March 2015 - Reverse-Merger.com

The ECOS Matter; When Is A Reverse Split Effective?

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

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

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

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

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

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

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

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

Rule 6490

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

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

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

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

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

Rule 6490(d)(3) provides:

(3) Deficiency Determination

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

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

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

State vs. Federal Regulation of Corporate Law

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

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

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

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

Conclusion

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

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

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

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

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

The Author

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

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile.

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

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

Download our mobile app at iTunes and Google Play.

« Insider Trading- A Case Study SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies »

Insider Trading- A Case Study

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Control Block Purchaser, effective s-1 registration statement, Insider Trading, Insider Trading Violations, Misappropriation theory, probability-magnitude test, Section 10(b), temporary insider

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Any and all persons that buy and sell stock may be subject to insider trading liability. This blog sets forth a particular hypothetical fact scenario and analyzes the associated insider trading implications.

Hypothetical Fact Pattern: Company X (the “Company”) sells shares to a group of 35 unaffiliated shareholders pursuant to an effective S-1 registration statement. These same 35 unaffiliated shareholders (the “Sellers”) sell their registered stock to a group of 35 unaffiliated purchasers (the Buyers”) in a private transaction (the “Transaction”). At or near the same time as the Transaction, the control block consisting of restricted shares of common stock is sold to a different purchaser (“Control Block Purchaser”) in a private transaction (collectively, the “Transactions”). The Transactions result in a complete change of control and shareholder base in the Company. The Buyers are known by the Control Block Purchaser and are introduced to the Transactions by the Control Block Purchaser. The Buyers and the Control Block Purchaser are aware of nonpublic information at the time of the Transactions. In particular, after the Transactions are completed, there will be either a reverse merger transaction with a previously identified operating business, or a complete change in direction of the Company’s current business. In addition, the Buyers are aware that a change of control transaction will occur contemporaneously with their Transaction. After the Transactions are complete, a reverse merger and/or complete change in direction of the Company’s business occurs, most likely resulting in an increase in value of the common stock of the Company.

Analysis and discussion:

Insider trading is prohibited by the general anti-fraud provisions and in particular Section 10(b) of the Securities Exchange Act of 1934, as amended and Rule 10b-5 thereunder. There are three main theories on which insider trading is based: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory.

Section 10(b) of the Exchange Act makes it unlawful for any person to, directly or indirectly, “use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Rule 10b-5, promulgated under Section 10(b), provides that “[I]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

The elements of a Section 10(b) and Rule 10b-5 claim include:

(i) Misrepresentation or Omission of a Material Fact – the key point here being “material.” A fact is material if, in light of the totality of information, it is substantially likely it would impact a reasonable person’s investment decision. The test is based on a reasonable person’s perspective, not necessarily the investor making the claim.

(ii) Scienter/State of Mind – Rule 10b-5 requires that the defendant be aware of the fraud. Awareness can be established either by actual awareness (defendant states that they have 5 contracts when there are only 3) or by showing that the defendant should have been aware with reasonable inquiry and diligence (defendant knew that the Control Block Purchaser owned and operated a separate business that he intended to bring public, but never asked if he was purchasing this particular control block for that purpose).

(iii) Reliance – An investment decision must have been made in reliance on the misinformation or lack of information. In other words, there must be a link between the alleged fraud and the investment decision. It is presumed, when material information is withheld, that there is reliance. The presumption of reliance can be rebutted by showing that the claimant’s decision to purchase or sell shares was not influenced by the alleged fraud, or that the alleged fraud did not alter or change the stock price.

(iv) Causation – the plaintiff in a 10b-5 claim must show that the fraud caused damages. Damages are a calculation of the monetary loss of the claimant or monetary gain by the defendant, and such damages must be linked to the fraud.

(v) Damages – in addition to linking the damages to the fraud, actual damages must exist.

Classical Theory

Rule description: Under the classical theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer. The “on the basis of” standard is met if the purchaser or seller is aware of the material nonpublic information at the time of the purchase or sale. Materiality is generally measured by whether there is a substantial likelihood that the material nonpublic information would have been viewed by a reasonable investor as having significantly altered the total mix of information currently available and influenced the investment decision. When forward-looking information is involved, including a potential reverse merger and/or future change in the direction of the Company’s business, a secondary layer of materiality is triggered, which is termed the probability-magnitude test. Under the probability-magnitude test, you must also weigh the likelihood that the future event will occur and the magnitude of the effect of the future event on the Company.

Nonpublic information is any information that is not generally disseminated to the investing public. A duty of trust or confidence arises when the person is a “corporate insider” or a “temporary insider.” A corporate insider is generally an officer, director, or employee of the Company. A temporary insider relationship arises when a special confidential relationship is established between the person and the Company in the conduct of business, and that person is given access to material nonpublic information solely for corporate purposes. A temporary insider is generally an accountant, attorney, underwriter, consultant, and directors or executives of another company that are engaged in merger talks with the Company. It is important to note that the insider trading rules under the classical theory require an insider to disclose or abstain from trading. This means that the insider must abstain from trading or disclose (disseminate) to the Company and the Company’s shareholders that the insider intends to trade on the material non-public information, and describe the information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the Company and the Company’s shareholders. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Under the classical theory, the Buyers would not be considered a corporate or temporary insider, since they are not affiliated with the Company at all and a special confidential relationship has not been created between any of the Buyers and the Company. Thus, even if every other element was met, an insider trading case under the classical theory would not be brought against Buyers. Under the classical theory, the previously unaffiliated Control Block Purchaser would not be considered a corporate insider until after the purchase of the control block. However, the Control Block Purchaser could be deemed a temporary insider of the Company if the Control Block Purchaser was an officer or director of the target company that was engaged in reverse merger talks with the Company before the purchase of the control block. If it could be shown that the Control Block Purchaser was a temporary insider of the Company, then there could be liability under the classical theory unless the Control Block Purchaser disclosed their intention to trade on the information. However, in our fact scenario, the Control Block Purchaser purchases restricted stock that is not eligible to trade. In the event that the same Control Block Purchaser bought or sold stock in open market transactions, such Control Block Purchaser would be subject to insider trading liability under the classical theory.

Misappropriation Theory

Rule Description: Under the misappropriation theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed to any other person who is the source of the material nonpublic information. The previous description of “on the basis of,” materiality, and nonpublic information apply under the misappropriation theory as well. Under Rule 10b5-2(b), a duty of trust or confidence owed to the source of the information generally arises when (a) a recipient agrees with the source to maintain the information in confidence (and it is implied that the person will not trade), (b) the recipient and the source have a history, pattern, or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the source expects the recipient will maintain confidentiality, or (c) when the recipient is a close family member (spouse, parents, children, siblings) of the source. It is important to note that the insider trading rules under the misappropriation theory require the recipient to disclose or abstain from trading. This means that the recipient must abstain from trading or disclose to the source that the recipient intends to trade on the material non-public information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the source. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Let us assume that before the Transaction, the Control Block Purchaser gave the Buyers information regarding an upcoming reverse merger and/or complete change in direction of the Company’s business, which we will also assume is material and non-public information. Under the misappropriation theory, the Buyers may have a duty of trust or confidence that is owed to the Control Block Purchaser. However, it is highly unlikely that the Buyers would have agreed to maintain the information in confidence or that the Buyers and the Control Block Purchaser had a history, pattern, or practice of sharing confidences and confidentiality was expected. However, the Control Block Purchaser was most likely informed by the Buyers that the Buyers intended to purchase the Company’s shares based on the material nonpublic information, which would eliminate any deception. The Buyers, however, would need to refrain from re-selling the shares while in possession of the material non-public information, as any subsequent purchaser could claim a deceit. As long as the Buyers refrained from any public trading in the shares while in possession of the material non-public information, an insider trading case under the misappropriation theory would most likely fail.

The Control Block Purchaser would also have exposure for insider trading liability under this theory. If the Control Block Purchaser knew of the merger talks (confidence with the target company) and engaged in public trading of the stock, the Control Block Purchaser would have violated its duty of confidence to such target company.

Tipper / Tippee Theory

Rule Description: This theory is utilized when a tipper gives material nonpublic information to a tippee (recipient) in breach of a duty of trust or confidence that is owed by the tipper. Under the tipper/tippee theory, the tippee assumes the duty to disclose their intent to trade on material nonpublic information to the Company, and/or the Company’s shareholders, and/or the original source of the information, which is derivative of the duty of a corporate insider, temporary insider, or a person who owes a duty to the original source of the information as detailed in Rule 10b5-2(b) under the misappropriation theory. It must be established that the tipper breached a duty of trust or confidence when the tipper disclosed the material nonpublic information to the tippee. Generally, that breach is established when the tipper directly or indirectly benefited personally from the disclosure of the nonpublic material information to the tippee (the tipper received money or reputational benefit, or if the tipper disclosed the information to repay a debt to a relative or friend). It also must be established that the tippee knew or should have known (reckless in not knowing) that the tipper had breached their duty. Furthermore, the other elements of Section 10(b) and/or Rule 10b-5 must be established as well.

Analysis: In this case, the Control Block Purchaser may be a tipper if the Control Block Purchaser buys the control block before the Transaction, and is deemed to be a corporate or temporary insider of the Company or to have a duty of trust or confidence with the potential reverse merger candidate. It would have to be established that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders by disclosing material nonpublic information (reverse merger and/or complete change in direction of the Company’s business) about the Company to the Buyers. In the alternative, it would have to be established that the Control Block Purchaser breached their duty of trust or confidence to the potential reverse merger candidate, by disclosing material nonpublic information about the upcoming reverse merger. Some personal benefit that the Control Block Purchaser received by disclosing the material nonpublic information would have to be established. The Buyers could be considered tippees, and it could be alleged that the Buyers knew or should have known that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders.

Defenses

The most common defenses to an insider trading claim are that the information is not material, the information is already publicly known or disseminated among the investing public, and/or that there is no intent to deceive because the requisite public disclosure was made before trading.

In a situation where the Control Block Purchaser obtains the control block in the Company before the Buyers purchase their shares, it is recommended that disclosure be made, such as the filing of a Form 8-K, which discloses the anticipated reverse merger and/or complete change in direction of the Company’s business. This would make the information publicly known, and generally eliminate any exposure for insider trading.

As a safe harbor from insider trading liability, Rule 10b5-1 provides that a purchase or sale of securities will not be deemed to be on the basis of material nonpublic information if it is pursuant to a contract, instruction or plan that (i) was entered into before the person became aware of the information; (ii) specifies the amounts, prices, and dates for transactions under the plan (or includes a formula for determining them); and (iii) does not later allow the person to influence how, when or whether transactions will occur.

Conclusion

Both the Control Block Purchaser and the Buyers have exposure for insider trading liability, and each should be aware and cautioned not to publicly trade in the stock of the Company until such information is made public. However, as long as all parties are aware of the material non-public information, there is likely no cause for insider trading from the Transactions themselves.

The Author

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

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

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

Download our mobile app at iTunes and Google Play.

« FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets The ECOS Matter; When Is A Reverse Split Effective? »

FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Finra, OTC BB, OTC Markets, OTCBB, OTCQX, PinkSheets, Rule 6431

On October 7, 2014, the SEC published a release instituting proceedings to determine whether to approve FINRA’s request to delete the rules related to, and the operations of, the OTC Bulletin Board quotation service. On June 27, 2014, FINRA quietly filed a proposed rule change with the SEC seeking to adopt rules relating to the quotation requirements for OTC equity services and to delete the rules relating to the OTCBB and thus cease its operations. Although the rule filing was published in the Federal Register, it garnered no attention in the small cap marketplace. Only one comment letter, from OTC Market Group, Inc. (“OTC Markets”) (i.e., the entity that owns and operates the inter-dealer quotation system known by its OTC Pink, OTCQB and OTCQX quotation tiers) was submitted in response to the filing.

The OTCBB has become increasingly irrelevant in the OTC marketplace for years. In October 2010, I wrote a blog titled “Has the OTCBB been replaced by the OTCQX and OTCQB”; at the time and up until May 16, 2013, my opinion was “yes” with one caveat. Prior to May 16, 2013, the OTCBB was considered “an established market” but the OTCQB and OTCQX were not. On May 16, 2013, that caveat was removed (see the blog detailing the changes Here) In particular, on May 16, 2013, the SEC updated their Compliance and Disclosure Interpretations confirming that the OTCQB and OTCQX marketplaces are now considered public marketplaces for purposes of establishing a public market price when registering securities for resale in equity line financings.

Since that time, the OTCBB has been largely irrelevant, and worse, a cause of confusion in the OTC marketplace. The OTC market is comprised of publicly traded securities that are not listed on a national securities exchange. The trading platforms for OTC securities are referred to as “inter-dealer quotation systems.” Today there are two main inter-dealer quotation systems: (i) the OTC Markets comprised of OTCQX, OTCQB, and pinksheets (www.otcmarkets.com); and (ii) the FINRA owed OTCBB (www.otcbb.com). Many small cap participants believe that the OTC marketplace is comprised of a single marketplace, and are confused by the actual existence of two such marketplaces.

The regulatory framework related to inter-dealer quotation services and OTC securities in general is widely centered on ensuring compliance with Section 17B of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 17B of the Exchange Act is the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”). Although a complete discussion of the Penny Stock Act is beyond the scope of this blog, the goal of the Act is to ensure the widespread dissemination of reliable and accurate quotation information on penny stocks. Over time, the OTC Markets has become much more efficient in meeting the goals of the Penny Stock Act while at the same time, the OTCBB has become much less efficient at meeting those same goals.

As set forth in the SEC Release, “FINRA proposed to adopt rules: (1) governing the treatment of quotations in OTC equity securities by member inter-dealer quotation systems and addressing fair and non-discriminatory access to such systems; (2) requiring member inter-dealer quotation systems to provide FINRA with a written description of quotation-related data products offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives; (3) expanding the reporting requirements related to quotation information in OTC equity securities; and (4) deleting the Rule 6500 Series and related rules and thereby ceasing operation of the OTCBB.”

The FINRA rule release seeks to eliminate the OTCBB and impose governing regulations on the remaining inter-dealer quotation system—to wit, the OTC Markets comprised of the OTCQX, OTCQB, and pinksheets (www.otcmarkets.com).

Proposed Deletion of the OTCBB Related Rules and OTCBB Marketplace

FINRA is proposing to delete the FINRA Rule 6500 Series, which governs the operation of the OTCBB, and cease operation of the OTCBB. In its request, FINRA states that the level of transparency in OTC equity securities facilitated by the OTCBB has been declining significantly for years such that the amount of information widely available to investors relying on the OTCBB bid and offer data has become negligible. FINRA further expressed its belief that “the remaining OTCBB information being disseminated to investors is so incomplete as to be potentially misleading with respect to the current pricing in these securities.”

There are approximately 10,000 OTC equity securities quoted on the OTC Markets, of which less than 10% are duly quoted on the OTC Markets and OTCBB and fewer than twelve (yes, 12) are solely quoted on the OTCBB. Moreover, it is widely known in the industry that the technology used to facilitate quotation on the OTCBB is antiquated and unreliable such that broker-dealers are derisive of using the system. Accordingly, FINRA notes that the discontinuance of the OTCBB will not have an impact on issuers, investors or member firms. FINRA has also committed to take steps to ensure a smooth transition for those few issuers still using the OTCBB system, including by directly contacting these issuers and assisting with a transition to OTC Markets.

Finally, FINRA believes that the requirements related to the Penny Stock Act, and in particular widely disseminated information regarding penny stocks, better lay with the issuers, broker-dealers, and FINRA members (such as OTC Markets) rather than with FINRA itself, which is an SRO (self-regulatory organization). In other words, FINRA does not believe it needs to own and operate an inter-dealer quotation system. However, presumably to address the SEC concerns in this regard, if the availability of quotation information to investors significantly declines, FINRA has committed to revisit and, if necessary, file a proposed rule change to establish an SRO-operated inter-dealer quotation system (or other measure) to ensure that compliance with the Penny Stock Act is met.

In response to FINRA’s request to eliminate the OTCBB, the SEC received a single comment letter and it was from OTC Markets. Needless to say, OTC Markets strongly supports the proposal as well as the proposed amendments to Rule 6431 discussed below. OTC Markets welcomes the enhanced responsibility and regulations imposed upon it and FINRA’s oversight as a regulator, and it agreed with all aspects of FINRA’s proposals. OTC Markets stated that the discontinuation of FINRA’s OTCBB, together with FINRA’s expanded oversight of OTC Markets, would help eliminate investor and issuer confusion while promoting compliance with the Penny Stock Act.

OTC Markets points out that “FINRA’s OTCBB no longer provides broker-dealers with an effective service for pricing securities, and market participants will be better served by FINRA regulating Qualifying IQSs [inter-dealer quotation services] instead of expending resources trying to operate the OTCBB.”

The Proposed Regulatory Rule Changes Related to Inter-Dealer Quotation Systems

Pursuant to Section 15A of the Exchange Act, FINRA is tasked with adopting and implementing regulations designed “to produce fair and informative quotations, to prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations.” In that regard, FINRA has developed a regulatory framework including FINRA’s Rule 6400 series (Quoting and Trading in OTC Equity Securities) and Rule 5200 Series (Quotation and Trading Obligations and Practices) and the Rule 6500 series, governing the OTCBB. FINRA also owns and operates the OTCBB.

The current regulatory framework governs the FINRA member firm’s quotation activity and not the inter-dealer quotation service itself. That is, the current regulatory framework governs the broker-dealers/FINRA member firms’ activities in entering quotes on the inter-dealer quotation system, but does not impose rules or regulations on the inter-dealer quotation system itself.

For example, there are rules that require FINRA members to either file a Form 211 with FINRA including due diligence and disclosure on the company whose securities are being quoted, or be able to rely on another firm’s 211 filing (piggyback qualified) prior to initiating a quote; rules related to minimum bid price increments ($0.0001 for OTC equity securities priced under $1.00 and $.01 for those priced over $1.00); rules prohibiting cross-quotation; rules requiring the display of customer limit orders; and a requirement that any quoted bid or asked price represent a bona fide bid for or offer of such security (i.e., the “fictitious quotation” prohibition).

FINRA is now proposing to adopt rules that regulate the inter-dealer quotation service itself, which after elimination of the OTCBB will be comprised of the OTC Markets, including the OTCQX, OTCQB, and pinksheets.

Proposed Rule 6431 Amendment

FINRA is proposing to implement new regulations by amending Rule 6431 to require OTC Markets (or any inter-dealer quotation service) to: “(1) adopt and provide to FINRA written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities, (2) establish and provide to FINRA fair and non-discriminatory written standards for granting access to quoting and trading on its system, and (3) provide to FINRA for regulatory purposes a written description of each quotation-related data product offered by such member inter-dealer quotation system and related pricing information, including fees, rebates, discounts and cross-product pricing incentives.”

Rule 6431 (Recording of Quotation Information) was originally implemented in 2003 to provide FINRA with access to quotation information on the OTC marketplace. When implemented, FINRA member broker-dealers had the duty to independently report to FINRA when quoting on the OTC Markets, because at the time OTC Markets was not, in and of itself, a FINRA member. Since that time, OTC Markets has become a licensed ATS (Alternative Trading System) and FINRA member. The proposed Rule 6431 amendment includes an adjustment such that now OTC Markets will be required to provide the quotation information and the broker-dealer will not. In practice, OTC Markets has been submitting the information on behalf of member firms already, and the rule change will codify this practice and officially relieve the broker-dealer member firm from the obligation.

As the vast majority of securities quoted on the OTC markets are also penny stocks, the new rules will also bolster the Exchange Act requirements related to ensuring the availability and dissemination of reliable and accurate information on penny stocks.

(1) Written policies and procedures relating to the collection and dissemination of quotation information

The amended Rule 6431 would require OTC Markets (or any inter-dealer quotation service) to establish, maintain and enforce fair and reasonable written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities. Such policies and procedures must ensure that quotations received are treated fairly and consistently and include methods for prioritizing and displaying such quotations. In simple terms, if an investor enters a buy or sell order with a broker, or a market maker enters such buy or sell order for their own account, there must be systems in place to ensure that that order is treated fairly vis-a-vis competing buy and sell orders on behalf of other investors through other brokerage firms and market makers.

In that regard, under amended Rule 6431, the OTC Markets will be required to address its method for ranking quotations, including factors such as price, size, time, capacity and type of quotation and any other factors used or considered in ranking and displaying quotations. OTC Markets will also be required to provide FINRA with a copy of its written policies and procedures relating to the collection and dissemination of quotation information, and any material updates, modifications and revisions thereto, upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written policy or procedure.

(2) Written standards for granting access to quoting and trading on its system

The amended Rule 6431 would require OTC Markets to establish “fair and non-discriminatory written standards for granting access to quoting and trading on the system that do not unreasonably prohibit or limit any person in respect to access to services offered by such inter-dealer quotation system.” In addition, OTC Markets will be required to keep records of all grants of access and denials or limitations of access, including the reasons for denying or limiting access. OTC Markets must provide FINRA with a copy of these written standards upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written standards.

(3) Written description of each quotation-related data product and related pricing information

The amended Rule 6431 would require OTC Markets to prepare a written description of each quotation-related product offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives—for example, the listing requirements for the OTCQB including application and annual fees (see Here); the OTC Disclosure and News Service; and the various other products and services offered by OTC Markets. OTC Markets must provide FINRA with a copy of the written product descriptions upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such products or pricing.

SEC Proceedings Related to Approval of the Proposals

The SEC has instituted proceedings to determine whether the proposed rule changes, including elimination of the OTCBB, should be approved. The SEC is requesting comments from interested persons in support or opposition to the change. The SEC notes that in considering the proposal, it must (i) determine whether the changes are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest”; (ii) the rules include provisions governing the form and content of quotations on the OTC marketplace; and (iii) whether the rules support the Penny Stock Act.

The SEC has opened a 21-day total period to submit comments and a 35-day total comment period including time for rebuttals to submitted comments.

Brief Commentary

First, like OTC Markets, I am proponent of the rule changes all around. The discontinuation of the OTCBB is a natural and necessary progression of the reality of the marketplace.

However, neither the legal publications by FINRA or the SEC nor the comment letter from OTC Markets address some basic market realities. That is, with the elimination of the OTCBB and the implementation of listing standards and fees associated with quotation on the OTCQB, a new regime has been established for OTC market securities. Penny Stock issuers that are subject to the reporting requirements of the Exchange Act will no longer have the ability to achieve the turnkey credibility associated with not being a pinksheet.

Although pinksheets will now include a large class of entities that are subject to the Exchange Act reporting requirements, in order to achieve a level of credibility and prestige, such issuers will be required to meet the quotation standards and pay the fees associated with listing on the OTCQB or OTCQX. I wonder if issuers that do not meet the standards for the OTCQB will opt to cease being subject to the Exchange Act reporting requirements in a sort of acquiescence to the new regime – i.e., if we are going to be a pinksheet anyway, why report, resulting in an overall reduced level of disclosure in the OTC marketplace.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

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 and Google Play.

« Penny Stock Rules And Broker Dealers Insider Trading- A Case Study »

Penny Stock Rules And Broker Dealers

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: penny stock, penny stock act, penny stock issuer, Penny Stock Rules, Schedule 15G, Section 15(h), Section 17B

In last week’s blog regarding FINRA’s request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, I touched upon the significance of penny stock rules related to the OTC marketplace. As further described herein, penny stocks are low-priced securities (under $5.00 per share) and are considered speculative and risky investments.

Penny stock rules focus on the activity of broker-dealers in effectuating trades in penny stocks. As a result of the risk associated with penny stock trading, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) requiring the SEC to enact rules requiring brokers or dealers to provide disclosures to customers effecting trades in penny stocks. The rules prohibit broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder and, in particular, Exchange Act rules 15g-1 through 15g-100 (the “penny stock rules”).

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.

Definition of Penny Stock

A penny stock is defined in Exchange Act Rule 3a51-1. Like many SEC rules, the penny stock rule begins by including all equity securities and then carves out exemptions (for example, all offers and sales of securities must be registered unless an exemption applies). In particular, Rule 3a51-1 defines a penny stock as any equity security other than:

(a) A NMS (national market system) stock that is a reported security that is (i) registered on a national securities exchange that is grandfathered in because it has been in continuous operation since prior to April 20, 1992; or (ii) is quoted on either a national securities exchange or automated quotation system that that has certain quantitative initial listing standards and continued listing standards that are reasonably related to the initial listing standards. The initial listing standards must meet or exceed the following criteria: (a) the issuer must have $5 million of stockholders’ equity, market value of listed securities of $50 million for 90 consecutive days prior to applying, or net income of $750,000 (excluding extraordinary or non-recurring items) in the most recently completed fiscal year or in two or the last three most recently completed fiscal years; (b) the issuer must have an operating history of at least one year or a market value of listed securities of $50 million; (c) the issuer’s stock must have a minimum bid price of $4 per share; (d) there shall be at least 300 round lot holders of common stock; and (e) there must be at least 1,000,000 publicly held common shares with a market value of at least $5 million.

(b) Is issued by an investment company registered under the Investment Company Act of 1940, as amended

(d) Has an inside bid quotation price of $5.00 (the Rule requires that the price be net of broker or dealer commissions, mark-up or mark-downs)

(e) Is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule

(f) Is a security futures product listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association; or

(g) Whose issuer has: (i) net tangible assets (as calculated in accordance with the rule) in excess of $2 million, if the issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (ii) average revenue (as calculated in accordance with the rule) of at least $6 million for the last three years.

Section 15(h) of the Exchange Act

Broker-dealers are required to comply with the penny stock rules, which rules center around disclosure of the risks and other market information associated with penny stock transactions and a determination of the suitability of the customer to engage in such high-risk transactions. Section 15(h) of the Exchange Act provides that no broker or dealer may effectuate the purchase or sale of any penny stock by a customer unless such broker or dealer (i) approves the customer for the specific penny stock transaction and receives from the customer a written agreement to the transaction; (ii) furnishes the customer a risk disclosure document describing the risks of investing in penny stocks; (iii) discloses to the customer the current market quotation, if any, for the penny stock, including the bid and ask price and the number of shares that apply to such bid and ask price; and (iv) discloses to the customer the amount of compensation the firm and its broker will receive for the trade. In addition, after executing the sale, a broker-dealer must send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Section 15(h) requires that the risk disclosure document include (i) a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (ii) a description of the broker or dealer’s duties to the customer and of the rights and remedies available to the customer with respect to violations of such duties or other requirements under the federal securities laws; (iii) a brief, clear, narrative description of a dealer market, including “bid” and “ask” prices for penny stocks and the significance of the spread between the bid and ask prices; (iv) contains the toll-free telephone number for inquiries on disciplinary actions; (v) defines significant terms used in the disclosure document or in the conduct of trading in penny stocks; and (vi) contains such information, and is in such form as the SEC requires.

Section 15(h) also requires the SEC to adopt rules setting forth additional standards for the disclosure by brokers and dealers to customers concerning transactions in penny stocks. As indicated above, those rules can be found in Exchange Act Rules 15g-1 through 15g-100.

The Penny Stock Rules – Penny Stock Disclosure Requirements

Brokers and dealers that are subject to the penny stock rules (see exclusions below set forth in Rule 15g-1) are required to comply with the penny stock disclosure requirements set forth in Rules 15g-2 through 15g-9.

Exchange Act Rule 15g-2 requires the delivery of a Schedule 15G and, in particular, makes it “unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless, prior to effecting such transaction, the broker or dealer has furnished to the customer a document containing the information set forth in Schedule 15G, Rule 15g-100, and has obtained from the customer a manually signed and dated written acknowledgement of receipt for the document.”

Rule 15g-3 requires the disclosure of quotations and other information relating to the penny stock market. Rule 15g-3 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with (i) the inside bid and offer quotation; (ii) where there is no inside bid and offer, the dealer’s bid or offer; and (iii) the number of shares to which the bid and offer apply.

Rule 15g-4 requires the disclosure of compensation to the broker or dealers. Rule 15g-4 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with the aggregate amount of any compensation received by such broker or dealer in connection with such transaction. Similarly, Rule 15g-5 requires the disclosure of the compensation to the natural person associated with the broker dealer, related to the penny stock transaction. Rule 15g-6 requires the broker-dealer to send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Rule 15g-9(a)(2) provides that, prior to effecting certain transactions in penny stocks, brokers and dealers must approve an investor’s account for transactions in penny stocks and receive a written agreement from the investor that provides the quantity of the particular stock to be purchased. In order to approve an investor’s account, the broker or dealer must obtain information regarding the investor’s financial situation, investment experience and investment objectives. Based on this information, the broker or dealer must determine whether transactions in penny stocks are suitable for the investor and whether the investor, or his or her adviser, has sufficient knowledge and experience to evaluate the associated risks. This determination must be delivered to the investor in writing and must be signed by the investor and returned to the broker or dealer prior to the broker or dealer effecting the trade.

In addition to the exemptions contained in Rule 15g-1 described below, no suitability determination need be made for established customers. Established customers are those that have held an account and effected transactions with that broker or dealer for more than one year prior to the subject penny stock transaction, or have made at least three purchases of penny stocks on different days and involving different issuers.

Schedule 15G

Schedule 15G is commonly referred to as the “penny stock disclosure document.” Rule 15g-100 contains the complete text of Schedule 15G. Schedule 15G may be delivered electronically, including by a link to the schedule on the SEC website. Schedule 15G sets forth information a customer must receive from the broker or dealer including the current market quotation, if any, for the penny stock, the bid and ask price and the number of shares that apply to such bid and ask price and discloses to the customer the amount of compensation the firm and its broker will receive for the trade. Schedule 15G can be read in its entirety Here.

If sent by e-mail, no other information can be included other than instructions on how to provide the broker-dealer with a signed acknowledgment of receipt and a standard privacy or confidentiality message.

Cooling-off Period

Rule 15g-2 also requires a two day “cooling-off” period after sending the Schedule 15G to the customer prior to effectuation of the penny stock transaction. Similarly, Rule 15g-9 to require a broker or dealer to wait two business days after sending its suitability determination and the transaction agreement to an investor before effecting a transaction.

Exclusions to Application of Penny Stock Rules to Broker-Dealers

Rule 15g-1 contains certain exclusions to the penny stock rule requirements and, in particular, exclusions for certain broker-dealers and certain transactions. Broker-dealers whose total commissions in penny stocks comprise less than 5% of its total generated commissions and who do not act as market makers for penny stocks are exempted from compliance with certain of the penny stock rules, including the requirement to furnish a Schedule 15G and to make a suitability determination. In addition, no Schedule 15G must be provided and no suitability determination must be made (i) for institutional accredited investors; (ii) for transactions involving private Regulation D offerings; (iii) where the customer is the issuer or an officer, director, or 5% or greater shareholder of the issuer; (iv) transactions that are not recommended by the broker or dealer; or (v) for transactions or persons for which the SEC grants an exemption.

Section 17B of the Exchange Act

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, establishes and regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks. The preamble to Section 17B finds that (i) “the market for penny stocks suffers from a lack of reliable and accurate quotation and last sale information available to investors and regulators” and (ii) “it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to improve significantly the information available to brokers, dealers, investors, and regulators with respect to quotations for and transactions in penny stocks.”

In that regard, Section 17B requires the SEC to “facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.” Ensuring compliance with Section 17B is a focus of the recent FINRA request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, which was the subject of my blog last week.

Other Significances Related to Penny Stocks

Penny Stock issuers may not avail themselves of certain disclosure or offering rules and benefits afforded their non-penny stock counterparts. Rule 405, promulgated under the Securities Act of 1933 (the “Securities Act”), contains a definition of “ineligible issuer” which definition includes penny stock issuers. Certain disclosure and offering rules throughout the Securities Act exclude “ineligible issuers,” including penny stock issuers.

For example—and this is not meant to be an exhaustive summary—a penny stock issuer may not use a free writing prospectus in conjunction with the registered offering of securities. A well-known seasoned issuer (WKSI) cannot be a penny stock issuer. A penny stock issuer may not incorporate by reference into a Form S-1. Rule 419 applies to all registered offerings of securities by blank check companies when the securities are penny stocks.

To be eligible to trade on the OTC Markets OTCQX trading platform, an issuer must meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of U.S. $5 or more; or (ii) have net tangible assets of U.S. $2 million if the company has been in continuous operation for at least three years, or U.S. $5,000,000 if the company has been in continuous operation for less than three years; or (iii) have average revenue of at least U.S. $6,000,000 for the last three years.

The Author

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

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

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

Download our mobile app at iTunes and Google Play.

« Risk Factor Disclosures For Reporting Public Companies FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets »

Risk Factor Disclosures For Reporting Public Companies

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Item 503, Regulation C, Regulation S-K, Risk Factor Disclosures, Risk Factors, Safe Harbor, Section 21E

A risk factor disclosure involves a discussion of circumstances, trends, or issues that may affect a company’s business, prospects, operating results, or financial condition. Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act. In addition, risk factors must be included in private offering documents where the exemption relied upon requires the delivery of a disclosure document, and is highly recommended even when such disclosure is not statutorily required.

The Importance of Risk Factors

Risk factors are one of the most often commented on sections of a registration statement. The careful crafting of pertinent risk factors can provide leeway for more robust discussion on business plans and future operations, and can satisfy a wide arrange of SEC concerns regarding existing financial and non-financial matters (such as potential default provisions in debt, dilution matters, inadvertent rule violations, etc.).

Although smaller reporting companies are not required to include risk factors in their annual Form 10-K and quarterly Form 10-Q, they may do so voluntarily and we recommend that such risk factors be included in their annual Form 10-K. As a reminder, a “smaller reporting company” is an issuer that is not an investment company or asset-backed issuer or majority-owned subsidiary and that (i) had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter; or (ii) in the case of an initial registration statement, had a public float of less than $75 million as of a date within days of the filing of the registration statement; or (iii) in the case of an issuer whose public float as calculated by (i) or (ii) is zero, had annual revenues of less than $75 million during the most recently completed fiscal year for which audited financial statements are available.

Risk factors, together with safe harbor language regarding forward-looking statements, can provide protection for forward-looking information contained in a document, such as plans and expectations, that do not pan out as expected or intended. Risk factors warn current and potential investors as to the risks of either purchasing or continuing to own the company’s stock. As the securities of smaller reporting companies are often high-risk penny stocks or thinly traded, and such companies tend to be in the business development and growth stage of their corporate life cycle, protections against failed or changed plans is fundamental.

By providing proper disclosure of the material risks associated with investing in a company’s securities, a company can mitigate the risk of liability to its shareholders should that risk come to pass. Risk factors act as an insurance policy and strong defense in the face of shareholder litigation.

The “bespeaks caution” doctrine refers to a line of judicial case law holding that statements of future forecasts, projections and expectations in an offering or other disclosure document are not misleading as long as they contain adequate cautionary language disclosing specific risks. Section 21E of the Exchange Act, enacted as part of the Private Securities Litigation Reform Act of 1995, codifies this doctrine for qualifying issuers. Section 21E provides a public company with a safe harbor defense in securities litigation challenging forward-looking statements. Among other exclusions, companies that issue penny stocks may not rely on Section 21E, but may rely on the “bespeaks caution” line of case law.

To avail itself of the safe harbor protection, the forward-looking statements must be identified and be accompanied by meaningful, cautionary language that identifies important factors that could cause actual results to differ materially from those projected—i.e., risk factors. To provide protection, the risk disclosure must be specific, not just boilerplate.

SEC Rules and Guidance on Risk Factors

Regulation S-K sets forth the non-financial statement disclosure requirements for both the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) and is applicable to both registration statements and ongoing reporting requirements. In addition, Regulation S-K serves as a guide in the preparation of private placement disclosure documents. Items 501 and 503 of Regulation S-K include the requirements for the disclosure of risk factors.

Risk factors must be disclosed in registration statements under the Securities Act and registration statements and reports under the Exchange Act. Item 503 of Regulation S-K requires concise, logically organized statements of the particular risks involving either the company, industry or the offering being made by the company. The statements should be categorized and appear in order of importance under each category. Item 503 requires that the disclosure of risk factors in a registration statement be included in the beginning immediately following the summary section, or if there is no summary section, immediately following the cover page.

Item 501 requires that the risk factor section must be prominently cross-referenced by page number, on the cover page of a registration statement. Most companies comply with this rule by using bold, italics, larger font size or a combination thereof to comply with this rule.

Risk factor disclosures cannot contain countervailing or offsetting language. That is, a company cannot explain away the risk.

Like many areas of securities laws, the SEC gives broad guidance on disclosure, trying to avoid boilerplate language. The SEC requires the reporting company to make relevant risk factor disclosures that are germane, concise and written in plain English. The risk factors should be written as of the date of the report in which they are contained regardless of the period of the financial statements contained in such report. Each risk must have a heading that adequately describes the risk being disclosed and such heading should be bolded, italicized or both. Each risk must be concise and focused on a single material risk. The risks must be easy to read and written in such a way to highlight the most important information.

As mentioned above, the SEC requires that the risks be written in plain English. This requirement is codified in Rule 421(d) of Regulation C. Over the years, the SEC has published and updated plain English handbooks. The SEC plain English guidelines require that the risk factor section contain (i) short sentences; (ii) definitive, concrete, everyday words; (iii) active voice; (iv) tables or bullet point lists, whenever possible; (v) no legal jargon or highly technical business terms; and (vi) no multiple negatives.

Categories of Risk Factors

In general, risk factors pertain to the company, the industry, or the investment or offering. Company risks are those specific to the reporting company such as particular restrictive covenant documents, reliance or dependence on a concentrated source, or a history of losses. Industry risks are particular to the industry of the reporting company, such as technology, manufacturing, textile, or commonly in today’s market, cannabis. Investment or offering risks are those specifically tied to the security or trading market for the company’s securities, such as illiquidity. The risks included in each category should be organized in the order of materiality and importance.

The common broad areas of risk factor disclosure include:

Absence of an operating history;
Absence of revenues;
Absence of profits;
An accumulated deficit;
High degree of leverage (debt);
Dependence on a single or small number of products, suppliers, customers, manufacturers or markets;
Dependence on key personnel;
Dependence on particular financial resources or source of capital;
Early stage of product development;
Competition;
Adequacy of production and/or distribution;
Technological factors such as possible obsolescence;
Capital needs and the lack of adequate current or future funding;
A concentration of voting control in management or others;
The absence of a trading market or a thinly traded, low-priced market;
Litigation;
Governmental regulations;
Foreign operations and the effects of foreign regulations, export laws, and currency fluctuations;
Labor matters;
Intellectual property matters;
Restrictive covenants in contracts; and
Off-balance sheet arrangements

Risks that apply to any issuer or any offering should be avoided. For example, a general statement that an economic downturn would negatively impact a business should not be included; however, a concise statement that a particular economic change, such as a reduction or increase in the federal interest rate (or whatever change impacts the reporting business), and the particular risk associated with that change, could be included. Specific example are encouraged.

Typical SEC Comments on Risk Factors

Risk factors are one of the most often commented on sections of a registration statement or SEC report. These common SEC comments illustrate the SEC’s focus in reviewing risk factor disclosures.

We suggest that you revise your risk factor captions to make your disclosure more meaningful to your investors and shareholders. Some of your risk factors merely state a fact about your business. You should succinctly state in your captions the particular risk that results from the uncertainty.
Some of your risk factors are too vague and generic and do not adequately describe the risk that follows. Readers should be able to read the risk factor heading and come away with a strong understanding of what the risk is and the result of the risk as it specifically applies to you. Revise your subheadings accordingly.
In each risk factor, get to the risk as quickly as possible and provide only enough detail to place the risk in context. In some of your risk factors, the actual risk you are trying to convey does not stand out from the rest of the information.
Avoid presenting risks that could apply to any issuer in your industry, do not reflect your current operations, are not material, or are generic, boilerplate disclosures. Rather, tailor each risk factor to your specific facts and circumstances.
Revise each risk to remove mitigating information.
Consider including a risk factor that addresses XYZ.
Provide the information investors need to assess the magnitude of the risk.
Where possible, quantify the risk.
The introductory paragraph to your risk factors section is not complete, there may be risks that you do not consider material now but may become material, or there may be risks that you have not yet identified. You must disclose all risks that you believe are material at this time.
You include more than one risk under one subheading. Revise to include only one risk under each subheading.

As always, competent legal counsel should be utilized in crafting SEC reports and/or offering disclosure documents.

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

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 and Google Play.

« SEC Suspends Trading On 128 OTC Markets Companies Penny Stock Rules And Broker Dealers »

SEC Suspends Trading On 128 OTC Markets Companies

Posted by Securities Attorney Laura Anthony | March 11, 2015

On March 2, 2015, the Securities and Exchange Commission (SEC) suspended the trading in 128 dormant shell companies trading on the OTC Link. The SEC suspended the trading in these shell companies because of questions regarding the accuracy and adequacy of publicly disseminated information concerning the companies’ operating status, if any.

The SEC notes in its release that OTC Markets had been unable to contact each of the issuers for more than one year. None of the subject issuers had filed any information or updated with either OTC Markets or the SEC in over a year. The SEC staff then independently attempted to contact the issuers and was able to contact 10 of the 128 companies and confirm from those ten that they had either ceased operations or gone private.

The trading suspensions are part of an SEC initiative tabbed Operation Shell-Expel by the SEC’s Microcap Fraud Working Group. As part of the initiative, the SEC Enforcement Division’s Office of Market Intelligence utilizes technology to search OTC traded securities and identify dormant companies. The SEC has a concern that unscrupulous individuals will take over the companies without the legal right to do so (corporate hijacking) and use the company to conduct a pump-and-dump scheme.

Since 2012, Operation Shell-Expel has suspended trading in more than 800 OTC companies. The federal securities laws allow the SEC to suspend trading in any stock for up to 10 business days. Once a company is suspended from trading, it cannot be quoted again until it provides updated information including complete disclosure of its business and accurate financial statements. In addition to providing the necessary information, to begin to trade again, a company must enlist a market maker to file a new 15c2-11 application with FINRA.

For a company with a trading suspension, this is a difficult process if not impossible. Many market makers are unwilling to take on the assignment and when they do, the comment process with FINRA can be lengthy and arduous. FINRA is charged with regulating the OTC Markets and taking measures to prevent potential fraud. In the case of a defunct or dormant entity, FINRA will exercise its full authority to conduct an in-depth review of the company history and associated people. Moreover, even if a 211 application is approved by FINRA, DTC may still refuse to qualify the security for electronic trading.

Bottom line, short of a new registration statement and going public process, these companies have effectively been removed from the public company trading system.

The SEC continues to send the message that companies without current information will not be allowed to trade. Moreover, the SEC has become much quicker at identifying and shutting down dormant shell companies.

The Author

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

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

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

Download our mobile app at iTunes and Google Play.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

« Once Again, DTC Amends Proposed Procedures For Issuers Affected By Chills And Proposes Subsequent Rule Change Risk Factor Disclosures For Reporting Public Companies »