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SEC Solicits Input To Improve Markets For Thinly Traded Securities

Posted by Securities Attorney Laura Anthony | November 12, 2019 Tags: SEC, SEC Solicits Input To Improve Markets For Thinly Traded Securities

On October 17, 2019, the SEC made a statement inviting stock exchanges and market participants to submit “innovative proposals designed to improve the secondary market structure for exchange listed equity securities that trade in lower volumes, commonly referred to as ‘thinly traded securities.’” On the same day the SEC issued a staff background paper on the subject. The SEC is not asking for input on how a company can better promote its stock and gain investor awareness, but rather how the capital market system, including trading rules and regulations, can be amended or improved to benefit thinly traded securities.

The staff background paper cites many statistics on the number of thinly traded securities, which they define as trading less than 100,000 shares daily. It also refers to the U.S. Department of the Treasury report entitled “A Financial System That Creates Economic Opportunities; Capital Markets” – see HERE for a summary of the report. As a result of this report, the SEC began looking at changes to Regulation NMS and unlisted trading privileges, both of which they continue to review and are now seeking public input on.

Regulation NMS

The SEC points out that thinly traded securities drive up transaction costs, and can make an exit of security holdings challenging and increase a company’s cost of capital. In its statement the SEC talks about potentially suspending unlisted trading privileges on multiple exchanges for thinly traded securities and overhauling Regulation NMS, including by providing exemptions from the rules. The SEC has raised these ideas previously, HERE).

Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.

Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations, and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.

Institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.

Unlisted Trading Privileges

One idea to improve liquidity is to restrict or even terminate unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC-traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.

Market Maker Incentives

In a recent roundtable, a suggestion was made to provide market makers with incentives to trade and make markets in thinly traded securities. Increased incentives to be in, and stay in, the markets for these securities could encourage market makers to quote more frequently and in greater size, which in turn could lead to narrower spreads and increased displayed order interest.

Intraday Auctions

Another possible strategy to help with thinly traded securities is to have periodic intraday auctions as a means of concentrating liquidity in thinly traded securities at times other than solely at the market open and market close. This strategy may assist market participants in finding counterparties for trades, especially larger block trades.

Non-Automated Markets

The idea around a non-automated market is that buyers and sellers could negotiate directly and communicate with each other to determine trade prices and order size. To me this seems to result in a sort of private market for thinly traded securities that could result in abuse and an unfair advantage for market participants with knowledge and contacts over Main Street investors.

General Information for Proposals

The SEC statement also includes general instructions and suggestions for submittals. The SEC invites exchanges to proceed with submittals for suspension or termination of unlisted trading privileges under Section 12(f) of the Exchange Act and for exemptive relief from Regulation NMS under current Exchange Act rules. Submittals and suggestions should include an analysis of broader market impacts. Proposals should also cite relevant statutory authority and requirements.

Since “thinly traded securities” is not statutorily defined, proposals should include a definition, whether based on average daily trading volume, number of trades, share volume, or dollar volume, combined with additional factors such as market capitalization, number of shareholders, or public float. Proposals should include an explanation of how the thresholds were set, including any relevant data and analysis and transitioning into and out of the definition. Proposals should include all parameters of a requested rule change, including exemptions, whether companies can opt in or out and the mechanics of implementation.

The Author

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SEC Cautionary Statement on Audits of Public Companies Operating in China

Posted by Securities Attorney Laura Anthony | February 12, 2019 Tags: SEC, SEC Cautionary Statement on Audits of Public Companies Operating in China

Eight years following the crash of the Chinese reverse merger boom and a slew of SEC enforcement proceedings, the SEC is once again concerned with the financial reporting by U.S. listed companies with operations based in China. In December 2018, the SEC issued a cautionary public statement from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III entitled “Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally – Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China.”

Just reading the title reminded me of the boom in China-based reverse mergers around 2009-2010 followed by the trading halts or delistings of at least 50 companies in 2011 and 2012. In the summer of 2010, the SEC launched an initiative to determine whether certain companies with foreign operations—including those that were the product of reverse mergers—were accurately reporting their financial results, and to assess the quality of the audits being done by their auditors. By June 2011, the SEC was strongly warning investors of the risks posed by reverse mergers in general, and Chinese deals in particular, singling out six Chinese issuers.

Numerous SEC enforcement actions and civil lawsuits were filed claiming fraud and misrepresentations in SEC filings including financial reports. Partially as a result of the crisis, in late 2011 both the NYSE and Nasdaq amended their listing requirements to add a seasoning requirement following a reverse merger. The seasoning rules prohibit a company that has completed a reverse merger with a public shell from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange, for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, the rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report.

In addition, the seasoning rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes an exception for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.

In addition to the specific additional listing requirements contained in the new rule, the Exchange may “in its discretion impose more stringent requirements than those set forth above if the Exchange believes it is warranted in the case of a particular reverse merger company based on, among other things, an inactive trading market in the reverse merger company’s securities, the existence of a low number of publicly held shares that are not subject to transfer restrictions, if the reverse merger company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or if the reverse merger company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the reverse merger company’s independent auditor and has not yet implemented an appropriate corrective action plan.”

Slowly since that time, Chinese companies have again started to access U.S. capital markets via both reverse mergers and direct IPO’s. However, clearly the issues and concerns raised by the SEC in 2011 have not all been resolved.

SEC Public Statement

The SEC’s recent cautionary public statement was issued jointly from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III. The statement’s opening sentence sets the tone for the rest of the content, and in particular, “[A]s we are nearing the end of the fiscal year for many reporting companies, it is important to remember that complete, accurate financial statements and credible audits are things we—investors, issuers, and regulators worldwide—all care about.”

The statement continues with a recognition of the global nature of both capital markets and companies, with U.S.- and non-U.S.-based companies seeking access to the U.S. capital markets and the fundraising and liquidity they bring. The statement points out that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017. Capital access and liquidity are made possible by the assurance that companies that list and trade on U.S. markets provide high-quality and reliable financial information and that U.S. rules, regulations, and regulatory oversight apply. When the listed company operates outside the U.S., regulators must operate in multiple jurisdictions to be able to access audit-related information and otherwise effectuate their responsibilities over any company trading in the U.S. markets.

A multinational company must comply with financial reporting obligations in many of the countries in which it operates and its auditors must be able to operate on a worldwide basis. The multi-jurisdictional aspect is sometimes challenging in that information necessary for regulatory oversight does not always flow back to the U.S. as it should. Barriers to the information flow include data protection, privacy, confidentiality, bank secrecy, state secrecy, or national security laws. The U.S. has been working with foreign jurisdictions to address these laws and barriers where a company subjects itself to U.S. regulatory oversight by listing on U.S. securities exchanges and accessing U.S. capital markets. For example, the SEC is one of over 120 signatories to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding, which provides for enforcement consultation and cooperation, and the exchange of information. Moreover, the SEC has over 75 formal cooperative arraignments with foreign regulators, the PCAOB has conducted inspections of registered accounting firms in over 50 foreign countries, and the PCAOB has cooperative arrangements with 23 foreign regulators.

Unfortunately, China is not one of these cooperative arrangements, and the PCAOB has been facing issues being able to inspect auditing firms in China, as well as Hong Kong where the audit client has operations in mainland China. Based on reports to the PCAOB from audit firms up to March 31, 2018, there were 213 listed companies in China and 11 in Belgium for which the PCAOB and SEC have not been able to inspect audit records despite ongoing and significant efforts. From March 31 to the date of the SEC’s public statement, some of those companies changed their listing or trading status, dropping the number down to 178 companies.

The SEC is and remains the principal regulator of the world’s largest securities markets and, as such, must often deal with cross-border issues. The SEC sees its mission as administering and enforcing requirements for reliable financial reporting globally in light of the global nature of the economy and the many companies that operate worldwide. The SEC furthers this mission by communicating and cooperating with regulators in other countries and by participating in international organizations such as IOSCO (the International Organization of Securities Commissions) and The Monitoring Group, which engages in the monitoring of international accounting, auditing, and ethics standards.

The SEC also oversees the PCAOB which, in turn, is the principal U.S. regulator that oversees the audits of public companies and SEC-registered brokers and dealers. The PCAOB is required by U.S. law to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports or that play a substantial role in their preparation. As noted above, the PCAOB has inspected audit firms in 50 different foreign countries. The PCAOB also often works in cooperation with foreign regulators and their audit inspection authorities.

However, despite the cooperative arrangements, there are legal impediments blocking the free flow of information from some countries. In particular, blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws sometimes complicate or outright restrict the sharing of information with U.S. regulators. Some of these laws prohibit foreign-domiciled companies from responding directly to SEC requests for information and documents or doing so, in whole or in part, only after protracted delays in obtaining authorization. Other laws can prevent the SEC from being able to conduct any type of examination, either on-site or by correspondence. Accordingly, securities regulators around the world seek agreements with one another for access to business books and records or auditor documentation. Likewise, some countries prohibit the PCAOB from inspecting audit firms within their borders, even if the auditor is PCAOB-registered. In that case, the PCAOB usually enters into cooperative arrangements with local regulators that allows them to jointly inspect a firm.

However, the SEC is generally not satisfied with their ability to inspect, investigate and enforce the U.S. securities laws in China. Despite the significant value of China-based companies trading in U.S. markets, Chinese law requires that the business books and records related to transactions and events occurring within China be kept and maintained there. China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. Also, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers. As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers. The SEC and PCAOB are engaging in ongoing discussions with Chinese officials and regulators but have not made satisfactory progress.

The SEC believes that if a company wants to access U.S. securities markets, the SEC needs to be able to directly supervise these entities and the auditors that audit their books and records. Any audit firm that registers with the PCAOB is legally obligated to cooperate and provide documents and testimony, if requested, in connection with inspections and investigations regardless of their locations. If the SEC and/or PCAOB cannot access a company or its auditor, they will seek sanctions and other remedial measures. To help keep investors informed of these issues, the PCAOB publishes a list of companies and auditors for which they have not been able to conduct inspections or obtain sufficient information.

The SEC continues to try and negotiate with Chinese authorities to improve relations and allow the SEC and PCAOB to have timely access to information necessary to conduct investigations or inspections but has not been successful to date. Many China-based companies and companies with significant operations in China want to access U.S. securities markets, but the inability of U.S. regulators to properly access records is causing the SEC concern about the risk to investors. Even if an audit is conducted correctly and financial reports are accurate, there is a greater risk to investors if the SEC cannot do its job and inspect the records. Of course, there is also the very real risk of fraud, which could emanate from a large company (for example, Enron or WorldCom) and have a broad market impact. The SEC is considering remedial measures, which could include requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances.

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SEC Solicits Comment On Earnings Releases And Quarterly Reports

Posted by Securities Attorney Laura Anthony | January 15, 2019 Tags: SEC, SEC Solicits Comment On Earnings Releases And Quarterly Reports

On December 18, 2018, the SEC published a request for comment soliciting input on the nature, content, and timing of earnings releases and quarterly reports made by reporting companies. The comment period remains open for 90 days from publication. The request is not surprising as earnings releases and quarterly reports were included in the pre-rule stage in the Fall 2018 SEC semiannual regulatory agenda and plans for rulemaking.

The request for comment seek input on how the SEC can reduce burdens on publicly reporting companies associated with quarterly reports while maintaining disclosure effectiveness and investor protections. The SEC also seeks comment on how the existing reporting system, earnings releases and earnings guidance may foster an overly short-term focus by companies and market participants. In addition, the SEC is looking for input on how to make the reporting process less cumbersome to investors, such as by having to compare an earnings release and Form 10-Q for differences.

This has been a hot topic over the years, with President Trump publicly calling for an elimination of quarterly reporting. The April 2016 concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements also requested comment on the subject. See my two-part blog on the S-K Concept Release HERE and HERE. The newest request for comment takes into consideration comments received in response to the 2016 release and drills down further on the quarterly reporting process.

The request for comment specifically addresses (i) the nature and timing of disclosures in quarterly reports, including when the disclosures overlap with voluntary earnings releases in Forms 8-K; (ii) how the SEC can make the process more efficient by eliminating duplication and how that can affect capital formation; (iii) whether the SEC should allow some or all reporting companies flexibility on the frequency of periodic reporting; and (iv) how the existing periodic reporting system may affect corporate decision making and may foster an inefficient outlook by focusing on short-term results.

Background on Form 10-Q

In addition to annual reports on Form 10-K and current reports on Form 8-K, companies subject to the periodic reporting requirements under the Securities Exchange Act of 1934 (“Exchange Act”), other than foreign private issuers, must file quarterly reports on Form 10-Q, which include independent auditor-reviewed interim financial statements and other disclosure items. For more information on SEC reporting requirements, see HERE and related to foreign private issuers, see HERE. Foreign private issuers must file annual but not quarterly reports.

These quarterly reports, as well as other periodic reports, may be forward incorporated by reference into Securities Act of 1933 (“Securities Act”) registration statements such as Forms S-1 and S-3, reducing the need for duplication of this information through post effective updates. As an aside, the FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies (see HERE), which category of company has recently increased with the amended definition of a smaller reporting company (see HERE). Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference.

A Form 10-Q is subject to the anti-fraud provisions of Sections 10(b) and 18 of the Exchange Act and Rule 10(b)(5) and can be the source of liability to the company, affiliates and underwriters under Sections 11, 12 and 17 of the Securities Act, related to the offer and sales of securities offerings. Each of these provisions imposes liability on companies in certain instances for making any untrue statements of a material fact or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. The difference in the Sections relate to whether the cause of action is private or can only be pursued by a regulator or governmental body, if private, who has a right to pursue the action (for example, Section 11 provides an action for any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket), the elements of proof (such as scienter or intent or loss causation), allowable damages, the standard of proof, etc..

Liability under certain of these provisions, such as Sections 11 and 12 of the Securities Act and Section 18 of the Exchange Act, attaches only to documents that are filed with the SEC or incorporated by reference into a Securities Act registration statement. A Form 10-Q is always deemed filed with the SEC.

However, the SEC allows certain information to be furnished as opposed to filed as long as the company specifically discloses that it is avowing itself of the ability to furnish and not file. For example, reports in a Form 8-K under Regulation FD and earnings press releases under Item 2.02 related to results of operations and financial condition are allowed to be furnished and not filed. Although liability under Section 10(b) and Rule 10b-5 of the Exchange Act may attach to documents that are “furnished,” the standard of proof and elements to state a cause of action are different under these rules.

As mentioned above, foreign private issuers must file annual but not quarterly reports. However, a foreign private issuer has obligations to furnish certain information under a Form 6-K, including, for example, information it (i) makes or is required to make public pursuant to the law of the jurisdiction of its domicile or in which it is incorporated or organized, or (ii) files or is required to file with a stock exchange on which its securities are traded and which was made public by that exchange, or (iii) distributes or is required to distribute to its security holders. This information is subject to liability under Section 10(b) and Rule 10b-5 of the Exchange Act and if incorporated into a registration statement, becomes filed in that registration statement, and subject to liability under Sections 11, 12 and 17 of the Securities Act.

As a result of these requirements, reports on Form 6-K often include quarterly reports or financial statements. For example, Canada, Hong Kong and Japan all require quarterly reporting. On the other hand, in 2013 the European Union (“EU”) amended its reporting requirements to eliminate the requirement to file quarterly reports altogether, which even prior to that time did not include financial statements. The EU found that quarterly reports were a burden for small and medium-sized companies, didn’t add to investor protection, encouraged a focus on short-term performance and discouraged long-term investments. Companies may still voluntarily file quarterly.

Earnings Releases

Many companies that file quarterly Form 10-Q’s also voluntarily issue quarterly financial results through earnings press releases, earnings calls and/or forward-looking earnings guidance. Other than through the anti-fraud rules, the presentation of non-GAAP financial measures (see HERE) and the requirement to file a Form 8-K, the SEC does not regulate these disclosures. Although when a company does issue earnings release information, it is generally duplicative to some information in the Form 10-Q, the Form 10-Q is more robust and includes XBRL interactive data. Disclosures in a Form 10-Q that are not in an earnings release also include full financial statements and notes to financial statements as opposed to summaries and a management discussion and analysis. Moreover, the financial statements in the Form 10-Q are reviewed by an independent auditor and the filing includes Sarbanes-Oxley certifications by the principal executive and financial officers. Contrarily, a Form 10-Q generally does not include expectations of future performance or forward-looking earnings guidance.

Request for Comments

In addition to the general request for comment on the issues and matters described above, the SEC drills down their requests into specific questions on the topic, such as why companies choose to issue earnings releases in addition to a Form 10-Q and what would be the impact on these releases if quarterly reports were not required. The SEC seeks information on the specific benefits of both earnings releases and Form 10-Q and standard market expectations and responses to both. Certainly, as a regulator the SEC understands the legal impact of “furnished vs. filed” and the various liability provisions, but their questions are more focused on the market players and investors uses of and needs for information as well as the burdens of providing same. The SEC also touches on XBRL, which has also been oft debated, especially for smaller reporting companies. The SEC lists 14 multifaceted in this area under the heading “Information Content Resulting from the Quarterly Reporting Process.”

The SEC requests comment on 3 additional multi-layered points related to the timing of the quarterly reporting process including vis-à-vis earnings releases. In particular, some companies issue an earnings release prior to the Form 10-Q while others wait until the same day or close thereafter. Earnings calls can be scheduled anywhere around the time of either filing or after. The SEC queries the reasons why and impacts of the timing.

The next area of questions relates to whether earnings releases should be the core quarterly disclosure, with 12 multi-layered queries. In this area it seems that the SEC is considering making an earnings release an optional alternative to a Form 10-Q by allowing the Form 10-Q to incorporate the earnings release by reference and/or only provide supplemental information in the Form 10-Q to the extent it was not included in the earnings release.

Finally, the SEC tackles the topic of reporting frequency, including considering semi-annual reporting with 17 in-depth, multifaceted questions for consideration.

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

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 Commissioner Hester Peirce Continues to Support Technology

Posted by Securities Attorney Laura Anthony | October 30, 2018 Tags: SEC, SEC Commissioner Hester Peirce Continues to Support Technology

In three recent speeches, SEC Commissioner Hester Peirce continued to proclaim her support for technological innovation and freedom in capital markets. On September 12, 2018, Ms. Peirce gave a speech at the Cato Institute’s FinTech Unbound Conference which she titled Motherhood and Humble Pie, on September 24 she spoke at the University of Michigan Law School titling her speech Wolves and Wolverines, and then on October 2 she spoke at the Financial Planning Association 2018 Major Firms Symposium, calling that speech Pickups and Put Downs. Besides the great titles, I applaud her content and perspective.

Motherhood and Humble Pie

A prevailing theme in all three speeches centered on her dissent to the SEC’s rejection of an exchange traded product or mutual fund. As an aside, since I wrote this blog on the SEC’s published concerns related to a cryptocurrency-related exchange traded product or mutual fund, HERE, the SEC has continued to deny several more applications for such a product.

As the title of her first speech in the series indicates, she uses motherhood as a metaphor to express her view that the SEC has been acting like a helicopter mother as opposed to a free-range mother, by refusing to let its “children” take risks by exploring new financial products that involve cryptocurrencies. In one of my favorite lines in her speech, she states, “[B]etter, we naturally think, not to allow the investor to leave the house, even for a quick trip down the street, unless properly helmeted, swaddled in regulation protective gear, and strapped into a vaguely European-branded car seat that is secured exactly in the center of the back seat of the largest SUV that an upper-middle class professional’s salary can buy.”

Certainly there is risk that investors will lose money and that there will be backlash against the regulatory body for failing to put proper protections in place, but Ms. Peirce thinks that the free-market environment should support such risk. Regardless of the level of regulatory protection, there will always be investor losses. Companies will fail, fraudsters will cheat and markets will downturn. Furthermore, capital markets are, by nature, risky. As Ms. Peirce notes, “[A] key purpose of financial markets is to permit investors to take risks, commensurate with their own risk appetites and circumstances, to earn returns on their investments.”

Ms. Peirce opines that the protection against the risk of cryptocurrency investments could go beyond the SEC’s actual authority. Congress has not empowered the SEC with eliminating risk or substituting the SEC’s investment judgment for that of an investor. The SEC also does not have the authority to regulate or require regulation of assets underlying securities, including digital assets. As I’ve written about in my blogs several times, the SEC regulatory framework centers around disclosure and not a merit review. For example, the SEC does not have the power to prohibit a registration statement from going effective if the disclosures are complete and compliant with Regulations S-K and S-X, regardless of how terrible the investment may be.

Specifically, the SEC’s high-level mandates are to protect investors, facilitate capital formation and maintain fair, orderly and efficient markets. For more on the SEC’s purpose, see HERE. Ms. Peirce believes this mandate requires the SEC to ensure that investors have access to products to allow them to create their own investment portfolios, including with new and expanding asset classes such as cryptocurrencies.

People already invest in cryptocurrencies, but they must do so through direct purchases on various exchanges, outside of their regular investment accounts. The individual investor is charged with keeping records and having a certain technical know-how to play in this marketplace. It is clear that there is a strong interest among investors to access this new type of investment, and for it to be available via exchange traded products, thus the consistent new applications by industry institutions.

Ms. Peirce lists five lessons that the SEC should learn when considering cryptocurrency products and technological innovation. In particular:

The SEC should avoid supplanting its own judgment with that of investors’ and avoid attempting to ascertain the viability of new technology in advance of its release in the marketplace as long as proper disclosures are in place.
The SEC’s efforts to protect investors from the risks of innovation will not change the desire for the marketplace to have access to these products and instead will cause investors to seek investment opportunities in other countries and markets that may be even less regulated than the US markets.
The SEC must be more accessible and willing to engage with entrepreneurs and market participants seeking to bring cryptocurrency products to market. Furthermore, the SEC needs to provide clear and reasonable rules for innovators.
The SEC needs to commit to expanding investor access to financial markets, including through innovative technology. Innovation does not just mean cryptocurrency products but includes mobile access to investment products, online disclosures, and all fintech.
The SEC has to consider the resources it requires in meeting regulatory burdens, including financial, coding and data analytics. These regulatory burdens take away resources that could be used on customer-serving innovation and stifle smaller businesses from pursuing technological innovation.

Ms. Peirce ends with calling for an SEC Office of Innovation, a request that was granted. On October 18, 2018, the SEC launched its new Strategic Hub for Innovation and Financial Technology (FinHub), which is a topic for an upcoming blog.

Wolves and Wolverines

Commissioner Peirce’s September 24 speech at the University of Michigan Law School focused on arbitration between public companies and their shareholders and my favorite topic, digital assets. Solidifying me as a fan even more, Ms. Peirce begins by pointing out that corporate law is a form of public interest law, noting that “[T]he hunt for profit drives companies to strive to identify and meet people’s needs using as few resources as possible.” The corporate ecosystem, including dealing with customers, supplies, creditors, shareholders, employees and communities, requires mutual responsibility and an obligation to exercise sound judgment and respectable ethics.

This sentiment, however, acted as a segue to discuss the fact that failures in corporate ethics, such as the Enron scandal, have resulted in a more conservative SEC and regulatory regime. Repeating her earlier speech, Ms. Peirce conveys her views that the SEC should not be substituting its judgment for that of the investment community. Rather, the SEC should be ensuring that the regulatory framework requires proper disclosure so that investors can make an informed decision, whether it be to trade in particular stocks or products on the public markets, or invest in a private company with “world-changing ideas.”

In addition to her views on access to cryptocurrency, Ms. Peirce has been targeted by pro-regulatory enthusiasts for her statement on mandatory arbitration in the corporate context. In particular, in response to a reporter’s question, she answered that she supports mandatory arbitration since shareholder litigation is expensive and costs all shareholders regardless of the merits of the claims. Arbitration can be more effective, quicker and less costly. Despite the fact that the topic of arbitration between corporations and their shareholders is within the jurisdiction of state corporate law, the SEC could exert its influence by using public policy to affect the ability of a company to register securities if it has an offending policy. Ms. Peirce is consistent with her conviction that on this topic, as with others, the SEC should not impose its judgment on such free-market matters but rather leave it to supply, demand and the investors’ own due diligence.

Ms. Peirce then turned to the topic of cryptocurrency-related exchange traded products and mutual funds. She reiterated much of her sentiment from her prior speech, spending even more time on her concern that the regulatory treatment of cryptocurrencies will stifle all technological innovation in the capital markets, not just those related to digital assets.

Ms. Peirce also impressively took on the question as to whether she thinks all ICOs involve the offering of securities and whether a token security can become a non-security (utility) thereafter. Although months earlier William Hinman, the Director of the SEC Division of Corporation Finance, had expressed his views that a token can become a utility or non-security (see HERE), Commissioner Peirce hedged on the answer but left the impression that she may lean toward continuing to view cryptocurrencies as securities over the long term. Interestingly, although she is very clear that she does not support any merit review, no matter how veiled behind investor protection, she also seems to support some new regulatory structure that would cover digital assets through a longer period of time, while fostering and allowing development and market testing.

Pickups and Put Downs

On October 2, Commissioner Peirce spoke at the Financial Planning Association 2018 Major Firms Symposium. Although Commissioner Peirce stays true to her belief in a more technology- and innovation-friendly SEC, this speech was geared towards its audience and concentrated on the fund management marketplace.

Of course, she could not resist expressing her disappointment with the SEC for denying cryptocurrency-related exchange traded products, stating that “[T]he regulatory process can be a formidable roadblock to the development of new products that could provide investors with more diversity and protection in their investment portfolios.” Ms. Peirce believes the SEC should be less concerned with the volatility and risk associated with a cryptocurrency investment, which involves an investor’s personal decision as long as they have proper disclosure, and instead consider.

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

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SEC Strategic Plan

Posted by Securities Attorney Laura Anthony | September 18, 2018 Tags: SEC, SEC Strategic Plan, Strategic Plan

On June 19, 2018, the SEC published a draft Strategic Plan and requested public comment on the Plan. The Strategic Plan would guide the SEC’s priorities through fiscal year 2022. The Plan reiterates the theme of serving the interests of Main Street investors, but also recognizes the changing technological world with a priority of becoming more innovative, responsive and resilient to market developments and trends. The Plan also broadly focuses on improving SEC staff’s performance using data and analytics.

The Strategic Plan begins with a broad overview about the SEC itself, a topic I go back to and reiterate on occasion, such as HERE. The SEC’s mission has remained unchanged over the years, including to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. In addition, according to the Strategic Plan, the SEC:

Engages and interacts with the investing public directly on a daily basis through a variety of channels, including investor roundtables and education programs and alerts on SEC.gov;
Oversees approximately $82 trillion in securities trading annually on U.S. equity markets;
Oversees approximately $40 trillion in the U.S. fixed-income market;
Selectively reviews the disclosures and financial statements of approximately 4,300 exchange-listed public companies with an aggregate market capitalization of $30 trillion;
Oversees the activities of over 26,000 registered market participants, including investment advisors, mutual funds, exchange-traded funds, broker-dealers, municipal advisors, and transfer agents, who employ at least 940,000 individuals in the United States;
Oversees 21 national securities exchanges, 10 credit-rating agencies, 7 active registered clearing agencies, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation (SIPC), and the Financial Accounting Standards Board (FASB); and
Provides critical market services through information technology systems, such as the more than 50 million pages of disclosure documents available on the EDGAR system.

The Strategic Plan describes three main goals: (i) focusing on the long-term interests of Main Street investors; (ii) recognizing significant developments and trends in evolving capital markets and adjusting efforts to ensure the effective allocation of resources; and (iii) elevate the SEC’s performance by enhancing analytical capabilities and human-capital development.

Long-term Interests of Main Street Investors

The American workforce is getting older and living longer. Moreover, many companies no longer manage retirement plans, instead leaving individuals to manage their own 401(k)’s and similar plans. The SEC is concerned that investors do not understand the difference between a stockbroker and an investment advisor or what the responsibilities are for investment advisor.

Furthermore, the SEC is concerned that fewer companies are going public, or are going public later, leaving fewer investment opportunities for Main Street investors. The slow IPO market has been a consistent theme with the SEC and market participants over the past year. See HERE, for example, a summary of Commissioner Piwowar’s speech and HERE for this summary of a U.S. Department of Treasury report.

The SEC identified five initiatives to further their first strategic goal.

Enhance the SEC’s understanding of how retail and institutional investors access capital markets.
Enhance the SEC’s outreach, education and consultation efforts, including taking into account the diversity of businesses and investors.
Pursue enforcement and examination proceedings focused on identifying and addressing misconduct that impacts retail investors. This effort includes uncovering new methods to administer scams and Ponzi schemes and the continued focus on penny stocks.
Modernize the delivery and content of disclosures so that investors can access readable, usable and timely information. The SEC will continue to examine business and accounting disclosures and make appropriate changes and to upgrade the EDGAR system to make it more usable to retail investors.
Identify ways to increase the number and type of long-term, cost-effective investment options available to retain investors, including by increasing the number of IPO’s and public companies.

Developments and Trends in Capital Markets; Effective Allocation of Resources

Technology has fundamentally changed the way consumers interact with the securities markets. Investors rely less on traditional personalized advisory services and instead are increasingly seeking advice and pursuing trades using data analytics and executed via algorithms on electronic platforms. This trend is expected to not only continue but to grow and expand with the advent of blockchain technology. Although these changes are beneficial, there are also increased risks, especially related to cybersecurity.

In addition, with the increase in technology there is a global marketplace that interconnects geographical areas and time zones on a 24-hour cycle. Information from one market impacts others, and capital flows across markets, both geographically and in asset type, in amounts that would have been unimaginable only a few decades ago. These changes add challenges to the SEC, especially related to global market participants that may be outside the jurisdiction of the SEC’s authority. The Strategic Plan specifically refers to the recent advent of ICO’s and those that plan offerings to avoid the US federal securities laws. The SEC will need to increase its coordination with other US regulatory bodies and with foreign regulators.

The SEC identified four initiatives to further their second strategic goal of recognizing significant developments and trends in evolving capital markets and adjusting their efforts to ensure the effective allocation of resources:

Expand market knowledge and oversight capabilities to identify, understand, analyze and respond effectively to market developments, including related to market operations, clearing and settlement, and electronic trading.
Identify and correct existing SEC rules and approaches that are outdated, including by monitoring new rules which may not be functioning as intended.
Examine cyber and infrastructure strategies related to risks faced by capital markets and market participants. In addition to focusing on its own direct risks, the SEC must also ensure that market participates are effectively managing their cybersecurity risks.
Promote SEC preparedness and emergency response capabilities, including through training and testing.

Enhance Analytical Capabilities and Human Capital Development

The SEC’s success, as with all agencies and companies, depends on using resources wisely. The SEC has a goal of improving its own workforce and finding ways to utilize data and technology to improve productivity and efficiency.

The SEC has identified five initiatives to further this third strategic goal:

Focus on the SEC’s workforce to increase capabilities and promote diversity and equality.
Expand the use of risk and data analytics, including through developing a data management program that is available on an SEC-wide basis but that provides privacy protections for sensitive information.
Enhance analytics of market and industry data to prevent, detect and prosecute improper behavior.
Enhance the SEC’s internal control and risk management capabilities related to cybersecurity.
Promote collaboration among SEC offices.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

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

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« FINRA Examines Fintech Including Blockchain Security or Utility Token? A Case Study – Part I »

SEC Adopts Inline XBRL

Posted by Securities Attorney Laura Anthony | August 21, 2018 Tags: Inline XBRL, SEC, SEC Adopts Inline XBRL, XBRL

On June 28, 2018, the SEC adopted amendments to the XBRL requirements to require the use of Inline XBRL for financial statement information and fund risk/return summaries. Inline XBRL involves embedding XBRL data directly into the filing so that the disclosure document is both human-readable and machine-readable. Accordingly, no separate XBRL filings are required. The amendments also eliminate the requirement for companies to post XBRL data on their websites.

In 2009 the SEC adopted rules requiring companies to provide the information from the financial statements accompanying their registration statements and periodic and current reports in machine-readable format using XBRL by submitting it to the SEC as exhibits to their filings and posting it on their websites, if any. Since that time, however, many industry participants have expressed concerns regarding the quality of, extent of use of, and cost to create XBRL data. In fact, the SEC itself has discovered quality issues with the data in XBRL. As with all regulatory requirements, XBRL has its proponents and supporters as well.

Pressure from both the naysayers and proponents, as well as the clear inefficiency of duplicative postings, drove the current amendments.

The requirement for companies and funds to post XBRL data on their websites will be eliminated upon the effective date of the amendments. The Inline XBRL requirements will become effective on a phased schedule as follows:

Large accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2019.
Accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2020.
All other filers will be required to comply beginning with fiscal periods ending on or after June 15, 2021.
Filers will be required to comply beginning with their first Form 10-Q filed for a fiscal period ending on or after the applicable compliance date.

In its press release announcing the amendments, the SEC cited the following potential benefits:

Is expected to reduce, over time, XBRL preparation time and effort by eliminating duplication and facilitating the review of XBRL data.
Gives the preparer full control over the presentation of XBRL disclosures within the HTML filing.
Is expected to reduce the likelihood of inconsistencies between HTML and XBRL filings and improve the quality of XBRL data.
Enhances the usability of structured disclosures for investors through greater accessibility and transparency of the data and enhanced capabilities for data users, who would no longer have to view the XBRL data separately from the text of the documents.

Statement of Commissioner Hester M. Peirce

Commissioner Hester Peirce dissented from the amendments and made a statement related to her dissenting position. Although Ms. Peirce supports a shift to Inline XBRL in general and supports the elimination of website-posting requirements, she doesn’t in general support the use of Inline XBRL for smaller public companies or funds due to the costs associated with switching to this technology.

Commissioner Peirce, who is consistently pro-business and very thoughtful in her role as a regulator, states:

As regulators, we have broad authority—authority we do not hesitate to use—to reach into the day-to-day operations of the companies we oversee. Our rules can radically change the way companies conduct their business, organize their workflow, and allocate resources. Today’s rule will require the adoption of very specific technology to be used in a very specific way on an ambitious timeline. When we issue such a mandate, it has wide-ranging effects on the industry, including knock-on effects on vendors, investors, and others who interact with the relevant filers. By mandating the use of inline XBRL, we are privileging one form of technology over present and potential future competitors. When we take this step, therefore, we must be very certain that we are choosing the right technology at the right time for the right purpose in the right set of companies.

She notes that companies have been able to voluntarily use Inline XBRL under a pilot program, but the uptake on that use has been minimal, with only 1.8% of all eligible filers using the technology and most of those being accelerated or large accelerated filers. She further points out that the benefit of XBRL at all for smaller companies is questionable, with few investors utilizing its technology, adding, “[B]efore requiring small filers to invest considerable resources in implementing inline XBRL, we should be sure that the data is actually useful to their investors.”

The costs and burdens on funds will be even greater, with investors bearing the cost burden without real benefit. In fact, Ms. Peirce suggests that the users of fund XBRL risk/return data are primarily data aggregators who sell the information.

The Author

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SEC Amends Definition of “A Smaller Reporting Company”

Posted by Securities Attorney Laura Anthony | July 17, 2018 Tags: SEC, Smaller Reporting Company

On June 28, 2018, the SEC adopted the much-anticipated amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. The amendments come almost two years to the day since the initial publication of proposed rule changes (see HERE).

Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.

As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.

The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton as directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

Background

The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) have come to the forefront over the past couple of years. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Over the years Regulation S-K has not been kept current with other Rule changes, the arduous reporting requirements for smaller companies has resulted in stifled capital formation and fewer smaller IPOs, and investors have questioned the quality and relevancy of information required to be included in reports.

The SEC disclosure requirements are scaled based on company size. The SEC established the smaller reporting company category in 2007 to provide general regulatory relief to these entities. Prior to this rule change, a “smaller reporting company” was defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K, as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

The following table, copied from the SEC rule release, summarizes the scaled disclosure accommodations available to smaller reporting companies:

Regulation S-K
Item	Scaled Disclosure Accommodation
101 − Description of Business	May satisfy disclosure obligations by describing the development of its business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non- smaller reporting companies.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters	Stock performance graph not required.
301 – Selected Financial Data	Not required.
302 – Supplementary Financial Information	Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)	Two-year MD&A comparison rather than three-year comparison. Two year discussion of impact of inflation and changes in prices rather than three years. Tabular disclosure of contractual obligations not required.
305 – Quantitative and Qualitative Disclosures About Market Risk	Not required.
402 – Executive Compensation	Three named executive officers rather than five. Two years of summary compensation table information rather than three. Not required: · Compensation discussion and analysis. · Grants of plan-based awards table. · Option exercises and stock vested table. · Pension benefits table. · Nonqualified deferred compensation table. · Disclosure of compensation policies and practices related to risk management. · Pay ratio disclosure.
Regulation S-K
Item	Scaled Disclosure Accommodation
404 – Transactions With Related Persons, Promoters and Certain Control Persons16	Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance	Audit committee financial expert disclosure not required in first year. Compensation committee interlocks and insider participation disclosure not required. Compensation committee report not required.
503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges	No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits	Statements regarding computation of ratios not required.
Regulation S-X
Rule	Scaled Disclosure
8-02 – Annual Financial Statements	Two years of income statements rather than three years. Two years of cash flow statements rather than three years. Two years of changes in stockholders’ equity statements rather than three years.
8-03 – Interim Financial Statements	Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired	Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information	Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired	Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements	Less stringent age of financial statements requirements.

Final Amendments to Smaller Reporting Company Definition

The SEC has competing goals of protecting investors and the marketplace through requiring companies to provide disclosure needed to make informed investment and voting decisions and promoting capital formation and reducing compliance costs for smaller companies. The SEC believes that by raising the financial thresholds for the smaller reporting company definition and thereby expanding the number of companies eligible to use the available scaled disclosure, it will be satisfying its goals and appropriately responding to comments and recommendations by the Advisory Committee on Small and Emerging Growth Companies, the SEC Government Business Forum on Small Business Capital Formation, Congress and industry commenters.

The SEC summarizes many of these recommendations, initiatives and comments in its rule release. For example, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For a summary of the recommendations, see my blog HERE. The FAST Act, which was passed into law on December 4, 2015, required the SEC to scale or eliminate duplicative, antiquated or unnecessary disclosure requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K.

The SEC considered comments it received to the initial proposed rule release (see HERE) and comments it received in response to the published concept release and request for public comment on Regulation S-K. My two-part blog on that concept release can be read HERE and HERE. As indicated above, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

My blog HERE contains a summary of the scaled disclosures available to smaller reporting companies. In addition, the FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies. A smaller reporting company may now incorporate any documents filed by the company, following the effective date of a registration statement, into such effective registration statement. In what was probably unintended in the drafting, the FAST Act changes only include smaller reporting companies and not emerging growth companies or non-accelerated filers. Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference. Accordingly, among the other benefits of the current proposed rule change, the number of companies that can utilize forward incorporation by reference in a Form S-1 will increase.

Amendments to Accelerated Filer and Large Accelerated Filer Definitions

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton has directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

The public float threshold for an accelerated filer is $75 million. Companies that currently file as an accelerated filer would continue to do so under the new rules, but would be able to benefit from the scaled disclosure requirements available to smaller reporting companies. The filing deadlines for each category of filer are:

Filer Category	Form 10-K	Form 10-Q
Large Accelerated Filer	60 days after fiscal year-end	40 days after quarter-end
Accelerated Filer	75 days after fiscal year-end	40 days after quarter-end
Non-accelerated Filer	90 days after fiscal year-end	45 days after quarter-end
Smaller Reporting Company	90 days after fiscal year-end	45 days after quarter-end

Statements of Commissioners on Rule Amendment

Commissioners Hester Peirce and Michael Piwowar made public statements regarding the rule change both supporting the amendment but expressing disappointment that it did not also include a change in the definition of an accelerated filer. Both commissioners think it is not enough to reduce regulatory burdens to encourage more companies to go public. Section 404(b) of the Sarbanes-Oxley Act is one of the largest burdens that face smaller public companies and Commissioner Piwowar believes that until that is changed, there will be no improvement in efforts to raise capital by smaller companies. Ms. Peirce goes further, stating that the failure to make a conforming change to the definition of an accelerated filer will actually be confusing to companies. That is, prior to the rule change, a smaller reporting company was always exempted from Section 404(b) compliance; however, now that will not be the case.

Ms. Peirce points to a poignant example from the comment letters. A group of biotech companies rightfully stated that money spent on compliance is less money spent on research and development and that investors in a smaller biotech company are more interested in getting FDA approval than the auditors’ blessing on internal controls.

On the upside, Chair Clayton has committed to continue to review this matter and work on changes to the definition of accelerated filer and/or changes to the requirements of 404(b) compliance.

The Author

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The SEC Has Provided Guidance On Ether and Bitcoin, Sort Of

Posted by Securities Attorney Laura Anthony | June 19, 2018 Tags: Bitcoin, Ether, SEC, Sort Of, The SEC Has Provided Guidance On Ether and Bitcoin

On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he made two huge revelations for the crypto marketplace. The first is that he believes a cryptocurrency issued in a securities offering could later be purchased and sold in transactions not subject to the securities laws. The second is that Ether and Bitcoin are not currently securities. Also, for the first time, Hinman gives the marketplace guidance on how to structure a token or coin such that it might not be a security.

While this gives the marketplace much-needed guidance on the topic, a speech by an executive with the SEC has no legal force. As a result, the blogs and press responding to Mr. Hinman’s speech have been mixed. Personally, I think it is a significant advancement in the regulatory uncertainty surrounding the crypto space and a signal that more constructive guidance will soon follow. I will summarize the entire speech later in this blog, but first right to the most salient point.

Although a speech by an SEC official does not have legal weight, it does give practitioners a firm foot on which to proceed. William Hinman is the Director of the Division of Corporation Finance (“CorpFin”), whose responsibility includes reviewing and commenting on SEC filings, a topic I’ve written about before. As described in my recent blog on the subject (see HERE), when responding to SEC comments, a company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director.

Related to Bitcoin, Director Hinman stated, “…when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.” Similarly, related to Ether, Mr. Hinman stated, “…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

As a direct result of these statements, at least 2 of our clients, with our support, have shifted how they will proceed with Regulation A offerings in which tokens are being offered, and Bitcoin and Ether expected to be accepted as a form of payment. Prior to Mr. Hinman’s comments, CorpFin issued comments to our clients, which comment letters gave an indication of the progression of the SEC’s thinking. In particular, in an earlier letter the SEC comment was in relevant part as follows:

We note that you will accept Bitcoin, Ether, Litecoin or Bitcoin Cash as payment for your common stock. Please disclose the mechanics of the transaction. For example, explain the following:

whether the digital assets are securities and, where you have determined they are, how you will structure each individual transaction so that you are in compliance with the federal securities laws;
disclose how long the company would typically hold these digital assets, some of which may be securities, before converting to U.S. dollars;
include risk factor disclosure discussing the impact of holding such assets and/or accepting this form of payment, including price volatility and liquidity risks as well as risks related to the fragmentation, potential for manipulation, and general lack of regulation underlying these digital asset markets; and
disclose how you will hold the digital assets that you may receive in this offering as payment in exchange for shares of your common stock. If you intend to act as custodian of these digital assets, some of which may be securities, please tell us whether you intend to register as a custodian with state or federal regulators and the nature of the registration.

The comment letter included many other points on cybersecurity, price volatility, risk factors and other issues not related to whether the Bitcoin or Ether were a security. In a recent comment letter for a different client, also offering tokens in a Regulation A offering and accepting Bitcoin and Ether as payment, the SEC did not issue any questions as to whether Bitcoin or Ether were a security, but did include substantially the same questions related to cybersecurity, price volatility, risk factors and other business points.

The SEC CorpFin is pragmatic in its approach and despite frustrations at times, would not allow its Division Director to make public statements and then allow its staff to issue comments or take positions that were in direct contravention to those statements. Keep in mind that SEC no-action letters technically do not set precedence or have any legal bearing outside of the parties to the letter, but are regularly relied upon by the SEC and practitioners for guidance.

Although Mr. Hinman’s speech does not have legal authority, I am confident that the SEC will not raise the issue or question whether Bitcoin or Ether are a security in current and future registration statements or Regulation A offerings, at least until there is different legal authority than exists today.… And, there could be different legal authority in the future. I attended a Regulation A conference in New York in the beginning of June, and one of the panels was related to cyrptocurrencies. In addition to attorneys in the space, the panel included Anita Bandy, Assistant Director of the SEC Division of Enforcement. Referring to token or coin offerings, one of the panel members specifically stated that Ether is a security and Ms. Bandy did not correct him. Furthermore, at the end of the panel, I privately asked Ms. Bandy if it is her opinion that Ether is a security today. She politely refused to answer the question, letting me know that she couldn’t express an opinion on that without conferring with other SEC management. Two days later, Mr. Hinman gave his speech.

…. But, Mr. Hinman is Director of CorpFin and Ms. Bandy is part of the Division of Enforcement. Although I believe that the SEC divisions are communicating with each other on the very relevant and important subject of cryptocurrency, and have even issued joint statements on the subject, they are separate. Moreover, decoding Mr. Hinman’s statements further, he said, “… putting aside the fundraising that accompanied the creation of Ether…” This begs the question: What would happen if the SEC Division of Enforcement took action related to the initial fundraising and creation of Ether, and how would that impact the current status of Ether? My thought is that they are mutually exclusive. Ether is decentralized today and will continue its own course.

The SEC Division of Enforcement could take action similar to the Munchee, Inc. case where it settled the proceeding with no civil penalty. The SEC could also issue another report on Ether similar to the Section 21(a) Report on the DAO issued a year ago in July 2017, though I don’t know what new or different information it could add to that analysis. If Ether violated the federal securities laws at its issuance, it did so in the same way as the DAO, using the SEC v. W. J. Howey Co. test. Perhaps a new report could provide more guidance as to the analysis of when a crypto reaches a point where it is decentralized enough such that it no longer meets the parameters laid out in Howey, or that might be wishful thinking on my part.

Director Hinman’s Speech “Digital Asset Transactions: When Howey Met Gary (Plastic)”

Director Hinman opens his speech with the gating question of whether a digital asset that is offered and sold as a security can, over time, become something other than a security. He then continues that in cases where the digital asset gives the holder a financial interest in an enterprise, it would remain a security. However, in cases where the enterprise becomes decentralized or the digital asset can only be used to purchase goods or services available through a network, the purchase and sale of the digital asset would no longer have to comply with the securities laws.

Reiterating the oft-repeated view of the SEC, Hinman notes that most initial coin or token offerings are substantially similar to debt or equity offerings in that they are just another way to raise money for a business or enterprise. In particular, funds are raised with the expectation that the network or system will be built and investors will get a return on their investment. The investment is often made for the purpose of the return and not by individuals that would ever use the eventual utility of the token. The return is often through the resale of the tokens or coins in a secondary market on cryptocurrency trading platforms.

In this case, the Howey Test is easy to apply to the initial investment. The Howey Test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. The emphasis is not on the thing being sold but the manner in which it is sold and the expectation of a return. Certainly, the thing being sold is not a security on its face; it is simply computer code. But the way it is sold – as part of an investment, to non-users, by promoters to develop the enterprise – can be, and in that context most often is, a security. Furthermore, in the case of ICOs, which are high-risk by nature, the disclosure requirements of the federal securities laws are fulfilling their purpose.

The securities laws apply to both the issuance or initial sale, and the resale of securities. In the case of coins or tokens, a careful analysis must be completed to determine if the resale of the coin or token also involves the sale of a security and compliance with the securities laws. If the network on which the token or coin is to function is sufficiently decentralized such that purchasers would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the assets may no longer represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful, such as with Ether and Bitcoin as discussed above.

An analysis as to whether an investment contract and therefore a security is being sold must be made based on facts and circumstances at any given time. Investment contracts can be made out of virtually any asset if it is packaged and promoted as such. Accordingly, although Bitcoin or Ether may not be a security on their own, if they were packaged as part of a fund or trust, they could be part of an investment contract that would need to comply with the federal securities laws.

Hinman provides some guidance in determining whether a particular sale involves the sale of an investment contract. The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment. Questions to consider include:

Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Hinman then, for the first time, gives some guidance to issuers and their counsel in determining whether a particular token or coin is being structured as a security. Hinman is clear that this list of factors is not comprehensive but rather lays the groundwork for a thoughtful analysis. Items to consider include:

Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
Is the asset marketed and distributed to potential users or the general public?
Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
Is the application fully functioning or in early stages of development?

In another step towards regulatory guidance, Hinman said the SEC is prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use. As recently as 3 months ago, the SEC had indicated it was not processing no-action letters on the subject at that time. In his speech, Hinman recognizes the implication of determining something is a security, including related to broker-dealer licensing, exchange registration, fund registration, investment advisor registration requirements, custody and valuation issues.

Hinman also expressed excitement about the potential surrounding digital ledger technology, including advancements in supply chain management, intellectual property rights licensing, and stock ownership transfers. He thinks the craze behind ICOs has passed, and I agree. In particular, as he states, realizing that securities laws apply to an ICO that funds development, industry participants have started to revert back to traditional debt or equity offerings and only selling a token once the network has been established, and then only to those that need the functionality of the network and not as an investment.

There have been earlier signs that the SEC is softening and rethinking its approach to cryptocurrencies as well. In a speech to the Medici Conference in Los Angeles on May 2, 2018, SEC Commissioner Hester M. Peirce warned against regulators stifling the innovation of blockchain by trying to label token and coins as securities and even when they are securities, being myopic on the need to fit within existing securities laws and regulations. Like Director Hinman, Commissioner Peirce encourages communication between market participants and the SEC as everyone tries to navigate the marketplace and technology.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

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

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty, and need for even further guidance in this space, see HERE.

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

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

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

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

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

Remarks by Chairman Jay Clayton

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

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

Remarks by Commissioner Michael Piwowar

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

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

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

Remarks by Commissioner Kara Stein

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

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The New Auditor Report

Posted by Securities Attorney Laura Anthony | February 13, 2018 Tags: CAM, CAM Requirements, CAMs, PCAOB, SEC, The Auditor’s Report, The New Audit Report Rules, The New Auditor Report

In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. Among other additions, an audit report will need to include critical audit matters (CAMs) and disclosure the tenure of the auditor. The new rule and requirements related to audit reports are significant as the audit report is the document in which the auditor itself communicates to the public and investors.

The new standard will require auditors to describe CAMs that are communicated to a company’s audit committee. Critical audit matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.

The new audit report standard also adds information related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks.

The process in finalizing the rule has been lengthy, having begun in 2010 in response to investor- and public-initiated comments. Once proposed, the rule went through three rounds of public solicitation for comment. Of particular concern is whether the new requirements will result in increased nuisance shareholder litigation, costing the company and its investors, and whether it will result in a chill on auditor-company communications. In a statement related to the new auditor report, SEC Chairman Jay Clayton expressly addressed this concern, stating:

“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”

As an aside, as with any rule making, SEC rules and regulations can and do result in unintended consequences. This is an issue I’ve raised many times over the years in my blogs, including, for example, the multitude of differences between requirements for smaller reporting companies and emerging growth companies, a topic the SEC is now working on addressing and rectifying. It is great to see Chair Clayton discuss this phenomenon directly and for the rule itself to take measures to monitor and initiate changes based on implementation analysis.

There are certain carve-outs from some of the rule requirements, including the CAM requirements. In particular, the CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans; however, they do specifically apply to smaller reporting companies. Moreover, the rule requires extensive post-implementation review, in light of the potential for negative unintended consequences, and such review could result in changes to the rule itself and its implementation schedule.

The New Audit Report Rules

The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.

The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. A CAM is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”

For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.

The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.

Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed. The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.

The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.

In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.

All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.

The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.

The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.

Effective Dates

All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.

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