fees beyond a reasonable administrative fee and could not receive compensation for making introductions. Advertising for the event would also be limited such that specific offerings could not be advertised and the information about a presenting company would be limited to: (i) notice that the company is conducting or planning to conduct an offering; (ii) the type and amount of securities offered; and (iii) the intended use of proceeds.
The new rule is similar to the broker-dealer exemption included in Securities Act Section 4(b) for online portals hosting offerings that allow for general solicitation and advertising such as Rule 506(c), Regulation A and Rule 147 and 147A intrastate offerings. For more on Section 4(b), see HERE.
Solicitations of Interest
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. In the current rule release, the SEC notes that “[W]e believe that the existing testing the-waters provisions allow issuers to consult effectively with investors as they evaluate market interest in a contemplated registered or Regulation A securities offering before incurring the costs associated with such an offering, while preserving investor protections.”
The SEC is proposing a new rule to allow 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 general solicitation or advertising. Likewise, the SEC is proposing to allow test-the-waters communications for Regulation Crowdfunding and to align the provisions such that a company could ultimately choose either a Regulation A or Regulation Crowdfunding offering.
The pre-offering determination generic solicitations, set forth in new Rule 241, would be similar to existing Rule 255 of Regulation A. Rule 241 would 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. The solicitations would be subject to the antifraud provisions of the federal securities laws.
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 would 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 then 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 filed in a Regulation A offering and proposed 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 after 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 would 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.
As an aside, the SEC has also expanded the ability for companies to test the waters in association with registered offerings – see HERE – but I believe those provisions should be expanded to be more analogous to Regulation A.
Regulation Crowdfunding
Currently a company may not solicit potential investors until their Form C is filed with the SEC. The proposed new rule will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. The new Regulation Crowdfunding test-the-waters provisions are proposed in new Rule 206.
Under proposed Rule 206, companies would be permitted to test the waters with all potential investors. The testing-the-waters materials would be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test the waters communications would 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.
As discussed above, Rule 206 is separate from the proposed new Rule 241. Rule 241 requires an integration analysis. Accordingly, if Rule 241 test-the-waters materials were used within 30 days of the commencement of a Regulation Crowdfunding offering, they would need to be filed with the SEC with the Form C together with any subsequent Rule 206 materials.
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Small Business Advocate Urges Capital Raising Relief
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
I’ve written a five-part series detailing the rule changes, the first of which can be read HERE. My plan to publish the five parts in five consecutive weeks was derailed by the coronavirus and more time-sensitive articles on relief for SEC filers and disclosure guidance, but will resume in weeks that do not have more pressing Covid-19 topics.
On April 2, 2020, the SEC Small Business Capital Formation Advisory Committee held a special meeting (remotely) to discuss the potentially severe and immediate impact of Covid-19 on small businesses. Although the Committee did not make specific rule-change recommendations, it did urge the SEC to take immediate action to ease online private capital raising rules to assist businesses in accessing capital quicker and from a larger body of investors.
Committee members argued for an ease in crowdfunding restrictions to allow small businesses to quickly access potential investors. Commissioner Peirce agreed with the approach, noting that allowing companies to raise funds over the internet is in line with current social distancing initiatives. Pierce suggested allowing a new micro-offering exemption for quick access to capital with few restrictions.
SEC Chair Jay Clayton gave opening remarks, stressing the unprecedented challenges faced by small businesses. Although he also offered no specific solutions, he did stress the importance of preserving the flows of credit and capital in our economy to better fight and ultimately recover from Covid-19.
Although no one brought it up, I think that quick rules which allow the payment of finder’s fees to unregistered individuals and entities would be extremely beneficial, and could be accomplished while maintaining investor protections. Many small business owners (or even larger business owners) simply do not even know where to begin when it comes to capital raising, and many are uncomfortable asking for money.
I would advocate for rules that include (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.
I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the FINRA Securities Industry Essentials Exam for finders that are otherwise exempt from the full broker-dealer registration requirements.
New C&DI on Filing Deadlines
As I wrote about in my last two blogs, the SEC has provided relief such that periodic filings that would have been due from between March 1 and July 1, 2020 can avail themselves of a 45-day extension (see HERE). In order to qualify for the extension, a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
On April 6, 2020, the SEC issued a new C&DI explaining how the extension impacts a company that excludes particular information in its Form 10-K intending to incorporate that information in its subsequently filed proxy or information statement. In particular, a Form 10-K allows a company to include Part III information in its subsequently filed proxy or information statement for its annual meeting as long as the proxy or information statement is filed within 120 days of the end of the fiscal year. In the event that a proxy or information statement containing the Part III information is not filed by the 120th-day deadline, then an amended Form 10-K must be filed by that date with the omitted information.
The SEC confirms that if a company is unable to file the Part III information by the 120th-day deadline, it may avail itself of the 45-day extension for companies affected by the Covid-19 crisis as long as the deadline is within the relief period (March 1 through July 1, 2020).
A company that timely filed its annual report on Form 10-K without relying on the Covid-19 Order should furnish a Form 8-K with the disclosures required in the Order by the 120-day deadline. The company would then need to provide the Part III information within 45 days of the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
A company may invoke the Covid-19 Order with respect to both the Form 10-K and the Part III information by furnishing a single Form 8-K by the original deadline for the Form 10-K that provides the disclosures required by the Order, indicates that the company will incorporate the Part III information by reference, and provides the estimated date by which the Part III information will be filed. The Part III information must then be filed no later than 45 days following the 120-day deadline.
A company that properly invoked the Covid-19 Order with respect to its Form 10-K by furnishing a Form 8-K but was silent on its ability to timely file Part III information may (1) include the Part III information in its Form 10-K filed within 45 days of the original Form 10-K deadline, or (2) furnish a second Form 8-K with the disclosures required in the Order by the original 120-day deadline and then file the Part III information no later than 45 days following the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
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SEC Small Business Advocate Releases First Annual Report
The SEC’s Office of Small Business Advocate launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat. The Office recently issued its first annual report (“Annual Report”).
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyzing the potential impact of regulatory changes on small businesses and their investors; (v) conducting outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
A highlight of the achievements of the office under the leadership of Martha Legg Miller include: (i) hosted and participated in various engagement events with entrepreneurs and investors; (ii) published its business plan; (iii) participated in National Small Business Week including the Small Business Roundtable and meeting of the Small Business Capital Formation Advisory Committee; (iv) launched explanatory videos on how to participate in and comment on rule making; and (v) hosted the annual Government-Business Forum on Small Business Capital Formation, a forum I have had the pleasure of attending in the past.
The Office’s Annual Report contains discussions on: (i) the state of small business capital formation; (ii) policy recommendations; and (iii) the Small Business Capital Formation Advisory Committee.
The State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in reliance on Rule 506(b) of Regulation D ($1.4 trillion for FYE June 30, 2019) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).
The industries raising the most capital include banking, technology, manufacturing, real estate, energy and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Florida and Texas are responsible for higher amounts of capital raised in aggregate.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited. The SEC recently proposed a change in the definition of accredited investor to open up investment opportunities to additional qualified investors (see HERE).
The Annual Report discusses costs for early-stage companies to raise capital, including attorneys’ fees. According to the report, attorneys’ fees are between $5,000 and $20,000 for very early-stage companies and from $20,000 to $40,000 for venture-stage entities. The Report is in line with fees in my firm.
Interestingly, the Annual Report notes a correlation between the increased availability of venture capital funding and job growth in metro areas. Generally, venture-capital or private-equity-backed companies enter the public markets – 44.8% of companies currently listed on the Nasdaq were formerly backed by a venture-capital or private-equity firm.
The Report contains information related to the much–talked-about growing delay in public offerings (see more information HERE and HERE.) According to the Annual Report, companies are going pubic later in their life cycle, which also results in less funds being raised in the public markets via follow-on offerings. The Annual Report indicates 204 IPO’s from July 1, 2018 through June 30, 2019 and 294 small public company follow-on offerings for the same period. Not surprisingly, 61% of exchange traded companies with less than a $100 million market cap have no research coverage.
Woman are founding more start-ups than previously, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. On the investor side, 29.5% of angel investors are women, 11% of VCs are women, and 71% of VC firms had no female partners.
There has also been a big uptick in minority-owned businesses. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. On the investor side, only 5.3% of angel investors and 1% of VCs are minorities.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.
Policy Recommendations
Modernize, Clarify and Harmonize Exempt Offering Framework
Following up on the SEC’s June 2019 concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework (see HERE), the Office of Small Business Advocate recommends a simplification to the exempt offering structure. The securities laws, including exempt offering regulations, are complex and difficult to navigate. The fact is that without competent securities counsel, the chances that a capital raise will be compliant with the securities laws is nonexistent.
The Office of Small Business Advocate suggests the following guiding principles to consider in restructuring the current exempt offering framework: (i) the rules, including all guidance on compliance, should be readily accessible and written in plain English; (ii) the rules should allow a company to progressively raise money throughout its growth (meaning very easy structures for small start-up capital raises); (iii) consider the Internet and technology advancements in communication (perhaps allow more open solicitation and advertising); (iv) dollar caps should be flexible for future review and adjustment and consider factors such as industry, geography and life-cycle stage; and (v) the principles underlying the current regulatory structure for exempt offerings should be re-examined.
Investor Participation in Private Offerings (the Accredited Investor Definition)
Most offering exemptions limit participation to accredited investors or if unaccredited investors are allowed, the number of such investors may be limited (506(b)), the disclosures required much more robust, or the investment amounts limited. As a result, the question of a change to the hard-line-in–the-sand accredited investor definition has been debated for years and answering the call, in December 2019, the SEC published a proposed amendment (see HERE).
The Annual Report notes that the definition of an accredited investor is designed to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. However, the current definition results in eliminating opportunities for retail investors to diversify their portfolios and participate in the growth of companies in the private markets. Public mutual funds rarely invest in private companies and private-equity, hedge funds and venture-capital funds raise capital using the same offering exemptions as private businesses and thus have the same accredited investor limitations. Also, as a result of poor drafting, some sophisticated entities such as American Indian tribal corporations have been left out of the definition, regardless of their asset value.
The Office believes that although investor protections are important, the current definition prioritizes risk of loss over sophistication and creates too strong a barrier to capital for small and emerging-growth companies. Furthermore, the current accredited investor definition structure (and prohibitions on advertising and solicitation) makes it difficult and time-consuming for accredited investors to source investment opportunities even when they want to.
Supporting the proposed rule changes, the Office agrees that adding financial professional licenses and education goalposts to the current accredited investor definition would be beneficial. Likewise, they would not support an increase in the current financial thresholds. Rather than add to the list of entities that could qualify, the Office suggests that any entity, regardless of corporate form, should be able to qualify if it has over $5 million in assets. The Office recommends that the changes be easy to navigate, providing simplicity and certainty in ascertaining qualification to avoid increasing transaction costs. Although not included in any current rule proposal, the Office also suggests modifying the Investment Company Act rules to allow for more public mutual funds to invest in private companies.
Finders
As all capital markets practitioners know, one of the biggest challenges to raising capital is finding and being introduced to potential investors. Although larger companies engage the services of broker-dealers, there simply aren’t many options for smaller or early-stage entities. Because of the very big need, an industry of unlicensed finders has developed. This is a topic I’ve written about many times (see HERE). Some finders operate within the parameters of the law, such as by providing a multitude of valuable services such as creating pitch materials, consulting on capital structure, helping with general business goals and objectives and marketing materials, and importantly, not collecting a success or separate fee for capital introductions. However, many violate the law, causing a host of potential issues for both the finder and the company utilizing their services. Despite pleas from industry participants, the ABA, committees within the SEC and numerous other groups, the need for a workable regulatory structure remains unanswered.
The Office calls for a clear finder’s framework. In implementing a framework for finders to support emerging businesses’ capital needs and provide clarity to investors participating in the market, it is critical that the rules be clear for marketplace participants to reduce confusion, defining in plain English the activities that do not trigger registration and delineating when the scope of activities rises to the level that registration is appropriate. The framework should make clear what offering exemptions are eligible, whether the introduced investors must be accredited, the nature of compensation the finder may receive, the types of other incidental activities that the finder may engage in on behalf of the business, and the respective roles of federal and state regulators.
As I’ve mentioned several times, I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even support a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.
Crowdfunding
Since 2012, Regulation CF has provided a method for businesses to raise a small amount of capital (capped at $1,070,000) from numerous investors over the Internet utilizing the services of a funding portal. The Annual Report suggests that crowdfunding has been a success, helping many entrepreneurs that may otherwise not have been able to access capital. However, the Annual Report points out some issues with the process including the inability to properly advertise and market and thus drive investors to the opportunity and higher-than-necessary compliance costs. The Office reports that the system overseas is better, with companies raising more capital at a lower cost.
The Office suggests: (i) increase the $1,070,000 cap (no amount is suggested); (ii) remove the investment cap for accredited investors; (iii) revise the various disclosure obligations to reduce compliance costs; (iv) enable the use of special-purpose vehicles for investment; and (v) reduce the compliance burdens for funding portals.
Disclosure Requirements for Small Public Companies
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer, negatively impacting the U.S. public marketplace.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on recent proposed changes to the management’s discussion and analysis section of SEC reports, see HERE. That blog also contains a complete breakdown of the SEC’s ongoing disclosure effectiveness initiative. In addition to supporting the recent initiative, the Office advocates for further changes to reduce compliance costs for smaller reporting companies.
The Small Business Capital Formation Advisory Committee
The Small Business Advocate Act also created the Small Business Capital Formation Advisory Committee, which replaced the SEC’s voluntarily created Advisory Committee on Small and Emerging Companies. The new Advisory Committee is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters related to emerging, privately held small businesses to publicly traded companies with less than $250 million in public market capitalization; trading in securities of such companies; and public reporting and corporate governance of such companies.
The Advisory Committee has made two recommendations to the SEC. In particular, related to the recent SEC’s proposed rule changes to the reporting requirements for the acquisitions and dispositions of businesses (see HERE), the Advisory Committee suggests that the rule change provide differing treatment for Regulation A companies and make Management’s Adjustments optional or not required at all. Overall the Advisory Committee supports the rules changes but would make some tweaks.
The second recommendation relates to the SEC’s proposed amendment to the definitions of “accelerated filer” and “large accelerated filer” (see HERE ). Although the Advisory Committee supports the change, it would go further to add more companies that would qualify as a non-accelerated filers by raising the revenue threshold (currently proposed to be $100 million), increasing the time for such revenue (from the last year to three years) and considering whether all smaller reporting companies should be non-accelerated filers.
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SEC Proposes Additional Disclosures For Resource Extraction Companies
In December 2019, the SEC proposed rules that would 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 proposed 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. However, the statutory mandate in the Dodd-Frank Act requiring the SEC to adopt these rules requiring the disclosure remains in place and as such, the SEC is now taking its third pass at it.
The proposed rules would require domestic and foreign resource extraction companies to file a Form SD on an annual basis that includes information about payments related to the commercial development of oil, natural gas, or minerals that are made to a foreign government or the U.S. federal government.
Proposed Rule
The Dodd-Frank Act added Section 13(q) to the Securities Exchange Act of 1934 (“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 proposed rules make many significant changes to the rejected 2016 rules. In particular, the proposed 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) review the definition of “not de minimis” at both the project and individual payment threshold such that disclosure of a payment that equals or exceeds $150,000 would be required when the total project payments equal or exceed $750,000; (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 at a level below the major subnational government level; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.
The proposed rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q). Under the proposed 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.
The proposed rules would 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 proposed definition of “commercial development” would capture 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 proposed definition of “commercial development” would capture 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 would not include downstream activities such as refining or smelting. “Export” would be 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, would not be 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 proposed rules would 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 will be included such that the rules would require disclosure with respect to an activity or payment that, although not within the categories included in the proposed 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. As proposed, a resource extraction issuer would 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 would require 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 would not be required. The third prong would require 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 proposed rules, a “foreign government” would be 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” would include 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 would 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 proposed rules, Form SD would expressly state that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited. The report will cover the company’s fiscal year and will need to be filed no later than nine months following the fiscal year-end. The Form SD must include XBRL tagging.
As noted above, the proposed 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 proposed targeted exemption, companies would 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 proposed 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 would 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 Fall 2019 Regulatory Agenda
In late 2019, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the spring 2019 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 has increased with 47 items as compared to 40 on the spring 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. Only one item is listed in the fall 2019 pre-rule state and that is portfolio margining harmonization. The only item that had been on the spring 2019 agenda in the pre-rule category was the harmonization of exempt offerings which moved to the proposed rule stage after the SEC published a concept release in June 2019 (see HERE).
Thirty-one items are included in the proposed rule stage, up from 22 on the spring list. Items include amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019); broker-dealer reporting, audit and notifications requirements and three amendments to Regulation NMS.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, remains on the proposed rule list. The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change. I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject. Comments and responses to the proposed rules have been voluminous and largely negative. The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system. At this point it is unclear as to the future of these much-needed changes.
Other items that first appeared on the spring agenda and have been gaining some traction and that are listed on the proposed rule stage include: (i) proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); and (ii) amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE). Both proposed rules have been controversial but should proceed to final within the planned 12 months. Also first proposed in spring and still on the proposed rule list are amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendment to MD&A were adopted in March 2019 (see HERE)
Continuing the SEC’s disclosure effectiveness initiative, the proposed rules include modernization and simplification of disclosures regarding description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE).
Earnings releases and quarterly reports were on the fall 2018 pre-rule list and then moved to long-term on the spring 2019 list. The topic is back on the proposed rule list. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments 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) remain on the proposed rule list. The SEC has recently amended the rules and issued a concept release (see HERE and HERE) and appears committed to enacting much-needed updates and improvements to the rules.
Highly debated and much needed, the amendments to the accredited investor definition moved from the long-term list to the proposed rule stage. The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE). As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.
Other items moved up from long-term to proposed-rule stage include executive compensation clawback (see HERE) and clawbacks of incentive compensation at financial institutions. Clawback rules would implement Section 954 of the Dodd-Frank Act and technically require that national securities exchanges require clawback provisions as a listing qualification. Also moved up from the long-term list are amendments to Guide 5 on real estate offerings and Form S-11, Regulation Crowdfunding amendments, and Regulation A amendments.
New to the list, appearing in the proposed rule category are amendments to Form 13F filer thresholds, investment company summary shareholder report, and registration of investment advisers to rural business investment companies.
Remaining on the proposed rule list is bank holding company disclosures (proposed rules published in September 2019); filing fee processing updates (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019); use of derivatives by registered investment companies and business development companies; amendments to marketing rules under the Advisors Act; amendments to the custody rules for investment advisors; procedures for investment company act applications; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and market data distribution and market access.
Amendments to the transfer agent rules remains on the proposed rule list although it has been almost four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). SEC top brass speeches suggest that this will finally be pushed over the finish line this year (see HERE, for example).
Sixteen items are included in the final rule stage, reduced from 18 on the spring list. Financial disclosures about acquired businesses has moved to the final rule stage with amendments having been proposed in May 2019 (see HERE). The matter has been an open item for several years (see HERE).
Also included in the final rule stage are amendments to the financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE). Although still on the final rule list, the SEC adopted final amendments extending testing-the-waters provisions to non-emerging growth companies in October 2019 (see HERE)
Amendments to the definition of an accelerated filer has moved up from the proposed rule stage to final rule stage (see HERE for the proposed rule changes). Fund of fund arrangements (proposed rules were issued in December 2018), offering reform for business development companies (proposed rules published in March 2019), amendments to Title VII cross-border rules (final rules adopted in September 2019), and customer margin requirements for securities futures (proposed rules published in July 2019) have also moved up from proposed to the final rule stage.
Other items still in the final rule stage include rules related to exchange-traded funds (ETF) (for basic information on ETFs, see HERE), disclosure for unit investment trusts and offering variable insurance products, recordkeeping and reporting for security based swap dealers (new rules were adopted in September 2019), a new definition for covered clearing agency (last amended in September 2016), risk mitigation techniques (new rules were adopted on December 18, 2019), amendments to the whistleblower program, amendments to the SEC’s Rules of Practice and prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds (new rules adopted in November 2019).
Several items have dropped off the final rule list as they have now been implemented and completed, including implementation of FAST Act report recommendations (see HERE); the controversial Regulation Best Interest, which was adopted in June 2019; amendment to the single issuer exemption for broker-dealers which was adopted in June 2019; auditor independence with respect to loans or debtor-creditor relationships adopted in June 2019; amendments to the single issuer exemption for broker-dealers adopted in June 2019; amendments to the rule for nationally recognized statistical rating organizations adopted in August 2019; and amendments to the Volcker Rule which were implemented in August 2019.
Thirty-seven items are listed as long-term actions (down from 52), including many that have been sitting on the list for a long time now. Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now. Other items still on the long-term list include universal proxy (originally proposed in October 2016 – see HERE); and corporate board diversity (although nothing has been proposed, it is a hot topic); and the definitions of mortgage-related security and small-business-related security.
Also still on the long-term list (or added to the list) are numerous Dodd-Frank mandated provisions including additional proxy process amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; conflict minerals amendments (being challenged in lengthy court proceedings on constitutional First Amendment basis); and covered broker-dealer provisions under Title II of Dodd-Frank.
New to the list are asset-backed securities disclosures (last amended in 2014); mandated electronic filings; Regulation AB amendments; modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; amendments to the Family Office Rule; 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; broker-dealer liquidity stress testing, early warning, and account transfer requirements; additional changes to exchange-traded products; recordkeeping and risk controls specific to algorithmic trading; amendments to the rules regarding the consolidated audit trail; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.
Also new to the list are a few electronic filing matters including electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports, 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 Forms ATS and ATS-R regarding the initial, quarterly, and cessation of operation reports by ATSs.
Several swap-based rules remain on the long-term list or have been added to the list including ownership limitations and governance requirements for security-based swap clearing agencies, security-based swap execution facilities, and national exchanges; end user exception to mandatory clearing of security-based swaps; registration and regulation of security based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
Also remaining on the long-term action list are Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See HERE for more information.
Other interesting items on the long-term agenda are rule changes to short sale disclosure reforms and registration of alternative trading systems. Alternative trading systems have garnered interest for their potential use for securities token trading.
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SEC Proposes Amendments To The Accredited Investor Definition
Four years after issuing its report on the definition of “accredited investors” in December 2015, the SEC has published a proposed rule amendment to the definition. See HERE for my blog on the SEC’s report. The amendments were anticipated following an in-depth discussion on the definition contained in the SEC’s Concept Release on Private Offerings published in July 2019 (see HERE)
As a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. In the rule amendment release the SEC cites numerous comment letters suggesting and supporting many of the proposed amendments including one from the Crowdfunding Professionals Association (CfPA), Legislative & Regulatory Affairs Division, a committee I sit on and for which I participated in the preparation of the comment letter.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify including a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC is also proposing to amend the definition of a “qualified institutional buyer” under Rule 144a of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments would also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
Background
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including rule 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows such investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2018 the estimated capital raised in rule 506 offerings was $1.7 trillion compared to $1.4 trillion in registered offerings. Of the $1.7 trillion, $1.5 trillion was raised by pooled investment funds and the balance directly by other businesses. The SEC has been talking about increasing access to this large and growing market sector for some time.
In November 2019 the topic was front and center at the Investor Advisory Committee meeting (see HERE). In my blog on the meeting, I suggested that access to private markets and private funds could be expanded by amending the definition of an “accredited investor” to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. The proposed amendments would do just that.
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
- Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
- Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
- Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
- Any entity in which all of the equity owners are accredited investors.
Proposed Amendments
The proposed amendments to the accredited investor definition would add new categories of natural persons based on professional knowledge, experience, or certifications. The proposed amendments would also add new categories of entities, including a catch-all category for any entity owning in excess of $5 million in investments. In particular, the proposed amendments would: (i) add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution; (ii) with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund; (iii) add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify; (iv) add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (v) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (vi) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The proposed amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test.
The proposed amendments to the qualified institutional buyer definition in Rule 144A would add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The proposed amendments would also add a catch-all category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
The proposed amendment would add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution. The added categories are intended to demonstrate an individual’s background and understanding in the areas of securities and investing and thus a reduced need for regulatory protection. The SEC believes that individuals with financial sophistication have the ability to balance risky investments, make risk assessments and avoid unsustainable losses.
The SEC proposes to include professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. The amendment would include a non-exclusive list of attributes the SEC would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
The SEC would issue an order designating professional certifications and designations or other credentials as qualifying for accredited investor status. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status would be posted on the SEC’s website.
The SEC also preliminarily anticipates including those that hold a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Also requiring that a list of individuals that hold the certifications be publicly available would reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC proposes to add a new category based on the person’s status as a “knowledgeable employee” of the fund. The private fund category is meant to encompass funds that rely on the exemptions found in Sections 3(c)(1) and 3(c)(7) from registration as an investment company under the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, if the knowledgeable employee does not qualified as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded. Accordingly, the SEC proposes to fill this gap and include knowledgeable employees of private funds in the amended definition of an accredited investor.
Spousal Equivalents
The SEC proposes to add a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent will be defined as a cohabitant in a relationship generally equivalent to a spouse. The rule will not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules would (i) add limited liability companies that were not formed for the specific purpose of making the investment, registered investment advisers and rural business investment companies (RBICs); (ii) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (iii) “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act, to the current list of entities that may qualify as accredited.
As mentioned above, these additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
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SEC Proposes To Tighten Shareholder Proposal Thresholds
As anticipated on November 5, 2019, the SEC issued two highly controversial rule proposals. The first is to amend Exchange Act rules to regulate proxy advisors. The second is to amend Securities Exchange Act Rule 14a-8(b) to increase the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954. Together the new rules would represent significant changes to the proxy disclosure and solicitation process and shareholder rights to include matters on a company’s proxy statement. Not surprisingly, given the debate surrounding this topic, each of the SEC Commissioners issued statements on the proposed rule changes.
I am in support of both rules. This blog addresses the proposed rule changes related to shareholder proposals. Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years. The rules have not been amended in decades and during that time, shareholder activism has shifted. Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets. The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements. I note that a 2018 study found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.
Background – Current Rule 14a-8
The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. 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 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.
All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.
Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors, and is accordingly a source of much contention. Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that if meet substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.
State laws in general allow a shareholder to attend a meeting in person and, at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process. By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost, to themselves. It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.
The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so. Procedurally to qualify to submit a proposal, a shareholder must:
- Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
- If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
- If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
- Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
- Clearly state the proposal and course of action that the shareholder desires the company to follow;
- Submit no more than one proposal for a particular annual meeting;
- Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
- Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
- If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
- The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.
A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.
Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC. If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.
As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion. Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.
As a refresher, substantive grounds for exclusion include:
- The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
- The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
- The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
- The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
- The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
- The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
- The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
- The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
- The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
- The proposal seeks to remove an existing director whose term is not completed;
- The proposal questions the competence, business judgment or character of one or more director nominees;
- The company has already substantially implemented the requested action;
- The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
- The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
- The proposal seeks to require the payment of a dividend; or
- The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.
Proposed Rule Change
The need for a change in the rules has become increasingly apparent in recent years. As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and as such is susceptible to abuse. In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules. Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals. The SEC also conducted a Proxy Process Roundtable and invited public comments and input.
The proposed rule changes address eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal. The proposed amendments would amend the proposal eligibility requirements in Rule 14a-8(b) to:
(i) update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;
(ii) require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal;
(iii) require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal, and provide contact information as well as business days and specific times that the shareholder is available to discuss the proposal with the company.
The proposed amendments would amend the “one proposal” requirements in Rule 14a-8(c) to:
(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.
Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.” The proposed amendments would amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to:
(i) increase the current resubmission thresholds of 3%, 6% and 10% for matters voted on once, twice or three or more times in the last five years, respectively, of shareholder support a proposal must receive to be eligible for future submission to thresholds of 5%, 15% and 25%; and
(ii) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote.
Commissioner Statements on the Proposed Rule Changes
Chair Jay Clayton supports the proposed amendments as part of the necessary modernization of the proxy process. He specifically believes that the requirement for shareholders to engage and meet with management on a proposal will have a significant beneficial impact on company-shareholder communications and the proxy process. Focusing on the resubmission changes, Chair Clayton states, “if after three attempts at a proposal within a 5 year period, 75% of your fellow shareholders still do not support your proposal, you should take a time out.”
Commissioner Roisman also supports the proposed rule changes discussing how long it has been since the last amendments and the significant changes in the markets and technology since that time. The SEC has an obligation to revisit rules regularly to ensure they remain appropriate in the current dynamic. He points out that this is especially true when the market participants are loudly proclaiming that the rules are not working, as in the case of the proxy process and shareholder submission and resubmission eligibility criteria.
Commissioner Hester Peirce supports the rule changes and is eloquent and clever in her statement, as usual. Cutting to the chase, the question in Rule 14a-8 is: “[W]hen should one shareholder be able to force other shareholders to pay for including the proponent shareholder’s proposal in the company’s proxy materials?” Continuing: “[T]he proposed changes would help to weed out proposals whose proponents do not have a real interest in the company and proposals for which other shareholders do not share the proponent’s enthusiasm.” The current proposals are fair, ensuring that shareholders with a real economic stake can submit proposal and resubmit those proposals where other shareholder interest increases.
Not surprisingly, Commissioner Jackson is not in support of the changes beginning his statement by characterizing the proposed rule changes as limiting public company investors’ ability to hold corporate insiders accountable. He agrees that the rules need to be updated and revisited but does not approve of proposals made.
Commissioner Allison Lee sides with Commissioner Jackson in seeing the proposed rules as suppressing shareholder rights. Commissioner Lee is specifically concerned about small shareholders being deterred from submitting proposals related to ESG matters including climate risk disclosures.
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