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SEC Continues Efforts To Prevent Microcap Fraud

Posted by Securities Attorney Laura Anthony | August 16, 2016 Tags: Finra, Micro-Cap Fraud, Microcap Fraud, SEC

As I’ve written about numerous times in the past, a primary agenda of the SEC and FINRA is to prevent small- and micro-cap fraud. On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC complaint, as well as numerous industry articles and a blog by Mr. Gentile himself, reveal in-depth efforts by the SEC together with FINRA and the FBI and DOJ to remove recidivist and bad actors from the micro-cap system. While the methods used by the regulators have been the subject of heated debates and articles, the message and result remain that the SEC is committed to its efforts to deter securities law violations.

Although small- and micro-cap fraud has always been an important area of concern and enforcement by the SEC since the financial crisis of 2008, it has increasingly been a focus. Regulators have amplified their efforts through regulations and stronger enforcement, including the SEC Broken Windows policy, increased Dodd-Frank whistleblower activity and reward payments, CEO and CFO liability for SEC reports under the Sarbanes-Oxley Act and increased bad actor prohibitions. See my blog HERE related to the SEC Broken Windows policy and CEO/CFO liability (as an aside, I note that the proposed Stronger Enforcement of Civil Penalties Act never made it past its introduction in July 2015) and HERE related to Rule 506 and Regulation A bad actor prohibitions.

The fight against small- and micro-cap fraud is an industry positive overall. While not a regulator, OTC Markets itself has taken great strides in improving the quality of and information available related to OTC Markets-traded companies, including through qualitative and quantitative standards for quotation on both the OTCQB (see my blog HERE) and OTCQX (see my blog HERE).

The Guy Gentile Case

On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC litigation release alleges that Gentile, who owned and operated Sure Trader, a registered broker-dealer, engaged in manipulative trading, provided illegal kickbacks, illegally issued unregistered stock and distributed promotional mailings of glossy newsletters using fake publication names to pump the stocks of at least two penny stocks (KYUS and RVNG). The SEC continues that Gentile misled investors with positive but fake price and volume trends while concealing the control persons’ identities and compensation. Apparently, Gentile, together with attorney Adam Gottbetter and a few stock promoters, controlled large blocks of the companies’ stock, which control was not disclosed in company filings or the promotional activities.

The SEC complaint, filed in March 2016, details Gentile’s actions involving KYUS and RVNG, which actions occurred in 2007 and 2008. As alleged by the SEC, the entire history of RVNG and KYUS was a fraud, from its creation using a sham registration (see my blog HERE for more on this) to its issuances of freely tradable securities to insiders, manipulative trades and promotional activities.

The SEC complaint does not address the fact that a period of 8-9 years went by between the illegal activities and the filing of the complaint. Guy Gentile has written a detailed blog explaining his version of events, or more precisely, what happened in the missing years. In particular, Gentile claims that he was arrested in 2012 and that from that time until the complaint against him in March 2016, he acted as a cooperating witness and SEC and FBI informant, assisting in the indictment of over a dozen individuals related to hundreds of millions of dollars in pump-and-dump and other illegal activities and resulting in over $12 million in fines and disgorgements with the potential of tens of millions more to come.

Gentile details his involvement in elaborate, and sometimes dangerous, undercover operations. The complaint, together with Gentile’s blog and numerous industry articles on the events, reads like a movie. It is undisputed that Gentile’s brokerage firm, Sure Trader, which was based in the Bahamas, remained in business and continued to market to U.S.-based retail customers after Gentile’s arrest in 2012 and through at least July 2015. It appears that the entire firm was wired up and all happenings were being recorded by the FBI.

Guy Gentile’s biggest defense is the statute of limitations, which is five years. However, apparently he signed a waiver of the statute of limitations while acting as an informant.

The prevention of fraud has been on the SEC agenda since the commission was founded in 1933, with efforts intensifying as the sophistication of the marketplace has grown. On November 17, 2009, President Obama established, by executive order, an Interagency Financial Fraud Enforcement Task Force to strengthen efforts to combat financial crime. To start, the Department of Justice led the task force and the Department of Treasury, HUD and the SEC served on the steering committee. The task force’s leadership, along with representatives from federal agencies and regulatory authorities, continue to work with state and local partners to investigate and prosecute significant financial crimes, address discrimination in the lending and financial markets, and recover proceeds for victims.

Putting aside the entertainment value of the entire case, it does fully illustrate the commitment by regulators to attack small- and micro-cap fraud. Clearly, the more of these egregious activities that are uncovered and prosecuted, the more success legitimate small businesses will have raising capital, growing, and supporting the U.S. economy including through job creation.

Conclusion

It is undisputed that emerging companies play a critical role in the U.S. economy, supporting growth, innovation and job creation. The JOBS Act made dramatic changes to the landscape for the marketing and selling of both private and public securities. These significant changes include: (i) the creation of Rule 506(c), which came into effect on September 23, 2013, and allows for general solicitation and advertising in private offerings where the purchasers are limited to accredited investors; (ii) the overhaul of Regulation A creating two tiers of offerings, which came into effect on June 19, 2015, and allows for both pre-filing and post-filing marketing of an offering, called “testing the waters”; (iii) the addition of Section 5(d) of the Securities Act, which came into effect in April 2012, permitting emerging-growth companies to test the waters by engaging in pre- and post-filing communications with qualified institutional buyers or institutions that are accredited investors; and (iv) Title III crowdfunding, which came into effect on May 19, 2016, and allows for the use of Internet-based marketing and sales of securities offerings.

Furthermore, the OTC Markets has proven itself as a small-cap venture exchange, supporting the secondary trading of small and emerging growth companies and providing a respected trading platform for companies prior to moving on to an exchange such as NASDAQ or the NYSE MKT.

The other side of these initiatives is the real concern of fraud. I’m not expressing an opinion on the methods used by the regulators in this case, but I do support the efforts. I also believe in the basic principle that it is better for the industry that investors believe egregious fraudulent activities will be prosecuted.

This firm does not participate in SEC enforcement proceedings or related litigation matters; however, as with any good securities attorney, we keep our clients informed of the law so that they can avoid participation in these proceedings.

The Author

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

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

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« SEC Issues Proposed Regulation S-K and S-X Amendments Smaller Reporting Companies vs. Emerging Growth Companies »

SEC Issues Proposed Regulation S-K and S-X Amendments

Posted by Securities Attorney Laura Anthony | August 9, 2016 Tags: Regulation S-K, Regulation S-K Amendments, Regulation S-X, Regulation S-X Amendments, S-K Amendments, S-X Amendments, SEC

On July 13, 2016, the SEC issued a 318-page proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). The proposed rule changes follow the 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

The proposed S-K and S-X Amendments are intended to facilitate the disclosure of information to investors while simplifying compliance efforts by companies. The proposed S-K and S-X Amendments come as a result of the Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72002 of the FAST Act. Prior to the issuance of these S-K and S-X Amendments, on June 27, 2016, as part of the same initiative, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The S-K and S-X Amendments also seek comment on certain disclosure requirements that overlap with U.S. GAAP and possible recommendations to FASB, the regulatory body that drafts and implements GAAP, for conforming changes.

Background

The topic of disclosure requirements under Regulations S-K and S-X as pertains to financial statements and disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has 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. Regulation S-X contains specific financial statement preparation and disclosure requirements.

In addition to affecting companies filing registration statements (including on Form 1-A in a Regulation A/A+ offering) and those filing reports with the SEC, the proposed S-K Amendments will affect acquired entities, acquirees, investment advisers, investment companies, broker-dealers and nationally recognized statistical rating organizations.

The underlying basis of the disclosures required by Regulations S-K and S-X is to keep shareholders and the markets informed on a regular basis in a transparent manner. Reports and registration statements filed with the SEC can be viewed by the public on the SEC EDGAR website. A reporting company also has record-keeping requirements, must implement internal accounting controls and is subject to the Sarbanes-Oxley Act of 2002, including the CEO/CFO certification requirements. Under the CEO/CFO certification requirement, the CEO and CFO must personally certify the content of the reports filed with the SEC and the procedures established by the issuer to report disclosures and prepare financial statements. For more information on that topic, see my blog HERE.

The proposed S-K and S-X Amendments cover:

Duplicative requirements, including duplications between financial footnote requirements and disclosures in the body of a registration statement or report;

Overlapping requirements which may not be completely duplicative. The S-K Amendments consider whether to delete certain disclosure requirements that are covered in GAAP or other financial reporting or integrate such disclosures into a single rule source;

Outdated requirements which have become obsolete due to the passage of time or changes regulations, business or technology; and

Superseded requirements which are inconsistent with recent legislation or updated rules and regulations.

Redundant or Duplicative Reporting Requirements

The proposed S-K and S-X Amendments seek to eliminate a laundry list of 26 redundant and duplicative disclosures. Most of these proposed changes are technical and nuanced related to particular Regulation S-X GAAP and other financial statement disclosures—for example, foreign currency; financial statement consolidation, income tax disclosures, contingencies and interim accounting adjustments. As the proposed rule eliminations are duplicative, they will not change the financial reporting or disclosure requirements.

Overlapping Requirements

Similar to redundant and duplicative disclosures, the SEC has identified numerous disclosure requirements that are related to, but not exactly the same as, GAAP, IFRS and other SEC disclosure obligations. The Regulation S-K and S-X Amendments propose to delete, scale back or integrate the overlapping disclosures to eliminate the overlap.

The SEC category of overlapping disclosures, and related Regulation S-K and S-X Amendments, have added broad considerations for which the SEC is seeking public comment. In particular, some of the proposed changes would result in the relocation of disclosures in the filings. This raises considerations related to the prominence of information in a particular report and moving information from outside to inside financial statements.

When information is in a different location in a report, it may receive more or less attention and be thought of as more or less prominent. Moreover, information inside of financial statements is subjected to audit and interim review, internal control over financial reporting and XBRL tagging. In addition, information inside of financial statements is not subject to the safe harbor protections of the Private Securities Litigation Reform Act of 1995 related to forward-looking statements.

A complete detail of all the proposed Regulation S-K and S-X Amendment changes related to overlapping disclosures is beyond the scope of this blog; however, a few items deserve discussion.

In general, many of the changes proposed by the SEC relate to interim financial reporting. In some cases where items are fully required to be reported in a Form 8-K, annual report or management discussion and analysis (MD&A), the SEC proposes eliminating the same or similar requirement from interim financial statements.

For example, the SEC proposes eliminating significant business combination pro forma financial statement requirements from interim financial statements for smaller reporting companies and Regulation A filers. The pro forma financial statements are already sufficiently required by Item 9.01 of Form 8-K. Likewise, the SEC makes the same proposed elimination of financial reporting in interim reports for a significant business disposition or discontinued operation.

As another example, currently Regulation S-X requires disclosure of certain subsequent events in the footnotes to interim financial statements and Item 303 of Regulation S-K related to management discussion and analysis (MD&A) requires substantially the same disclosure. The SEC proposes to delete the Regulation S-X requirement and only require disclosure of these subsequent events in the MD&A. Likewise, the SEC proposes eliminating segment financial information from the footnotes and leaving it only in MD&A.

In other cases, the SEC supports elimination of a disclosure in the body of a document in favor of a financial statement disclosure. For example, the SEC proposes eliminating a discussion of warrants, rights and convertible instruments from the body of a Form 10 or S-1, noting that a complete disclosure including dilution is required in financial statements.

Outdated Requirements

The SEC has identified disclosure requirement that have become obsolete as a result of time, regulatory, business or technological changes. The Regulation S-K and S-X Amendments propose to amend and sometimes add, but not delete, disclosure as a result of outdated requirements.

Again, most of the outdated requirements are technical (for example, income tax disclosures) in nature and beyond the scope of this blog. Some are common sense; for example, a reference to information being available in the SEC public reference room would be amended to include only a reference to the SEC Internet address for EDGAR filings.

Another common-sense change is the proposal to eliminate the requirement to post the high and low bid or trading prices for each quarter for the prior two fiscal years in an annual 10-K. The SEC reasons that the daily market and trading prices of a security are readily available on a number of websites. Moreover, these websites allow for the download and collation of trading prices over periods of time and provide much more robust information than currently contained in a 10-K.

Superseded Requirements

The constant change in accounting and disclosure requirements and regulations have created inconsistencies in Regulation S-K and S-X. The SEC has gone through and proposed amendments to eliminate such inconsistencies. For example, certain provisions in Regulation S-X still refer to development-stage companies, a concept that was eliminated by FASB in June 2014.

The SEC also took this opportunity to clean up some nonexistent or incorrect references that resulted from regulatory changes over time.

Further Background

Prior to the S-K Concept Release and current Regulation S-K and S-X proposed amendments, 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 more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

The Author

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

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

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« SEC Advisory Committee On Small And Emerging Companies Issues Further Recommendations On Accredited Investor Definition SEC Continues Efforts To Prevent Microcap Fraud »

OTC Markets Petitions The SEC To Expand Regulation A To Include SEC Reporting Companies

Posted by Securities Attorney Laura Anthony | June 28, 2016 Tags: OTC Markets, OTC Markets Listing Requirements, OTCQB, OTCQX, Regulation A, Regulation a SEC, SEC, SEC Regulation A, SEC Reporting Companies

On June 6, OTC Markets filed a petition for rulemaking with the SEC requesting that the SEC amend Regulation A to expand the eligibility criteria to include all small issuers, including those that are subject to the Securities Exchange Act of 1934 (“Exchange Act”) reporting requirements and to allow “at-the-market offerings.”

Background

On March 25, 2015, the SEC released final rules amending Regulation A. The new Regulation A creates two tiers of offerings. Tier I of Regulation A, which does not preempt state law, allows offerings of up to $20 million in a twelve-month period. Due to difficult blue sky compliance, Tier 1 is rarely used. Tier 2, which does preempt state law, allows a raise of up to $50 million. Issuers may elect to proceed under either Tier I or Tier 2 for offerings up to $20 million. The new rules went into effect on June 19, 2015 and have been gaining traction ever since. Since that time, the SEC Division of Corporation Finance has issued periodic Compliance and Disclosure Interpretations (C&DI) to provide guidance related to Regulation A. I have previously written several articles on Regulation A and the C&DI. For a good review and summary, please see my blog HERE.

From inception, a Regulation A company could apply for a listing on the OTC Markets OTCQX Tier assuming it meets the qualifications. Elio Motors trades on the OTCQX. For a review of such qualifications, see my blog HERE. Unlike the OTCQX, generally a company that is not subject to the Exchange Act reporting requirements did not qualify for the OTCQB; however, effective July 10, the OTCQB has amended their rules to allow a Tier 2 reporting entity to qualify to apply for and trade on the OTCQB. My blog on the OTCQB rules related to Regulation A can be read HERE.

Whether trading on the OTCQX or OTCQB, keep in mind that unless the issuer has filed a Form 8-A or Form 10, they will not be considered “subject to the Exchange Act reporting requirements” for purposes of benefiting from the shorter 6-month Rule 144 holding period. For a short overview of Rule 144, see HERE.

Regulation A Eligibility – Reporting Issuers

As enacted, Regulation A is available to companies organized and operating in the United States and Canada. The following issuers are not be eligible for a Regulation A+ offering:

Companies currently subject to the reporting requirements of the Exchange Act;
Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s;
Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents, or assets consisting of any amount of cash and cash equivalents and nominal other assets. Accordingly, a start-up business or minimally operating business may utilize Regulation A+;
Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;
Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years;
Issuers that became subject to Exchange Act reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and
Issuers that are disqualified under the “bad actor” rules and, in particular, Rule 262 of Regulation A+.

Although companies subject to the reporting requirement have been disqualified from day one, the SEC quickly issued guidance clarifying that Regulation A may be used by many existing “reporting entities” either because they voluntarily report (generally because they never filed a Form 8-A or Form 10 after an S-1 registration statement and the initial required reporting period has passed) or through a wholly owned subsidiary resulting in a complete or partial spin-off.

The SEC specifically provided that a company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A. The determination of eligibility is made at the time of the offering. Moreover, a company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to rely on Regulation A. In addition, a wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A+ offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued.

Related to small business issuers, the current rules create an unfair distinction. A company trading on the OTC Markets that voluntarily reports to the SEC would be eligible, whereas a company that may be substantially similar but is required to file reports would be ineligible to utilize Regulation A+.

On June 6, 2016, OTC Markets filed a petition for rulemaking with the SEC requesting that the SEC amend Regulation A+ to expand the eligibility criteria to include all small issuers, including those that are subject to the Exchange Act reporting requirements and to allow “at-the-market offerings.”

The OTC Markets petition is concise and to the point. When Congress passed the JOBS Act, it left the particulars of Regulation A+ rulemaking to the SEC with only the following mandates:

The aggregate offering amount of all securities sold within a 12-month period shall not exceed $50,000,000;
The securities may be offered and sold publicly;
The securities shall not be restricted securities within the meaning of the federal securities laws;
The civil liability provisions under Section 12(a)(2) of the Securities Act shall apply to any person offering or selling Regulation A securities;
The issuer may solicit interest in the offering prior to filing any offering statement, on such terms and condition as the SEC may prescribe in the public interest and protecting investors;
The SEC shall require the issuer to file annual audited financial statements; and
Such other terms and conditions as the SEC shall determine are necessary in the public interest and protecting investors.

The JOBS Act itself did not prohibit or limit the use of Regulation A+ for reporting companies, and accordingly, that decision is within the SEC rulemaking discretion. In fact, throughout the JOBS Act and in particular in Title IV related to Regulation A+, Congress refers to expanding capital formation for “small issues” under $50 million with the goal of increasing capital to all small companies.

The SEC reasoning for excluding reporting companies in the first place is weak at best. In particular, the SEC excluded reporting issuers because the prior Regulation A rules, which were admittedly rarely used and ineffective at assisting in small business capital formation, contained the exclusion. That is, when revamping Regulation A+ as mandated by the JOBS Act, the SEC just didn’t change that provision.

The OTC Markets points out that the Regulation A+ rules as enacted offer more protections for non-accredited investors than a fully registered S-1 or S-3 offering. In particular, there are no investor limitations for unaccredited purchasers in an S-1 or S-3 offering, whereas a Regulation A+ offering limits investments by unaccredited investors to no more than 10% of the greater of the investor’s annual income or net worth. In addition, a traditional S-1 or S-3 does not have any limitations or prohibitions related to bad actor disqualifications, whereas Regulation A+ does prohibit use by “bad actors.”

The OTC Markets petition also contains a good discussion on the costs associated with an S-1 or S-3 offering, including added costs of state blue sky law compliance. State blue sky preemption is one of the cornerstones of Tier 2 Regulation A+ offerings that benefit issuers. Moreover, generally only much larger issuers are S-3 eligible and thus S-3 is not considered a “small company” capital formation tool. Similarly, private offerings under Regulation D are not registered and so do not offer the same level of investor protections. These offerings also result in restricted securities and thus less investor incentive to participate.

In addition to the obvious benefit to small and emerging company capital formation of allowing small reporting companies to utilize Regulation A+, there is also an added potential benefit to the capital markets as a whole. OTC Markets opines that the flow of freely tradable securities into the marketplace for existing public companies could have a positive uptick on the liquidity and overall growth and vitality of venture markets. Regulation A+ could have the benefit of pushing forward the much needed venture market for the secondary trading of securities of early-stage, small and emerging growth companies. OTC Markets points out that it could and should be that venture market.

The OTC Markets petition contains a pointed discussion on the market benefits, including noting that “Regulation A+ allows smaller companies, traditionally lacking the backing of bulge bracket investment banks and the large base of institutional ownership needed to fund ongoing research coverage, to reach out to a broader pool of potential investors through ‘testing the waters’ provisions and the efficient economical reach of the Internet and social media. Emerging companies can use Regulation A+ online offerings to tap into large numbers of individual investors and efficiently target smaller institutions. Allowing fully SEC reporting companies the same ability to leverage technology and transparency to reach potential investors would be expected to provide a ready source of growth capital, and, equally important, an increase in liquidity in the secondary market.”

Interestingly, OTC argues that opening up Regulation A+ to small reporting companies may reduce or minimize the use of toxic financing options which carry substantial dilution and downward pricing pressure on company stock. Moreover, allowing small reporting companies to utilize Regulation A+ may raise the interest in these offerings for investment banks.

Finally, in order to make Regulation A+ the most useful for reporting companies, OTC Markets requests that the SEC also amend the rules to allow “at-the-market” offerings. Currently all Regulation A+ offerings must be priced. In the case of a security that is already trading, the ability to price accurately is difficult and the inability to adjust such pricing in response to fluctuating market conditions can impede the success of the offering.

Further Thoughts

From my perspective, Regulation A has become the most popular method of fundraising and private-to-public transactions for small business issuers. Although as of the date of this blog, only one issuer, Elio Motors, Inc., has received a trading symbol and actively trades, many others are in the works and I think we will see an opening of the floodgates. As Tier 2 requires audited financial statements, the preparation process can take months and the placement of an offering can also take months.

A traditional IPO is completed using an underwriter on a “firm commitment” basis where the underwriter buys all the company’s securities on the first day of the IPO and proceeds to resell them. No Regulation A offerings have yet been completed in a firm commitment underwritten offering. To the contrary, current Regulation A offerings are either self-placed by the issuing company, or completed with the assistance of a broker-dealer placement agent on a best efforts basis. This placement process can take several months to complete. Accordingly, many issuers have not closed out their offerings as of yet and therefore have not reached the point of eligibility to apply for a trade symbol. My office alone has over half a dozen Regulation A offerings in the works.

Tier 2 offerings in particular present a much-needed opportunity for smaller companies to go public without the added time and expense of state blue sky compliance but with added investor qualifications. Tier 2 offerings preempt state blue sky laws. To compromise with opponents to the state blue sky preemption, the SEC included investor qualifications for Tier 2 offerings. In particular, Tier 2 offerings have a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth. It is the obligation of the issuer to notify investors of these limitations. Issuers may rely on the investors’ representations as to accreditation and investment limits with no added verification.

Tier 2 issuers that have used the S-1 format for their Form 1-A filing will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. A Form 8-A is a simple registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC. Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. With the filing of a Form 8-A, the issuer can apply to trade on a national exchange.

This marks a huge change and opportunity for companies that wish to go public directly and raise less than $50 million. An initial or direct public offering on Form S-1 does not preempt state law. By choosing a Tier 2 Regulation A+ offering followed by a Form 8-A, the issuer can achieve the same result – i.e., become a fully reporting trading public company, without the added time and expense of complying with state blue sky laws. The other consideration would be the added investor qualifications, but if the issuer meets the requirements for and lists on a national exchange, the added investor qualifications no longer apply.

The SEC has a well published mission of “protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation.” Regulation A+ offers significant investor protections in that a form of registration statement is filed with the SEC and subject to a review and comment process. In addition, Regulation A+ allows for pre- and post-filing marketing using the Internet, social media, presentations and the like, provided all such materials are filed with the SEC and subject to review and comment. This process provides significant investor protections, including a permanent record of disclosures made during the offering process. Regulation A+ also provides a streamlined, affordable registration process with access to an expanded pool of investors, thus facilitating capital formation.

To the contrary, private offering documents are not filed or reviewed with the SEC and the process and level of disclosure are far less regulated. Public offerings using Form S-1 limit offering communications, and those communications are not necessarily filed or reviewed by the SEC. The Form S-1 process does not allow for broad Internet, crowd or social media marketing. A Form S-1 process also does not preempt state law and accordingly has significant added costs for a company. A Form S-1 works best for larger issuers with strong underwriter and institutional support. Regulation A+ provides the best method of registered capital formation for small companies, including those that are already subject to the SEC reporting requirements.

As was understood in passing the JOBS Act in 2012, the transparent Regulation A+ process is a preferred method of capital raising for small businesses, especially companies already subject to the reporting requirements who have audited financial statements readily available and processes in place for meeting SEC reporting and review requirements.

When the SEC issued the Regulation A+ rules on March 25, 2015, it issued a press release in which SEC Chair Mary Jo White was quoted as saying, “These new rules provide an effective, workable path to raising capital that also provides strong investor protections. It is important for the Commission to continue to look for ways that our rules can facilitate capital raising by smaller companies.” Allowing small reporting companies to partake in Regulation A+ meets all the mandates of the JOBS Act while concurrently satisfying the SEC goal of providing investor protections, and I am a strong advocate in support of a rule change in that regard.

The Author

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

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

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

Download our mobile app at iTunes.

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SEC Issues Concept Release On Regulation S-K; Part 2

Posted by Securities Attorney Laura Anthony | May 17, 2016 Tags: Form 8-K, MD&A, Regulation S-K, Regulation S-X, S-K Concept Release, SEC

On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). This blog is the second part discussing that concept release. In Part I, which can be read HERE, I discussed the background and general concepts for which the SEC provides discussion and seeks comment. In this Part II, I will discuss the rules and recommendations made by the SEC and, in particular, those related to the 100, 200, 300, 500 and 700 series of Regulation S-K.

Background

The fundamental tenet of the federal securities laws is defined by one word: disclosure. In fact, the SEC neither reviews nor opines on the merits of any company or transaction, but only upon the appropriate disclosure, including risks, made by that company. However, excessive rote immaterial disclosure can dilute the material important information regarding that particular company and have the unintended consequence of weakening necessary disclosure to potential investors and the public trading markets.

The SEC non-financial disclosure requirements for both registration statements and reports under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are found in Regulation S-K.

At the highest level, the purpose of disclosure is to provide investors and the marketplace with information needed to make informed investment and voting decisions. As discussed in the S-K Concept Release, proper disclosure “may lead to more accurate share prices, discourage fraud, heighten monitoring of the managers of companies, and increase liquidity.” Further, effective disclosure should “increase the integrity of securities markets, build investor confidence, and support the provision of capital to the market.”

The SEC seeks comment on hundreds of questions from broad conceptual points to specific rule changes. In many cases the SEC indicates that additional disclosure might be necessary on a particular topic. Although disclosure improvement is the goal, that does not necessarily mean less information and, in many cases, may actually mean more information.

Description of Business and Properties

The SEC believes that the information elicited under Item 101 regarding a description of the company’s business and Item 102 related to the company’s materially important physical properties, provides the necessary foundation needed by investors to make investing and voting decisions. This basic information assists in putting other disclosure items into context. The SEC seeks comment on whether Items 101 and 102 should be eliminated or modified and whether new or different disclosure requirements should be added to these Items.

The Concept Release contains detailed discussion of each of the requirements under Items 101 and 102, including prior comments received from the public and SEC views. Currently Item 101 requires a description of the general development of the company’s business over the past 3 years for smaller reporting companies and 5 years for other classes of company, or such shorter period as the company has been in business. Item 102 requires disclosure of the location and general character of plants, mines and other materially important physical properties.

Examples of information required include disclosure of the basic background of the business such as: (i) the year of formation; (ii) type of entity; (iii) nature and results of any bankruptcy, receivership or similar; (iv) nature and result of any material reclassification, merger or consolidation; (v) the acquisition or disposition of any material assets outside the ordinary course of business; and (vi) material changes to the business operations. In addition, Item 101 requires a narrative description of a company’s business, including 13 specific areas as follows: (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of business; (vi) working capital practices; (vii) dependence on certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) company sponsored research and development activities; (xii) compliance with environmental laws; and (xiii) number of employees.

Smaller reporting companies benefit from several other scaled disclosures from the standard requirements, including: (i) elimination of the requirement to discuss seasonality, working capital practices, backlog or government contracts; (ii) names of principal suppliers; (iii) royalty agreements or labor contracts; (iv) need for government approval for products or services; and (v) effects of existing or probable government regulations.

Emerging growth companies must meet all of the standard requirements. Moreover, keeping in line with the concept of materiality, where a smaller reporting company is in a business that makes any of the standard disclosures material to its business, it must include those discussions, even if not technically required. Accordingly, for example, a smaller reporting company in a cannabis-related industry would need to include a discussion on the need for government approval for products and services, and the effects of existing or probable government regulations on its business, even though the scaled disclosure requirements would not otherwise require such discussion.

As with other areas of discussion, the SEC requests comments on the scaled disclosure requirements and whether the current disparities between requirements related to smaller reporting companies and emerging growth companies should be eliminated.

The SEC discusses eliminating redundancies in the 101 and 102 disclosure requirements. In particular there are several categories in Form 8-K that request the same information elicited in Items 101 and 102 and included in all 10-Q’s and 10-K’s. Information on business background is included in the MD&A discussion and in footnotes to financial statements. Redundancies could be eliminated by allowing cross-referencing, including internal hyperlinks. Moreover, the SEC could, and should, distinguish between new registrants disclosing their business background for the first time, and those that are established reporting companies repeating information again and again.

Many of the detailed requirements may not be relevant in today’s business environment, which differs greatly from even twenty years ago. For instance, many businesses no longer have physical locations or corporate headquarters but rather run through virtual offices. For those businesses, providing a detailed discussion of each location (home office…) would not be relevant and rather could diminish the value of the business discussion. Likewise, businesses in today’s world often outsource or hire independent contractors. Consideration should be given to expanding the requirements to include such independent contractors, or eliminate this requirement altogether where it does not add value to the particular business. For example, it may be important to know that certain companies are scaling back on their workforce, while for others, the information is not relevant.

Likewise, Regulation S-K does not currently address the current reliance on web-based and intellectual property-based assets and as such, additional disclosure items may need to be included. Another area that may need increased disclosure relates to international business operations and reliance on non-U.S.-based assets.

Management Discussion and Analysis

Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis (“MD&A”) not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.

MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity for MD&A to use a principles/materiality approach and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.

In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. There has been a rise in recent controversy over the use of these non-GAAP numbers, an in-depth discussion of which will be the topic of a future blog.

However, the short version is that 90% of companies use non-GAAP numbers to explain their financial operations and the SEC is pushing back, making a review of the rules related to non-GAAP use a priority. There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves needs some adjustment.

Risk Factors

Risk-related disclosures need a thorough review and potential overhaul. Although the SEC has long stated that risk factors should not be boilerplate repetition of items applicable to the market as a whole and not necessarily applicable to a particular company, most companies use boilerplate language. I note that Item 503 contains examples of risks that a company can make related to its offerings, and so, of course, those risks, in boilerplate format, are always included in registration statements and reports.

Currently, risk-related disclosures are currently included in multiple items under Regulation S-K, including Item 503 related to investment risk and Item 305 related to market risk. The focus of the SEC discussion is on aggregating risk information in a more central readable format and improving the content to enhance investors’ ability to evaluate the particular risk factors.

Securities of the Company

Several Items in Regulation S-K address the securities of a company. For example, Item 202 requires a description of the terms and conditions of securities being registered; Item 201 requires disclosure of the number of holders of common securities; Item 701 requires disclosure of sales of unregistered securities and use of proceeds from offerings, and Item 703 requires disclosure of securities re-purchased by a company and its affiliates.

As with other areas, the SEC focuses on whether these disclosures should be modified, increased or eliminated and on the presentation of the information.

The Author

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

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

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

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Responding To SEC Comments

Posted by Securities Attorney Laura Anthony | March 29, 2016 Tags: OTC Attorney, OTC Attorneys, OTC Lawyer, OTC Lawyers, OTC Markets, OTC Securities, responding to sec comments, SEC, sec comment process

Background

The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and to enhance such disclosures as to each particular issuer. CorpFin will also be cognizant of the anti-fraud provisions of the federal securities laws and may refer a matter to the Division of Enforcement where material concerns arise over the adequacy and accuracy of reported information or other securities law violations, including violations of the Section 5 registration requirements. CorpFin has an Office of Enforcement Liason in that regard.

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

CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed. Forms 8-K reporting a change of auditor, a material acquisition, or a change in financial statements are almost always reviewed. Moreover, the Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

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

There are three basic levels of review. A review by CorpFin can be a “full review” in which CorpFin will review a filing from cover to cover, including both legal and accounting aspects and basic form for compliance with the federal securities laws. A partial review may include either legal or accounting, but generally a partial review is related to financial statements and related disclosures, including Management Discussion and Analysis of Financial Condition and Results of Operations, and is completed by CorpFin accounting staff. A review may also be a targeted review in which CorpFin will examine the filing for one or more specific items of disclosure. Moreover, although not a designated level of review, CorpFin sometimes “monitors” a filing, which is a term used for a light review.

Reviewers are appointed files based on industry sectors. CorpFin has broken down its reviewers into the following eleven broad industry sectors: healthcare and insurance; consumer products; information technologies and services; natural resources; transportation and leisure; manufacturing and construction; financial services; real estate and commodities; beverages, apparel and mining; electronics and machinery and telecommunications. Each industry office is staffed with an assistant director and approximately 25 to 35 professionals, primarily accountants and lawyers. Each filing has more than one reviewer with a frontline contact person and supervisor. A full review file will have an accounting and legal reviewer as well as a supervisor.

Neither the SEC nor the CorpFin evaluates the merits of any transaction or makes an assessment or determination as to whether a transaction or company is appropriate for any particular investor or the marketplace as a whole. The purpose of a review is to ensure compliance with the disclosure requirements of the securities laws. In that regard, CorpFin may ask for increased risk factors and clear disclosure related to the merits or lack thereof of a particular transaction, but they do not assess or comment upon those merits beyond the disclosure.

Comment Letters and Responses

Comment letters are based on a company’s filings and other public information about the company. For instance, CorpFin will review press releases and a company’s website, management communications and speeches, and conference presentations in addition to the company’s filings with the SEC. In comment letters, CorpFin may ask that a company provide additional supplemental information to the staff (such as backup materials to justify factual information such as reference to reports, statistics, market or industry size, etc.), revise disclosure in the document, provide additional disclosure in the reviewed filing or provide additional or different disclosure in future filings. Where a change is requested in future filings, intended disclosures may be provided in the comment letter response for SEC advance approval.

A company generally responds to the particular comment letter with a responsive letter that addresses each comment and where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure. CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses. The company should carefully consider its responses to comments that could open the door to additional review and comments. Comments related to accounting treatment and the flow-through to MD&A can be especially tricky and open the door to further review and changes.

Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, explain how the company is burdened and how the alternative provided by the company will provide adequate disclosure for investors. The argument that technical compliance is overly burdensome rarely succeeds with CorpFin, but at times a middle ground can be reached if the company is convincing enough in its analysis.

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

Although the basic process involves letters and responses, the CorpFin staff is available to discuss comments with a company and its legal, accounting and other advisors. The process can and often does involve such conversations. CorpFin will not give legal or accounting advice, but it will talk through comments and responses and discuss the analysis and adequacy related to disclosures. The initial comment letter received from CorpFin will have the reviewer’s direct contact information. The back-and-forth process does not require a formal protocol other than the required written response letter. That is, a company or its advisors may engage in conversations regarding comments, or request the staff to reconsider certain comments prior to putting pen to paper.

Moreover, CorpFin encourages this type of conversation, especially where the company or its advisors do not understand a particular comment. The staff would rather discuss it than have the company guess and proceed in the wrong direction. Where the staff suggests that a company should revise its disclosure or its financial statements, the company may, and should as appropriate, provide the staff with a written explanation of why it provided the disclosure it did. This explanation may resolve the comment without the need for the requested amendment. A CorpFin review is not an attack and should not be approached as such. My experience with CorpFin has always been pleasant and involves a type of collaboration to improve company disclosures.

A company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director. Matters of legal disclosure or application of GAAP accounting principles are not an exact science, and discussions are encouraged such that the end result is an enhanced disclosure by the company and consistent disclosures across different companies. The SEC provides all of these individuals contact information on its website and will willingly engage in productive conversations with a company.

When responding to comment letters and communicating with SEC staff, it is important that a person who understands the process, such as SEC counsel, take the lead in communication. Responses should be consistent, both related to a particular comment letter and over time. A company that flip-flops on accounting treatment or disclosures will lose credibility with the SEC and invoke further review and comments.

CorpFin is also willing to provide a reasonable amount of extra time to respond to comment letters when requested. Most comment letters request a response within 10 days. CorpFin is usually willing to give an extra 10 days but will balk at much longer than that without a very good reason by the company for the delay.

If the reviewed filing is a Securities Act registration statement, such as an S-1, the CorpFin staff will verbally inform the company that it has cleared comments and the company may request that the SEC declare the registration statement effective. Where the reviewed filing is an Exchange Act filing that does not need to be declared effective, CorpFin will provide the company with a letter stating that it has resolved all of its comments.

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

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

The company acknowledges that:

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

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

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

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

The company acknowledges the following:

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

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

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

A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting. The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included. As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports. As CorpFin is only reviewing information provided by, or publicly available related to, a company, the completion of a review is not a guarantee as to the accuracy or adequacy of the information in the filing and cannot be used as a defense to claims of fraud or misrepresentations.

Although a full discussion of confidential treatment and requests are beyond the scope of this blog, a company may seek confidential treatment of materials and responses to comments under Rule 83. Rule 83 requires the company to respond to comments with two separate letters – one containing the confidential information and the other not. Unlike confidential treatment requests under Rule 406 and 24b-2, a confidential treatment request for a comment response letter does not require that the company provide a justification for such confidential treatment. However, if a Freedom of Information Act (FOIA) request is submitted by a third party related to such comment letter response, the SEC will inform the company and request justification for continued confidential treatment. Confidential treatment under Rule 83 expires after 10 years unless a renewal is requested. Both Rule 83 and other confidential treatment rules require very specific transmittal procedures, and the documents must all clearly indicate that confidential treatment is requested. In a future blog I will discuss confidential treatment requests and SEC review policies.

Conclusion

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

For a review of basic public company disclosures, see my blog HERE. For more information regarding officer and director liability associated with signing SEC reports, see my blog HERE.

The Author

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

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

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

SEC Advisory Committee On Small And Emerging Companies Reviews Capital Formation

Posted by Securities Attorney Laura Anthony | March 22, 2016 Tags: private equity, private offerings, SEC, sec guidance

On February 25, 2016, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and listened to three presentations on access to capital and private offerings. The three presentations were by Jeffrey E. Sohl, Professor of Entrepreneurship and Decision Science Director, Center For Venture Research at University of New Hampshire; Brian Knight, Associate Director of Financial Policy, Center for Financial Markets at the Milken Institute; and Scott Bauguess, Deputy Director, Division of Economic and Risk Analysis at the SEC. The presentations expound upon the recent SEC study on unregistered offerings (see blog HERE).

The presentations were designed to provide information to the Advisory Committee as they continue to explore recommendations to the SEC on various capital formation topics. This blog summarizes the 3 presentations.

By way of reminder, the Committee was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

Presentation by Jeffrey E. Sohl, Professor of Entrepreneurship and Decision Science Director, Center For Venture Research at University of New Hampshire

As I’ve written about many times, all offers and sales of securities must be either registered under the Securities Act of 1933, as amended (“Securities Act”) or made in reliance on an available exemption from registration. The exemptions for private offerings are found in Sections 3 and 4 of the Securities Act. In particular, most private offerings are governed by Sections 4(a)(2), 3(b) and 3(a)(11) of the Securities Act. Rules 506(b) and 506(c) of Regulation D, Regulation S and 144A provide safe harbors under Section 4(a)(2). Section 3(b) provides the authority for Rules 504 and 505 of Regulation D. Section 3(a)(11) provides statutory authority for intrastate offerings. In addition Regulation Crowdfunding, expected to go effective in May 2016, will implement the much anticipated Title III crowdfunding as codified in the new Section 4(a)(6) (see HERE).

Crowdfunding generally is where an entity or individual raises funds by seeking contributions from a large number of people. Accordingly, any offering that allows solicitation of the crowd is viewed as a form of crowdfunding. Equity crowdfunding is currently accomplished through the use of: (i) Rule 506(c) offerings which allow for advertising and solicitation to a crowd as long as all sales are strictly limited to accredited investors, and such accredited status is reasonably verified by the issuer (see HERE); (ii) Intrastate offerings under Section 3(a)(11) and Rule 147 (see HERE); and (iii) Rule 504 state specific offerings (see HERE).

Mr. Sohl’s presentation concentrates on a statistical analysis of capital raising for pre-seed, seed/start-up, early-stage and later-stage enterprises. Pre-seed funds almost unilaterally come from founders, friends and family. Generally, no unaffiliated third-party source invests at this stage. Mr. Sohl’s presentation is in the form of a needs analysis illustrating the difficulties in accessing capital and the funding gaps for new businesses.

Third-party private equity can begin at the seed/start-up phase but grows with the level of maturity of the enterprise. Sohl begins with the premise that third-party private equity comes from three primary sources: crowdfunding, angels and venture capitalists, in that order, based on the maturity of the company. In other words, crowdfunding is likely to be involved in the seed/start-up phase followed by angels with venture funds stepping in at later series A and B rounds. According to Sohl, since 2013 equity crowdfunding has had a success rate of 19.6% with an average raise ask being $2,000,000 and an average actual raise being at $210,000. Of the funds raised, 21% have been convertible debt, 7% straight debt and 72% equity. Sohl presents similar statistics on the success of angel and venture capital rounds, average deal sizes and a breakdown by industry sector. The numbers are low. For example, only 4.2% of seed and start-up financing comes from venture capital sources.

Using Sohl’s data analytics and assuming that a new business has successfully begun using founders, friends and family funds, Sohl points out that there remains a large funding gap for seed/start-up and early-stage companies.

Presentation by Brian Knight, Associate Director of Financial Policy, Center for Financial Markets at the Milken Institute

Brian Knight’s presentation is titled “How Small and Mid-size Businesses are Funding Their Future.” Mr. Knight and Milken Institute surveyed 636 owners and c-suite executive of private companies with annual revenues from less than $500,000 up to $1 billion on the topic of how these small and mid-size businesses are funding their businesses, accessing capital and planning for growth. Mr. Knight and the Milken Institute published a complete report on their findings. This blog is a short summary based on the presentation made to the SEC Advisory Committee.

The key findings in the report are (i) debt is the preferred method of financing; (ii) when choosing between financing sources, price, ease of access, speed of funding and certainty are the highest ranking considerations; (iii) there is no clear preference between bank and non-bank financing though banking relationships are valued; and (iv) businesses have a lack of understanding, and interest, in alternative sources of funding and recent securities law changes (nearly 80% of those surveyed were unfamiliar with recent changes to the laws).

I find this last point very interesting and think that the lack of understanding and interest is a result of a lack of reliable succinct sources of information, presented in layman’s terms, together with a time of rapidly changing rules and regulations. The survey also found that 90% of businesses would not consider alternative financing such as crowdfunding, intrastate offerings or Regulation A. However, I think that this tells more about the pool of companies surveyed (only 636) and is a factor of the lack of knowledge by these companies.

The survey also asked what reasons a company would consider in using alternative financing sources, with those reasons being, in order of importance: (i) they believe it would be good for public relations/press; (ii) believe such funding could be achieved on better terms; (iii) believe such funding will be less expensive to pursue and have lower compliance costs; and (iv) they want to expand their investor base. To the contrary, the reasons for rejecting such financing options include: (i) lack of knowledge and understanding; (ii) uncertainty about legality; (iii) fear of investor fraud; and (iv) a desire to know their investors.

Of the firms surveyed, 32% had not raised capital in the last three years. Of those that raised capital, 32% did so through bank financing, 10% from non-bank loans, 9% from friends and family, 9% from family offices and 8% from other equity investment sources. The survey also showed that the majority of companies expected to be able to self-fund through current and retained revenues. The survey found what we all would logically expect, which is that the more advanced the business is in its life cycle, the less it needs outside funding sources.

Although debt is the preferred financing source, the same businesses almost unilaterally agree that little or no debt is best for a business’s balance sheet. The decision to incur debt financing is needs-driven. Businesses borrow when they need cash flow.

Presentation by Scott Bauguess, Deputy Director, Division of Economic and Risk Analysis at the SEC

The presentation by the SEC was organized as a discussion of the findings of the SEC study on unregistered offerings and recent activity resulting from the JOBS Act implementation. As a reminder, Title I of the JOBS Act, creating emerging growth companies (EGC) and providing a more cost-effective IPO onramp with greater test-the-waters abilities, was enacted on April 5, 2012. Since the creation of the EGC category of business, close to 85% of IPO’s are by EGC qualified businesses. Title II, creating Rule 506(c) allowing for general solicitation and advertising in private offerings, became effective on September 23, 2013. Title IV, creating Regulation A/A+, became effective on June 19, 2015. Very little Regulation A/A+ information is available as it is too new. Finally, Title III Crowdfunding is expected to become effective on May 16, 2016.

Continuing the trend discussed in the SEC survey, in 2014 and 2015, Regulation D remained the most often used method of raising capital. Small businesses continue to have the greatest need for capital and continue to be a driver of employment in the U.S. economy. Even amongst public companies, smaller reporting companies comprise the largest class of company at over 40% of all issuers. In 2013, there were more than 5 million businesses with fewer than 500 employees.

The SEC is hopeful that the JOBS Act provisions will both open opportunities to companies that would successfully raise capital from other sources, and provide an opportunity for businesses that otherwise could not raise capital from other sources.

Related to Rule 506(c), the SEC has not seen any increase in fraud on the market as a result of general solicitation. However, the SEC also notes that Rule 506(c) has been slow to gain traction but continues to be more and more widely used. The SEC will continue to monitor its use and report statistical findings.

The Author

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

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

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

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SEC Gives Insight On 2016 Initiatives

Posted by Securities Attorney Laura Anthony | March 8, 2016 Tags: dodd-frank act, mary jo white, SEC, The Fast Act, the jobs act

SEC Chair Mary Jo White gave a speech at the annual mid-February SEC Speaks program and, as usual, gave some insight into the SEC’s focus in the coming year. This blog summarized Chair White’s speech and provides further insight and information on the topics she addresses.

Consistent with her prior messages, Chair White focuses on enforcement, stating that the SEC “needs to go beyond disclosure” in carrying out its mission. That mission, as articulated by Chair White, is the protection of investors, maintaining fair, orderly and efficient markets, and facilitating capital formation. In 2015 the SEC brought a record number of enforcement proceedings and secured an all-time high for penalty and disgorgement orders. The primary areas of focus included cybersecurity, market structure requirements, dark pools, microcap fraud, financial reporting failures, insider trading, disclosure deficiencies in municipal offerings and protection of retail investors and retiree savings. In 2016 the SEC intends to focus enforcement on financial reporting, market structure, and the structuring, disclosure and sales of complex financial instruments.

2016 Disclosure Agenda

Chair White hit on the tremendous volume of regulatory changes and congressional mandates. Since 2010 Congress has given the SEC nearly 100 statutory mandates covering a multitude of complex rule requirements, with the FAST Act, JOBS Act, and the Dodd-Frank Act just being 3 examples. White confirms that the amount of recent rulemaking is of historic proportions, completing or overhauling many regulatory areas and providing dramatic changes to others. Again, 3 small examples are the FAST Act, JOBS Act and the Dodd-Frank Act, with the multitude of regulatory changes flowing from these 3 statutory directives.

In 2016 the SEC will continue implementing rules as directed by Congress. In addition to finalizing the remaining security swap and security-based swap dealer requirements under the Dodd-Frank Act, the SEC hopes to continue rulemaking related to the asset management industry, the structure of the equity markets and disclosure requirements (under Regulation S-K and Regulation S-X).

Related to the asset management industry, in May 2015 the SEC proposed increased reporting for investment advisers and mutual funds, including a requirement that funds report risk metrics, the use of derivatives, securities lending and liquidity of holdings.

Related to the structure of equity markets, the SEC has increased oversight over proprietary traders (see my blog HERE) and has proposed major revisions to regulations for alternative trading systems (this will be the subject of a future blog). Also related to equity markets, Chair White referenced the recent ANPR on new transfer agent rules (see my blog HERE) and the Tick Size Pilot program (see my blog HERE). Moreover, Chair White revealed that the SEC intends to shorten the clearing settlement life cycle from T+3 to T+2.

Disclosure effectiveness has been an ongoing central topic since the JOBS Act required the SEC to launch its Disclosure Effectiveness Initiative. The SEC intends to continue its focus in this arena and expects both additional rulemaking and industry guidance in 2016.

I have written several times on the SEC initiative and the subject of improving the disclosure requirements for reporting companies. Recently the SEC sought comment on financial disclosure requirements for subsidiaries and affiliate entities (see my blog HERE). Moreover, several of the provisions in the recent FAST Act were related to these initiatives. In particular, The FAST Act adopted many of the provisions of a bill titled the Disclosure Modernization and Simplification Act, including rules to: (i) allow issuers to include a summary page to Form 10-K (Section 72001); and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for EGCs, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K (Section 72002). In addition, the SEC is required to conduct yet another study on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information (Section 72003). See my blog on the FAST Act and these provisions HERE.

In September 2015, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. My blog on these recommendations can be read HERE.

Prior to that, in March 2015, the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For a review of these recommendations, see my blog HERE.

Mission and Philosophy

Chair White made a point of conveying the message that the SEC is not just about disclosure. They have broad regulatory authority over trading markets, broker-dealers, SRO’s, the settlement and clearing process and the PCAOB. The SEC intends to continue to work in each of these areas, including additional regulations on the swaps markets, clearing agencies, transfer agents, and technology systems. In addition, the SEC has and will continue to seek public comment on proposed rules, ideas related to proposed rules, and concepts in general. As Chair White states, “[W]e are therefore increasingly considering using measures beyond disclosure to fulfill our mission of providing strong investor protection, safeguarding market integrity, and achieving other regulatory objectives.”

The Author

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

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

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

Download our mobile app at iTunes.

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SEC Proposes Transfer Agent Rules

Posted by Securities Attorney Laura Anthony | February 23, 2016 Tags: DTC Eligibility, SEC, Transfer Agent Rules

On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. The transfer agent rules were adopted in 1977 and have remained essentially unchanged since that time. An advance notice of proposed rulemaking (ANPR) describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. The SEC indicates that following the comment process associated with this ANPR, it intends to propose actual new rules as soon as practicable.

To invoke thoughtful comment and response, the SEC summarized the history of the role of transfer agents within the securities clearing system as well as the current rules and proposed new rules. In addition, the SEC discusses and seeks comments on broader topics that may affect transfer agents and the securities system as a whole. This blog gives a high level review of the whole APNR and concept release with a more detailed focus on the proposed rules and discussions that will directly impact the transfer and deposit of restricted securities in the small-cap industry.

Introduction

As set out by the SEC, among other functions, transfer agents (i) track, record and maintain the official shareholders registrar and ownership records; (ii) cancel, issue and transfer securities, both in certificate and book entry form; (iii) communicate with shareholders on behalf of issuers; and (iv) process dividends and corporate actions such as reverse splits. In addition, from my own experience, transfer agents will act as mailing agent for proxy and other communications from the issuer, sometimes offer EDGAR agent services, and facilitate DTC eligibility applications with DTC member firms, obtain DWAC/FAST DTC eligibility for issuers and act as a front line where shareholders are attempting to remove a restrictive legend and deposit securities with brokerage firms.

Transfer agents are also seen as a gatekeeper in the prevention of fraud, and compliance with the registration and exemption provisions of the federal securities laws. In that regard, the SEC intends to impose obligations on a transfer agent in the processing and transfer of restricted securities. A major focus of the rulemaking is related to combatting microcap fraud. This is consistent with the recent SEC approach of increasing obligations and pressure on the gatekeepers, including brokerage firms related to the deposit of securities (see my blog HERE), attorneys and auditors, and transfer agents.

For the discussion of the proposed new rules related to the transfers of restricted securities, see the discussion below under the subheading “Restricted Securities and Compliance with Federal Securities Laws.”

History and Background

The SEC ANPR is lengthy and provides an in-depth discussion of the history of the clearing and settlement process and role of transfer agents in the process. Briefly, the ownership of securities represents certain property rights and the securities themselves are a negotiable instrument under state law allowing the owner to transfer such property to a third party. Where federal securities laws govern the registration and exemption provisions, the individual state’s Uniform Commercial Code (UCC) governs the transfer of certificates and securities as property. Accordingly, in addition to compliance with federal law, the daily activities of a transfer agent require knowledge of and compliance with the UCC.

Under the UCC, in order to obtain valid title to a security, the seller must voluntarily transfer possession of the security and the buyer must give value, not have notice of any adverse claim to the security and actually obtain control over the security. It is compliance with the UCC that requires that a certificate be endorsed, the signature guaranteed, instructions and authority from the seller, proof of payment/consideration from the buyer, proper cancellation of certificates and the proper registration and recording on the shareholder list. Moreover, it is the UCC that governs the process for replacing lost or stolen certificates and for an issuer or security holder to impose stop transfer restrictions.

Technology has helped streamline some of this process and for traded securities in DTC eliminated paper certificates altogether, but as all in the industry know, the paperwork is still extensive. Article 8 of the UCC governs the transfer of electronic or uncertificated securities. The SEC gives an interesting background discussion of the Paperwork Crisis beginning in the 1960s resulting from the massive volumes of paper needed to transfer securities associated with the growing and active trading markets. As a result of the Paperwork Crisis, the Depository Trust Company (DTC) and its securities holding arm, CEDE, were formed.

Moreover, for those interested, the APNR and concept release provides a thorough history of the creation and amendments to the national market system, national clearing and settlement system, SIPC, DTC the FAST program, and development of laws allowing for the holding and trading of book entry and electronic securities. Although this history is well beyond the scope of this blog, what I found particularly interesting is how recent many of these developments have been. For instance, it was only in 1996 that the Direct Registration System (DRS) was implemented that allowed investors to hold uncertificated securities in registered form on the books of the transfer agent and to utilize the FAST system to transfer shares to and from and brokerage account. It was during the late 1990s that DTC really flourished to become the largest depository and clearing house in the US. Today DTC provides the depository and book entry services for virtually all securities available for trading in the US.

Transfer Agent Role in Clearance and Settlement Processes

A transfer agent is an integral part of the National C&S System. The clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved. I will detail the clearing and settlement process in a future blog.

Security ownership can be either registered or beneficial. State corporate law conveys certain rights to registered owners that beneficial owners may not receive. For example, the right to examine a stockholder list at a meeting is limited to registered and not beneficial owners. Registered owners are listed on the stockholder list by name and are sometimes referred to as “holders of record.” In addition to state law rights, the holders of record is an important concept throughout the securities laws. For example, Section 12(g) of the Securities Exchange Act requires a company to register when it has 2,000 or more holders of record. Likewise, deregistration eligibility is determined in part by the number of holders of record.

A transfer agent often deals directly with a holder of record, including in the provision of transfer services, dividend payments and communications, such as the delivery of proxy forms. Record holders may hold their securities in either certificate or book entry form.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name which have been deposited with a brokerage firm and are in the DTC system. These securities usually show up on the shareholder list in the Cede account and sometimes in the name of the particular brokerage firm. Each brokerage and clearing firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Current Transfer Agent Regulations

Transfer agents have been regulated by federal securities laws since 1975. A “transfer agent” is defined as any person who engages in the following activities on behalf of an issuer: (i) countersigning securities upon issuance; (ii) monitoring issuances and preventing unauthorized issuances; (iii) registering the transfer of securities; (iv) exchanging or converting securities; or (v) processing transfer and maintaining book entry ownership records. Public company transfer agents are required to be registered with the SEC.

The SEC currently regulates (i) registration and annual reporting requirements; (ii) timing and certain notice and reporting requirements (the “turnaround rules”); and (iii) recordkeeping and record retention rules and safeguarding requirements for securities and funds. The current transfer agent rules are extensive, and below is just a very high-level brief overview.

Current Registration and Annual Reporting Requirements

The current registration and annual reporting requirements are found in Exchange Act Rules 17Ac2-1 through 17Ac3-1. All transfer agents must register with the SEC on Form TA-1. The rules include eligibility prohibitions against certain “bad actors” similar to other bad actor rules within the securities laws. All transfer agents must file an annual report on Form TA-2, including information on compliance with turnaround rules, number of accounts, items received, funds distributed and lost securities. Both the application and the annual report can be viewed by the public on EDGAR. In addition to reviewing these forms, the SEC performs site visits and examinations of transfer agents.

Current Processing, Reporting, Recordkeeping and Exemptions

Exchange Act Rules 17Ad-1 through 17Ad-7 set forth performance standards for transfer agents. In relation to these rules, transfer agents must have written internal controls and procedures. The rules focus on establishing minimum performance and recordkeeping standards for routine transfers, cancellations and issuances. Routine items must be processed within 3 business days of receipt and non-routine items must receive “diligent and continuous attention” and be “turned around as soon as possible.” Routine items are defined in the negative such that all items are routine except items (i) requiring the issuance of a new certificate that the transfer agent does not have; (ii) subject to stop order, adverse claim or other restriction; (iii) requiring additional documentation to review and complete; (iv) are part of a corporate action (such as split or dividend); (v) are part of a public or private offering; or (vi) certain warrants, options or other convertible securities. The performance rules contain certain exemptions, such as for the processing of limited partnerships and redemptions for registered investment companies and for certain very small transfer agents.

The performance rules also require a transfer agent to respond to certain written inquiries within prescribed time periods and, in particular, within 5, 10 or 20 days depending on the person making the inquiry and the subject of the inquiry.

Transfer agents are required to keep detailed, defined records including minimum delineated information that allows for the prompt delivery of information related to shareholders, ownership positions and historical records related to same. Records, funds and securities in a transfer agent’s custody must be safeguarded to prevent theft, loss, destruction or misuse.

Transfer agents are required to notify DTC when terminating or assuming transfer agent services for an issuer.

SRO Rules and Requirements

In addition to federal securities laws, transfer agents are regulated by SRO’s including, for example, the NYSE and DTC. The NYSE requirements include further regulation on turnaround times and recordkeeping as well as capitalization and insurance requirements.

All transfer agents that include electronic or book entry services (which is really all of them) must comply with DTC rules including (i) being “Limited Participants” in DTC; (ii) participate in the FAST program and agree to DTC’s Operational Arrangements; (iii) link with DTC’s electronic communication system; and (iv) participate in DTC’s Profile Surety Program.

State Law

As briefly discussed above, transfer agents must comply with state corporate statutes related to recordkeeping and notice requirements as well as each state’s Uniform Commercial Code.

Proposed New Rules

The SEC has issued an advance notice of proposed rulemaking (ANPR) which describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. Following the receipt of public comment on the ANPR, the SEC will publish proposed rules. The ANPR reveals a thorough revamping of the transfer agent rules.

The ANPR proposes rules to (i) increase the scope of information on the registration application (Form TA-1) and annual report (Form TA-2) for transfer agents; (ii) require all contracts between a transfer agent and issuer to be in writing, which includes a fee schedule and termination provisions, including provisions for handing over information to a new transfer agent; (iii) enhance transfer agent requirements for the safeguarding of funds and securities; (iv) apply anti-fraud provisions to specific transfer agent activities; (v) require transfer agents to establish business continuity and disaster recovery plans; (vi) require transfer agents to establish basic procedures regarding the use of information, including safeguarding personal information; (vii) revise recordkeeping requirements; and (viii) conform and update various terms and definitions and eliminate those that are obsolete.

Restricted Securities and Compliance with Federal Securities Laws

All sales of securities, including the re-sale of restricted securities held by a current shareholder, must either be registered under the Securities Act or there must be an available exemption. The most common exemption for the resale of restricted securities is Section 4(a)(1) of the Securities Act and Rule 144, which is a safe harbor under Section 4(a)(1). Since transfer agents are responsible for affixing a restrictive legend on stock certificates or making a restrictive notation on book entry securities and for processing the transfer and legend removal from such securities, they are an important gatekeeper in the prevention of fraud and unregistered distributions.

Transfer agents are subject to aiding and abetting liability for violations of the registration requirements under Section 5 of the Securities Act. In addition, like any market participant, a transfer agent could be charged with fraud violations under Section 10(b) and Rule 10b-5 under the Exchange Act and Section 17(a) of the Securities Act.

Currently a transfer agent must determine whether any particular request is routine and thus requires a 3-day turnaround, and whether the state UCC requires the processing of a request. Neither federal nor state UCC regulations require the processing of a request that does not comply with the federal securities laws. Accordingly, the transfer agent must determine whether a particular request complies with federal (or state) securities laws and thus what their particular processing requirements are. It is this determination that has made it an industry practice to require an opinion letter from counsel with each request to transfer or remove a legend from restricted securities. The SEC is concerned that reliance on opinion letters from a shareholder’s or issuer’s counsel does not offer enough protection against improper transfers or fraud.

Accordingly, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from directly or indirectly taking any action to facilitate a transfer of securities if such person knows or has reason to know that an illegal distribution of securities would occur in connection with the transfer. Such knowledge qualifier carries a duty to make reasonable inquiry.

Moreover, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from making any materially false statements or omissions or engaging in any other fraudulent activity in connection with the performance of their duties.

In addition, the SEC proposes new rules requiring each transfer agent to adopt internal controls, policies and procedures reasonably designed to ensure compliance with securities laws and requiring that each transfer agent designate a chief compliance officer.

There is no proposal to adopt rules that would provide specificity to a transfer agent related to the removal of a restrictive legend or transfer of restricted securities. However, the SEC does seek comment on same and, in particular, whether there should be requirements related to (i) obtaining an attorney opinion letter; (ii) obtaining issuer approval; (iii) requiring evidence of a registration statement or available exemption; (iv) requiring evidence of beneficial ownership; (v) requiring representations related to affiliation; and/or (vi) conducting some level of due diligence. I would advocate for such guidelines.

As the SEC notes, there is a potential conflict between a transfer agent’s duties to process a transfer and to ensure compliance with federal securities laws. However, in my opinion, from a transfer agent’s perspective, there are certain rules (turnaround rules and the UCC) requiring processing and only a vague fear of being charged with aiding and abetting related to ensuring compliance with federal securities laws. The proposed new rule generally increasing the potential liability on the transfer agent is likewise vague in the APNR. Without specific guidelines and standards, transfer agents will have a hard time navigating the new regulatory environment and all market participants will pay the price.

In fact, fear of regulatory retribution has already created a very challenging environment in the small-and mid-cap marketplace. The deposit of penny stock securities has become extremely difficult and expensive, but the flow of information to the market participants as to what is and is not acceptable has been slow and disjointed. At the same time that the OTC Markets has created self-imposed quantitative and qualitative standards to improve the marketplace and has been attempting to support small and emerging growth business capital formation, the secondary trading becomes increasingly difficult.

Moreover, there is a contrarian reality among the legislature, the SEC’s public position, and again, the actual small-cap secondary trading market, including the ability to deposit securities. The JOBS Act, including Regulation Crowdfunding, and the FAST Act are designed to improve capital formation in the small and emerging growth sectors, including a specific focus on allowing companies easier access to public markets and facilitating going public transactions. The advent of Regulation A+ and 506(c), the creation of the emerging growth company category, the various provisions of the FAST Act including improvements to the Form S-1 filing process and the SEC initiatives to modernize and update disclosure obligations are all meant to ease capital formation and public filings for micro- and small-cap companies.

Further, the active SEC Advisory Committee on Small and Emerging Companies was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

The contrary side to all of this is the extreme difficulty in depositing securities for small- and micro-cap public companies and in creating a vibrant trading market. Although not comprehensive on the issues, see my blogs HERE regarding broker duties in depositing stocks and HERE regarding the need for a venture exchange.

The small- and micro-cap marketplace needs more definitive standards that companies and practitioners can rely upon. The fact is, it is relatively easy for a company to pass a footnote 32 type vehicle through the SEC and obtain a ticker symbol from FINRA and then extremely difficult to do anything with it. See my blog HERE. The fact that it is easy to create the vehicles in the first place creates a sort of confusion and disconnect in the marketplace. I’d rather see the SEC and FINRA be more stringent in their review process on these obvious vehicles and require that they label themselves a shell such that brokers and transfer agents have some comfort that when a company has cleared the SEC and FINRA, it is as labeled, subject of course to post effectiveness changes.

Of course, brokers and transfer agents still need to be gatekeepers, but the standards they are relying upon and the issues they are facing in their own SEC investigations and reviews need to be articulated and communicated to the marketplace. New proposed transfer agent rules is a step in the right direction and a very good start, but if those rules include a vague requirement that the transfer agent follow the law, we will not have made the type of headway that is badly needed to support real and viable small businesses and their capital formation.

I note that as part of the SEC request for comment there are some extreme thoughts. For instance, the SEC requests comment on whether a transfer agent should be required to (i) confirm the existence and legitimacy of an issuer’s business by reviewing contracts and corporate records; (ii) conduct credit and criminal background checks for issuers and their officers and directors; (iii) obtain information on shareholders before processing requests for legend removal; and (iv) review public news and information on issuers and principals. My view is that this level of review by a transfer agent is too extreme. I strongly oppose giving a transfer agent that level of independent power over an issuer and its shareholders. In addition to the shutdown in the small and micro-cap markets that would entail, the re-tooling of current transfer agents to adequately be able to satisfy this level of responsibility would be cost-prohibitive both to the transfer agents and their clientele.

Some of the other comment requests of interest (and my view in parentheses) include: (i) should the SEC enumerate red flags that would trigger a duty of further inquiry by a transfer agent (yes); (ii) should there be a heightened review for securities of non-reporting issuers (yes, if no current information); (iii) should a transfer agent be required to deliver securities only to the registered shareholder and not third parties (yes, unless the third party is an attorney or other proper representative of the shareholder); and (iv) should transfer agents be prohibited from accepting stock as compensation (no).

Registration and Annual Reporting

The purpose of the registration and annual reporting requirements is to assist the regulators, issuers and investors in determining whether a transfer agent is performing its functions properly, determining the nature of a particular transfer agent’s business, assisting the SEC in making examination and investigation decisions, including areas of concern, monitoring the transfer agents activities and ensuring compliance with rules and regulations.

The SEC proposes to add information to the registration and annual reporting requirements, including financial information, potential conflicts of interest and details about the types of services being provided and the transfer agent’s clientele. For example, it is proposed that a transfer agent disclose any past or present affiliations with or ownership of issuers or broker-dealers serviced by or affiliated with a transfer agent. I note that several small-cap broker-dealers have sister transfer agencies and do not believe such vertical business investment is problematic nor should it be construed as nefarious. However, I do see benefit in the disclosure of same.

The SEC also proposed to require a transfer agent to designate a chief compliance officer with responsibilities to ensure compliance with written internal controls and procedures.

Written Agreements Between Transfer Agents and Issuers

The APNR proposed to require written agreements between transfer agents and issuers. Although it is not now a legal requirement, I think most transfer agents do have such agreements. I am hard-pressed to think of any issuer clients that do not have a written contract with their transfer agent, and most are quick to require the signing of an addendum or updated contract where there is a change of management or control of the issuer.

However, the SEC rightfully points out that where there is either no written agreement or the agreement does not cover certain questions, there is an increase of disputes with respect to (i) the duration of the arrangement; (ii) termination rights; (iii) the disposition of records and transfer of records to a new transfer agent; and (iv) fees. These issues are most prevalent in the small-cap world, especially where a transfer agent “holds records hostage” in exchange for a large termination fee. The APNR does not suggest that the transfer agent be limited in allowable termination fees, nor that a transfer agent be required to turn over records regardless of sums owed or the payment of a termination fee, though it does seek comment on such issues.

Safeguarding Funds and Securities

Transfer agents often provide administrative and processing services in relation to dividends, payouts associated with splits (paying agent services) and other transactional escrow services. The APNR proposes a more robust set of standards for transfer agents acting as a paying agent or providing escrow services. The APNR indicates the SEC will provide new rules such as (i) maintaining secure vaults; (ii) installing theft and fire alarms; (iii) having written procedures related to access and control over accounts and information; (iv) greater bookkeeping requirements; (v) and specific unclaimed property procedures. In addition, the SEC intends to impose rules similar to those for broker-dealers, requiring internal controls, annual reporting and independent audits related to these services.

Cybersecurity, Information Technology and Related Issues

Cybersecurity is a big concern for the SEC. In 2014 the SEC adopted Regulation Systems, Compliance and Integrity requiring covered entities to test their automated systems for vulnerabilities, test their business continuity and disaster recovery plans and notify the SEC of intrusions. In particular, the SEC intends to propose new or amended rules requiring registered transfer agents to, among other things: (i) create and maintain a written business continuity plan; (ii) create and maintain basic procedures and guidelines governing the transfer agent’s use of information technology, including methods of safeguarding data and personally identifiable information; and (iii) create and maintain appropriate procedures and guidelines related to a transfer agent’s operational capacity, such as IT governance and management.

Concept Release and Request for Additional Comment

The SEC concept release contains discussion and seeks comment from the public on issues outside of and in addition to the APNR. The SEC highlights different questions and issues such as whether brokerage firms should also be required to be registered as transfer agents when they hold securities in nominee accounts; specific issues affecting transfer agents for mutual funds and transfer agents that serve as administrators for employee stock option and similar plans. The concept release also seeks comment on a transfer agent’s role in a Regulation Crowdfunding offering (Title III Crowdfunding).

The Author

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

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

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

Download our mobile app at iTunes.

« SEC’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies State Blue Sky Concerns; Florida and New York »

SEC’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies

Posted by Securities Attorney Laura Anthony | February 16, 2016 Tags: SEC

As required by the JOBS Act, in 2013 the SEC launched its Disclosure Effectiveness Initiative and has been examining disclosure requirements under Regulation S-K and Regulation S-X and methods to improve such requirements. In September 2015, the SEC issued a request for comment related to the Regulation S-X financial disclosure obligations for certain entities other than the reporting entity. In particular, the SEC is seeking comments on the current financial disclosure requirements for acquired businesses, subsidiaries not consolidated, 50% or less owned entities, issuers of guaranteed securities, and affiliates whose securities collateralize the reporting company’s securities.

It is important to note that the SEC release relates to general financial statement and reporting requirements, and not the modified reporting requirements for smaller reporting companies or emerging growth companies. In particular, Article 8 of Regulation S-X applies to smaller reporting companies and Article 3 to those that do not qualify for the reduced Article 8 requirements. The SEC discussion and request for comment specifically addresses certain Article 3 rules.

As my clients are, for the most part, either smaller reporting companies or emerging growth companies, I have provided information related to those entities where applicable. In the request for comment, the SEC does ask for input and comments on the correlating Article 8 rules where applicable.

Specific rules being addressed

The SEC request for comment is specifically related to the following rules and their related requirements:

Rule 3-05, Financial Statements of Businesses Acquired or to be Acquired;

Rule 3-09, Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons;

Rule 3-10, Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered; and

Rule 3-16, Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered.

The comments sought and the SEC review are centered on how these requirements assist and inform investors and potential investors in making investment and voting decisions on the one hand, and the challenges and issues of the reporting company in preparing and providing the information on the other hand. Moreover, as required by the Exchange Act in all SEC rulemaking, the SEC must consider how any changes will promote efficiency, competition and capital formation.

Rule 3-05 of Regulation S-X – Financial Statements of Businesses Acquired or to be Acquired

Summary of current rule

Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue producing assets will likely be treated as the purchase of a business.

In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X. The investment test considers the value of the purchase price relative to the value of the total assets of the company prior to the purchase. The asset test considers the total value of the assets of the company pre and post purchase. The income test considers the change in income of the company as a result of the purchase.

Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal year and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.

Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.

Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.

An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.

The Rule 3-05 or Rule 8-04 financial statements will also be required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.

In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.

Reason for the rules and request for comment

Clearly financial disclosure regarding acquired businesses is important for an investor to understand the impact of transactions. An acquisition will change a company’s financial condition, results of operation, liquidity and future prospects. However, the SEC admits that the type of information currently required may have limitations vis-à-vis the intended purpose. Many commentators have questioned the need and utility of historical financial information on the acquired business. Historical financial statements do not reflect the new accounting basis resulting from the acquisition, changes in management, changes in business plan, the efficiencies of scale of the combined entities (such as workforce reductions and facility closings), etc.

Related to the financial statement requirements, the SEC specifically requested comments associated with (i) how investors use the financial information; (ii) what changes would make the information more useful to investors and what challenges are there to providing this information; (iii) what challenges companies have in providing the currently required financial information and how these could be addressed; (iv) whether the current requirements include information that is not useful; (v) how pro forma requirements could be changed to make them more useful; (vi) whether the 75-day rule should be shortened; and (vii) whether the pre-closing requirements for registration statements and Section 14 (Schedule 14C or 14A) filings should be modified.

Related to the investment, asset and income tests, the SEC specifically requested comments on (i) whether the current significance tests are the appropriate measure to determine the nature, timing and extent of financial statement disclosure requirements; (ii) what changes or alternatives the SEC should consider; (iii) whether the current test thresholds should be modified; (iv) whether additional or different tests should be implemented (such as purchase price compared to market cap); and (v) whether companies should be given more judgment in determining what is significant.

The SEC has also asked for comment on the application of changes to Rule 8-04 for smaller reporting companies and application of the rules to different issuers such as investment companies and foreign private issuers.

Rule 3-09 of Regulation S-X – Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons

Summary of current rule

Rule 3-09 does not apply to smaller reporting companies or emerging growth companies at all and, as such, I am only providing a very brief review. Rule 3-09 requires that certain separate financial statements be provided for subsidiaries and persons even if the reporting company owns less than 50% if the investment is significant. Significance is determined using modifications of the investment and income tests. If neither of the tests exceed 20%, no Rule 3-09 financial statements are required, but if either exceeds 20%, all financial statements are required and such statements must be audited for each year that a test exceeds the 20% threshold.

Separately Rule 4-08 requires summarized financial information in the notes to financial statements if a Rule 3-09 test exceeds 10%. This summarized financial information is not required if the full separate financial statements are otherwise provided.

Reason for the rules and request for comment

Even investments in businesses that are not controlling (over 50%) impact financial condition, results of operation, liquidity and future prospects – hence, the Rule 3-09 requirements. However, as with Rule 3-05, the SEC recognizes the limited utility of the current requirements. One of the biggest concerns is the inability to reconcile separate financial statements for these investment entities, with the value of such investment on the financial statement on the registrant’s balance sheet. Moreover, the aggregation of investments in the summary presentations further dilutes the ability to discern particular value for any one individual entity’s separate financial statements.

The SEC is requesting comment on (i) how investors use Rule 3-09 financial information; (ii) what changes could be made to make the information more useful to investors; (iii) what challenges companies face in obtaining and preparing this financial information; (iv) how those challenges can be addressed or improved; and (v) whether there are parts of the current requirements that are not useful.

Related to the investment and income tests, the SEC specifically requested comments on (i) whether the current significance tests are the appropriate measure to determine the nature, timing and extent of financial statement disclosure requirements; (ii) whether the Rule 3-09 tests should be modified to correlate more closely with other financial statement requirements in Regulation S-X (such as Rule 10-01); (iii) what changes or alternatives the SEC should consider; (iv) whether the current test thresholds should be modified; (v) whether additional or different tests should be implemented (such as purchase price compared to market cap); and (vi) whether companies should be given more judgment in determining what is significant.

The SEC has also requested comment on whether Rule 3-09 should be expanded to include smaller reporting companies and emerging growth companies. My view on this is a definite “no.” The SEC has asked comment on whether Rule 3-09 should be modified for business development companies and, if so, in what way. My view on this is “yes,” but an in-depth discussion on business development companies is beyond the scope of this blog.

Rule 3-10 of Regulation S-X – Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered

Summary of current rule

A guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, must file their own audited annual and reviewed stub period financial statements under Rule 3-10 of Regulation S-X. Rule 3-10 provides certain exemptions, including (i) where a parent company offers securities guaranteed by one or more of its subsidiaries; or (ii) where a subsidiary offers securities guaranteed by another subsidiary.

Also, if the subsidiary issuer and guarantor satisfy certain conditions, the parent company can provide disclosures in its regular annual and interim consolidated financial statements for each subsidiary and guarantor (called “Alternative Disclosure”). Without getting into the minutiae of how to qualify for Alternative Disclosure, generally to qualify the subsidiary issuer/guarantor must be 100% owned by the parent and the guarantees must be full and unconditional.

In simple terms, usually a parent company merely consolidates the financial statements of its subsidiaries and no separate financial statement information is provided for individual operating subs. Where a sub or parent becomes a separate issuer or guarantor, separate financial information must be filed for those subsidiaries. Where qualified, Rule 3-10 allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.

The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.

To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. The parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.

Reason for the rules and request for comment

The rule is designed to provide investors with information to evaluate the likelihood of payment by the issuer and guarantors. The format and content of the Alternative Disclosure is unique and not found elsewhere in SEC rules or accounting standards.

The SEC has requested comment on (i) how investors use Rule 3-10 financial information; (ii) what changes could be made to make the information more useful to investors; (iii) what challenges companies face in obtaining and preparing this financial information; (iv) how those challenges can be addressed or improved; and (v) whether there are parts of the current requirements that are not useful.

In addition, the SEC has requested comments on the conditions that must be satisfied to qualify for Alternative Disclosure and the time periods for providing such disclosure.

Rule 3-16 of Regulation S-X – Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered

Summary of current rule

Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities act as a substantial part of collateral for securities being registered. The financial statements must be provided as if that affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required. Similarly, but separately, Rule 4-08 requires financial statement footnote disclosure of amounts of assets mortgaged, pledged or otherwise subject to a lien.

Reason for the rules and request for comment

The disclosures are meant to provide information on the ability of an affiliate to meet an obligation where the registrant defaults. However, many believe that the financial disclosure is confusing and not very useful to meet its intended purpose.

The SEC has requested comment on (i) whether the Rule 3-16 requirements influence the structure of collateral arrangements and, if so, what the consequences are to investors and registrants; (ii) how investors use Rule 3-16 financial information; (iii) what changes could be made to make the information more useful to investors; (iv) what challenges companies face in obtaining and preparing this financial information; (v) how those challenges can be addressed or improved; and (vi) whether there are parts of the current requirements that are not useful.

Additional information and further reading

The SEC has received many comment letters in response to its request and, on January 13, 2016, met with representatives of Deloitte & Touche on the subject. This blog summarizes the current rules and the SEC request for comment but does not include a discussion of the comment letters submitted to the SEC. Although many of the comment letters themselves contain useful and thought-provoking information, they are numerous and lengthy and such discussions may or may not ultimately influence the actual rules we practitioners work with. I will, of course, blog about future rules and rule amendments resulting from these discussions. For those interested in reading the comment letters, they can be found HERE.

I have written several times on the SEC initiative and the subject of improving the disclosure requirements for reporting companies. Several of the provisions in the recent FAST Act were related to these initiatives. In particular, The FAST Act adopted many of the provisions of a bill titled the Disclosure Modernization and Simplification Act, including rules to: (i) allow issuers to include a summary page to Form 10-K (Section 72001); and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for EGCs, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K (Section 72002). In addition, the SEC is required to conduct yet another study on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information (Section 72003). See my blog on the FAST Act and these provisions HERE.

The Author

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

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

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« SEC Study On Unregistered Offerings SEC Proposes Transfer Agent Rules »

SEC Study On Unregistered Offerings

Posted by Securities Attorney Laura Anthony | February 9, 2016 Tags: SEC, Unregistered Offerings

In October 2015, the SEC Division of Economic and Risk Analysis issued a white paper study on unregistered securities offerings from 2009 through 2014 (the “Report”). The Report provides insight into what is working in the private placement market and has been on my radar as a blog since its release, but with so many pressing, timely topics to write about, I am only now getting to this one. The SEC Report is only through 2014; however, at the end of this blog, I have provided supplemental information from another source related to PIPE (private placements into public equity) transactions in 2015.

Private offerings are the largest segment of capital formation in the U.S. markets. In 2014 private offerings raised more than $2 trillion. The SEC study used information collected from Form D filings to provide insight into the offering characteristics, including types of issuers, investors and financial intermediaries that participate in offerings. The Report focuses on Regulation D offerings and in particular Rules 504, 505, 506(b) and 506(c).

A summary of the main findings in the Report includes:

In 2014, there were 33,429 Regulation D offerings reported on Form D filings, accounting for more than $1.3 trillion raised.

Issuers in non-financial industries reported raising $133 billion in 2014. Among financial issuers, hedge funds raised $388 billion, private equity funds raised $316 billion and non-pooled investment funds (such as banks, insurance companies and investment banks) raised $375 billion.

Foreign issuers accounted for 20% of the 2014 total. Most foreign issuers are based on Canada, the Cayman Islands or Israel.

Rule 506 accounts for 99% of all private offerings. Rule 506 was used 97% of the time for offerings below the Rule 504 and 505 limits, showing that Rule 506 is preferred regardless of the amount of the offering (I believe this is firmly as a result of the state law pre-emption in a 506 offering).

Since the effectiveness of Rule 506(c) on September 23, 2013, allowing for general solicitation and advertising, only a small portion of raises – i.e., 2% of the total or $33 billion – relied on this exemption.

Capital raised through private markets correlates with the strength of public markets. The strength of the private market is closely tied to the health of the public market.

The median offer size of non-financial issuers is less than $2 million, indicating that small businesses rely on private, unregistered offerings the most.

Approximately 301,000 investors participated in Regulation D offerings during 2014. A large majority of these investors participated in offerings by non-financial issuers (presumably because financial issuers relied on a small number of institutional investors). Non-accredited investors participated in only 10% of the offerings.

Background on private offerings

All offers and sales of securities must be either registered under the Securities Act of 1933, as amended (“Securities Act”) or made in reliance on an available exemption from registration. Public offerings generally must always be registered (with the exception of a Rule 506(c) offering) and private offerings can generally be completed in reliance on an exemption. The private offering rules have various investor restrictions (limits on sales to unaccredited investors), information requirements and/or offering limits to balance the competing directives of the SEC to assist with capital formation and protect investors.

The exemptions for private offerings are found in Sections 3 and 4 of the Securities Act. In particular, most private offerings are governed by Sections 4(a)(2), 3(b) and 3(a)(11) of the Securities Act. Rules 506(b) and 506(c) of Regulation D, Regulation S and 144A provide safe harbors under Section 4(a)(2). Section 3(b) provides the authority for Rules 504 and 505 of Regulation D. Section 3(a)(11) provides statutory authority for intrastate offerings.

Even after the JOBS Act, private offerings remain the biggest source of capital formation for small and emerging companies, which companies are the largest source for creating new jobs, driving innovation and accelerating economic growth. At $1.3 trillion raised in 2014, private offerings represented more than what was raised in public equity and debt offerings combined.

From 2009 – 2014, there were more than 64,000 offerings by small businesses with a median offer size of less than $2 million. Only 21% of private offerings reported using a financial intermediary such as a broker-dealer. For those that did use such a placement agent, the average commission size was 5%.

Although the Report was issued in October 2015, it only examines the private offering market through 2014. The Report indicates that the vast majority of offerings are completed under Rule 506(b) with Rule 506(c) being only a very small percentage.

The analysis in the Report takes into consideration factors that may affect an issuer’s choice of private offering exemption, including pre-emption of state securities laws, ability to advertise, ability to sell to non-accredited investors, limits on amount of capital raise, geographical constraints, and levels of required disclosure. The Report is organized by discussions on the overall private offering market; capital formation in the market for Regulation D offerings and characteristics of market participants. This blog maintains that order of discussion.

The size of the private offerings market

The SEC Report does not give complete information on the size of the private offerings market. The information in the Report is based on Form D filings, which does not necessarily include offerings relying on straight Section 4(a)(2) or Regulation S as neither of these require a Form D filing. Moreover, many issuers that rely on Regulation D neglect to file a Form D and accordingly, the market size is somewhat larger than as stated in the SEC report.

In 2014 registered offerings accounted for $1.35 trillion compared to $2.1 trillion raised in private offerings. As reported by the SEC, Regulation D and Rule 144A are the most common offering methods, being primarily equity and Rule 144A being primarily debt. The Report includes comparative information on registered offerings as well. During the years 2009-2014, registered debt offerings far outweighed equity offerings.

The number of private offerings per year also far outweighs the number of registered offerings, though this is to be expected. A private offering can be completed far quicker and with greater frequency than a public offering that is subject to SEC filings, comment process and effectiveness procedures. As Regulation D is commonly used by smaller entities, it follows that there are significantly more of such offerings at smaller dollar values. Rule 144A, on the other hand, usually involves institutional investors at a much higher dollar amount and lower frequency. For instance, there were approximately 33,429 Regulation D offerings in 2014 compared to 1,534 Rule 144A offerings in the same year. In 2014 there were 1,176 registered public equity offerings and 1,576 registered public debt offerings.

The Report gives comparable information for each year from 2009 through 2014 as well. As a summary, 2010 was a very big year in the offering marketplace (both private and public), skewing the results somewhat, but other than that, the number of all offerings has increased year over year since 2009.

The Regulation D market

The Regulation D market is comprised of Rules 504 and 505 promulgated under Section 3(b) of the Securities Act and Rules 506(b) and 506(c), both of which are safe harbors under Section 4(a)(2) of the Securities Act. Again, the SEC Report is only based on Form D filings and, accordingly, is subject to deviation for offerings that did not file and/or inaccurate or incomplete information reported by issuers.

Both the number of and dollar value of Regulation D offerings has been increasing from 2009 through 2014. For instance, there were 13,764 reported Regulation D offerings in 2009 and 22,004 in 2014. The total amount sold in 2009 was $595 billion and in 2014 was $1,332 billion. Interestingly, the average offering size was larger in 2009 at $36 million than in 2014 at $24 million.

The SEC Report discussed the cyclicality of offerings as well. Although it is well documented that public markets are cyclical and depend on such factors as business cycle, investor sentiment and time varying information asymmetry, comparable information is not available for the private offering markets. Just based on Form D filings, the SEC Report considers whether there is support for the theory that companies rely on private markets when public markets are in distress, such as during a recession. There is not. In fact, rather it appears that the private offering market increases during strong public markets and decreases during weak public markets. The health of the private offering market correlates with the health of the public market.

As noted in the Report, “there is a strong, positive correlation of the incidence of new Regulation D offerings with the economic condition of the public markets. In particular the level of Regulation D offering activity closely follows the level of the S&P 500 index.” From 2009-2014 there has been an increase in Regulation D offering activity consistent with the steady increase in the S&P 500.

The Regulation D marketplace for non-financial issuers generally comprises equity offerings as opposed to debt offerings, which are more common in the public market. Moreover, equity is usually indicative of new money and capital whereas debt is often used as a refinancing tool for existing debt. Financial issuers generally use Rule 144A and such offerings are generally debt. In other words, small businesses looking to grow with new capital rely on Regulation D equity offerings.

Rule 506 of Regulation D continues to be the most common exemption. Since 2009, 95% of private offerings are completed under Rule 506. It is clear to me, and the SEC, that the reason for this is that Rule 506 pre-empts state law, avoiding state registration and other arduous blue sky process. The SEC points out that depending on state law, Rule 504 and 505 offerings can be sold to non-accredited investors and, under Rule 504, can be freely tradeable. Despite this benefit, issuers clearly find the state law pre-emption as a more important deciding factor and are willing to accept the restrictions under Rule 506 as a trade-off (i.e., either accredited only or a limit of 35 unaccredited, restricted securities, no general solicitation or advertising under 506(b) and added accredited verification under 506(c), etc.).

From September 23, 2013, the date of enactment, through December 31, 2014, a total of 2,117 Rule 506(c) offerings were reported on Form D by a total of 1,911 issuers (some issuers had multiple offerings). During this time a total of $32.5 billion was reported as being raised. As a comparison, during the same time period there were 24,500 Rule 506(b) offerings that raised $821.3 billion. Moreover, even after the enactment of Rule 506(c), the number of new 506(b) offerings continues to increase and vastly outpace the number of new Rule 506(c) offerings.

I am not surprised by this information as I think that the 506(c) marketplace has taken its time to find its place in the private offering market as a whole, and continues to do so. From my own experience it is clear that accredited investors do not just look at a website and send money! Offerings are sold, not bought, and the advertising and marketing is good for lead generation, ease of information flow, and general exposure, but does not cause a sophisticated investor to part with their money without more. Even though the accredited verification process has become easier with services such as Crowdcheck, it is clear that issuers, placement agents, and the investing public still prefer the old-fashioned Rule 506(b) and avoiding the accredited verification process. See, for example, my blog HERE discussing new SEC guidance and the Citizen VC no action letter.

I still strongly believe in the benefits of Rule 506(c) and its viability. The SEC Report does as well, pointing out that issuers will become more comfortable with market practices, accredited investor verification procedures, and methods of advertising and solicitation over time.

During this same time period there continues to be a decline in the use of Rules 504 and 505. For example, there were only 544 Rule 504 offerings and 289 Rule 505 offerings in 2014. The SEC Report contains quite a bit of comparative information on Rules 504 and 505 for those interested in further information. As I’ve previously written about, the SEC has proposed new amendments for Rules 504 and 505 which may increase their use, though I do not expect a big impact. My blog on these proposed rules can be read HERE.

Both foreign issuers and public companies rely on Regulation D. For example, 20% of all Regulation D offerings from 2009-2014 were completed by foreign issuers. Public issuers are active in PIPE transactions as well, with 13% of Regulation D offerings being completed by public companies. At the end of this blog I have a section with 2015 data on the PIPE market from other sources.

Regulation D market participants

Pooled investment funds such as hedge funds, venture capital and private equity funds represent the largest business category, by amount raised, utilizing Regulation D. From 2009-2014 pooled investment funds raised $4.8 trillion as compared to $905 billion by non-funds. Non-funds, however, use Rule 506(c) more than pooled funds, representing 75% of those offerings. Moreover, non-funds account for a much higher percentage of total offerings by number of offerings, representing 60% of all new Form D filings.

Companies completing Rule 506(c) offerings usually check the “other,” “other technology,” “other real estate,” “oil and gas,” or “commercial” industry boxes of their Form D filings. Counting all non-funds using all Regulation D offerings, the industries in order of most often used are banking, technology, real estate, health care and energy. Interestingly, the number of offerings by banking entities and manufacturing industries have both decreased during the study period. There has been a big uptick in real estate offerings in 2013 and 2014, which makes sense in light of the improved real estate market since 2008.

The median offering size for these non-fund issuers is $1 million compared to $11 million for hedge funds and $30 million for private equity funds. As mentioned above, this information indicates that small businesses are utilizing Regulation D, which the Report finds is consistent with the regulatory objectives.

The majority of issuers decline to disclose revenue and of those that did, most disclosed less than $1 million. This is consistent with the findings that Regulation D is widely used by small businesses. Beyond that, I can’t find a lot of meaning in that information, other than that smaller issuers are most likely to file a Form D without the assistance of counsel, and counsel usually recommends not disclosing revenue.

The Form D’s do show that a majority (67%) of companies that file a Form D are less than 3 years old. This is true for both fund and non-fund entities. I note that this is consistent with the SEC Advisory Committee on Small and Emerging Companies’ consistent message that new entities are the most in need of methods to raise capital and secondarily that those same new entities create the most new jobs.

Most U.S. companies that file Form D’s have their principal place of business in California and New York with Texas, Florida and Massachusetts following. These are also the most common states of investor location. Most investors are accredited.

Less than a fifth of all issuers reported repeat offerings but 25% of non-fund issuers had repeat offerings. Form D filings do not tell of the success of an offering; however, 31% of issuers had raised 100% of their offering at the time they filed the Form D, which is typical of PIPE transactions offerings with a small handful of investors.

Form D’s will also not tell the final investor count or breakdown, but compiling Form D information shows that only 300,000 investors participated in Regulation D offerings in 2014 and only 110,000 in non-financial issuers. That seems to be a very small number of investors overall and clearly shows the importance of properly packaging an offering and presenting it to the right audience.

Only 21% of offerings for the period 2009-2014 used a placement agent, with a decrease in their use in 2014 compared to 2009-2013. Issuers in non-financial industries paid an average of 6% commission and in financial industries, an average of 1.4%. This is likely because the size of the offering is much larger and number of investors much smaller in the financial industry. On average, higher fees are paid for Rule 506(c) offerings than 506(b), which makes sense in light of additional work (verification of accreditation) and risk associated with advertising.

2015 PIPE Market

A PIPE is a private placement into public equity, or in other words, a private placement by a public company. According to PrivateRaise, a private placement data service, PIPE’s raised $89.97 billion in 2015, up 14.8% from 2014. The amount was spread over approximately 1,000 offerings.

The Author

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

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

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

Download our mobile app at iTunes.

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