January 2016 - Reverse-Merger.com

FINRA Proposes New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | January 26, 2016 Tags: Broker Dealer, CAB

In December, 2015, FINRA proposed rules for a whole new category of broker-dealer, called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. In February 2014 FINRA sought comment on the proposal, which at the time referred to a CAB as a limited corporate financing broker (LCFB). Following many comments that the LCFB rules did not have a significant impact on the regulatory burden for full member firms, the new rules modify the original LCFB proposal in more than just name. The new rules will take effect upon approval by the SEC and are currently open to public comments.

A CAB will generally be a broker-dealer that engages in M&A transactions, raising funds through private placements and evaluating strategic alternatives and that collects transaction based compensation for such activities. A CAB will not handle customer funds or securities, manage customer accounts or engage in market making or proprietary trading.

As with all FINRA rules, the proposed CAB rules are designed to comply with Section 15A of the Exchange Act related to FINRA rules and, in particular, that such rules be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principals of trade, and in general to protect investors and the public interest.

What is a Capital Acquisition Broker (“CAB”)?

There are currently FINRA registered firms which limit their activities to advising on mergers and acquisitions, advising on raising debt and equity capital in private placements or advising on strategic and financial alternatives. Generally these firms register as a broker because they may receive transaction-based compensation as part of their services. However, they do not engage in typical broker-dealer activities, including carrying or acting as an introducing broker for customer accounts, accepting orders to purchase or sell securities either as principal or agent, exercising investment discretion over customer accounts or engaging in proprietary trading or market-making activities.

The proposed new rules will create a new category of broker-dealer called a Capital Acquisition Broker (“CAB”). A CAB will have its own set of FINRA rules but will be subject to the current FINRA bylaws and will be required to be a FINRA member. FINRA estimates there are approximately 750 current member firms that would qualify as a CAB and that could immediately take advantage of the new rules.

FINRA is also hopeful that current firms that engage in the type of business that a CAB would, but that are not registered as they do not accept transaction-based compensation, would reconsider and register as a CAB with the new rules. In that regard, FINRA’s goal would be to increase its regulatory oversight in the industry as a whole. I think that on the one hand, many in the industry are looking for more precision in their allowable business activities and compensation structures, but on the other hand, the costs, regulatory burden, and a distrust of regulatory organizations will be a deterrent to registration. It is likely that businesses that firmly act within the purview of a CAB but for the transactional compensation and that intend to continue or expand in such business, will consider registration if they believe they are “leaving money on the table” as a result of not being registered. Of course, such a determination would include a cost-benefit analysis, including the application fees and ongoing legal and compliance costs of registration. In that regard, the industry, like all industries, is very small at its core. If firms register as a CAB and find the process and ongoing compliance reasonable, not overly burdensome and ultimately profitable, word will get out and others will follow suit. The contrary will happen as well if the program does not meet these business objectives.

A CAB will be defined as a broker that solely engages in one or more of the following activities:

Advising an issuer on its securities offerings or other capital-raising activities;

Advising a company regarding its purchase or sale of a business or assets or regarding a corporation restructuring, including going private transactions, divestitures and mergers;

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;

Qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in respect to the purchase or sale of unregistered securities (see below for the FINRA definition of institutional investor, which is much different and has a much higher standard than an accredited investor);

Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no action letters. For more information on this, see my blog HERE regarding the SEC no action letter granting a broker registration exemption for certain M&A transactions.

Since placing securities in private offerings is limited to institutional investors, that definition is also very important. Moreover, FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. Under the proposed CAB Rules, an institutional investor is defined to include any:

Bank, savings and loan association, insurance company or registered investment company;

Government entity or subdivision thereof;

Employee benefit plan that meets the requirements of Sections 403(b) or 457 of the Internal Revenue Code and that has a minimum of 100 participants;

Qualified employee plans as defined in Section 3(a)(12)(C) of the Exchange Act and that have a minimum of 100 participants;

Any person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million;

Persons acting solely on behalf of any such institutional investor; and

Any person meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (i.e., any natural person that owns at least $5 million in investments; family offices with at least $5 million in investments; trusts with at least $5 million in investments; any person acting on their own or as a representative with discretionary authority, that owns at least $25 million in investments).

A CAB will not include any broker that does any of the following:

Carries or acts as an introducing broker with respect to customer accounts;Holds or handles customers’ funds or securities;

Accepts orders from customers to purchase or sell securities either as principal or agent for the customer;

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making;

Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act (interesting that FINRA would include Regulation A in this, as currently no license is required at all to maintain such a platform – only platforms for Regulation Crowdfunding require such a license).

Application; Associated Person Registration; Supervision

A CAB firm will generally be subject to the current member application rules and will follow the same procedures for membership as any other FINRA applicant with four main differences. In particular: (i) the application has to state that the applicant will solely operate as a CAB; (ii) the FINRA review will consider whether the proposed activities are limited to CAB activities; (iii) FINRA has set out procedures for an existing member to change to a CAB; and (iv) FINRA has set out procedures for a CAB to change its status to regular full-service FINRA member firm.

The CAB rules also set out registration and qualification of principals and representatives, which incorporate by reference to existing NASD rules, including the registration and examination requirements for principals and registered representatives. CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs will also be subject to current rules regarding Operations Professional registration.

CABs would have a limited set of supervisory rules, although they will need to certify a chief compliance officer and have a written anti-money laundering (AML) program. In particular, the CAB rules model some, but not all, of current FINRA Rule 3110 related to supervision. CABs will be able to create their own supervisory procedures tailored to their business model. CABs will not be required to hold annual compliance meetings with their staff. CABs are also not subject to the Rule 3110 requirements for principals to review all investment banking transactions or prohibiting supervisors from supervising their own activities.

CABs would be subject to FINRA Rules 3220 – Influencing or Rewarding Employees of Others, Rule 3240 – Borrowing form or Lending to Customers, and Rule 3270 – Outside Activities of Registered Persons.

Conduct Rules for CABs

The proposed CAB rules include a streamlined set of conduct rules. This is a brief summary of some of the conduct rules related to CABs. CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Rules 2080 and 2081 regarding expungement of customer disputes; and the FINRA arbitration requirements in Rules 2263 and 2268. CABs will also be subject to know-your-customer and suitability obligations similar to current FINRA rules for full-service member firms, and likewise will be subject to the FINRA exception to that rule for institutional investors. CABs will be subject to abbreviated rules governing communications with the public and, of course, prohibitions against false and misleading statements.

CABs are specifically not subject to FINRA rules related to transactions not within the purview of allowable CAB activities. For example, CABs are not subject to FINRA Rule 2121 related to fair prices and commissions. Rule 2121 requires a fair price for buy or sell transactions where a member firm acts as principal and a fair commission or service charge where a firm acts as an agent in a transaction. Although a CAB could act as an agent in a buy or sell transaction where a counter-party is an institutional investor or where it arranges securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no action letters on such M&A deals, FINRA believes these transactions are outside the standard securities transactions that typically raise issues under Rule 2121.

Financial and Operational Rules for CABs

CABs would be subject to a streamlined set of financial and operational obligations. CABs would be subject to certain existing FINRA rules including, for example, audit requirement, maintenance of books and records, preparation of FOCUS reports and similar matters.

CABs would also have net capital requirements and be subject to suspension for non-compliance. CABs will be subject to the current net capital requirements set out by Exchange Act Rule 15c3-1.

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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« The SEC Issues Guidance On The FAST Act As It Relates To Savings And Loan Companies SEC Issues Rules Implementing Certain Provisions Of The FAST Act »

The SEC Issues Guidance On The FAST Act As It Relates To Savings And Loan Companies

Posted by Securities Attorney Laura Anthony | January 19, 2016 Tags: SEC, The Fast Act

On December 4, 2015, President Obama signed the Fixing America’s Surface Transportation Act (the “FAST Act”) into law, which included many capital markets/securities-related bills. The FAST Act is being dubbed the JOBS Act 2.0 by many industry insiders. The FAST Act has an aggressive rulemaking timetable and some of its provisions became effective immediately upon signing the bill into law on December 4, 2015.

On December 10, 2015, the SEC Division of Corporate Finance addressed the FAST Act by making an announcement with guidance and issuing two new Compliance & Disclosure Interpretations (C&DI). As the FAST Act is a transportation bill that rolled in securities law matters relatively quickly and then was signed into law even quicker, this was the first SEC acknowledgement and guidance on the subject.

My blog on the FAST Act and the first two C&DI on the Act can be read HERE.

On December 21, 2015, the SEC issued 4 additional C&DI on the FAST Act. Each of the new C&DI addresses the FAST Act’s impact on Section 12(g) and Section 15(d) of the Exchange Act.

Section 85001 of the FAST Act amends Section 12(g) and Section 15(d) of the Securities Exchange Act such that savings and loan holding companies are treated similar to banks for purposes of the registration, termination of registration and suspension of reporting obligations under the Exchange Act.

In particular, the FAST Act amends Section 12(g) and Section 15(d) of the Exchange Act as follows:

Savings and loan holding companies, as such term is defined in Section 10 of the Home Owners’ Loan Act, will have a Section 12(g) registration obligation as of any fiscal year-end after December 4, 2015, with respect to a class of equity security held of record by 2,000 or more persons.

The holders of record threshold for Section 12(g) deregistration for savings and loan holding companies has been increased from 300 to 1,200 persons.

The holders of record threshold for the suspension of reporting under Section 15(d) for savings and loan holding companies has been increased from 300 to 1,200 persons.

The new guidance explains the timing of the new provisions. The SEC clarifies:

Under Section 12(g)(1)(B), a savings and loan holding company will have a Section 12(g) registration obligation if, as of any fiscal year-end after December 4, 2015, it has total assets of more than $10 million and a class of equity security held of record by 2,000 or more persons. We consider that the effect of this provision is to eliminate, for savings and loan holding companies, any Section 12(g) registration obligation with respect to a class of equity security as of a fiscal year-end on or before December 4, 2015. Therefore, if a savings and loan holding company has filed an Exchange Act registration statement and the registration statement is not yet effective, then it may withdraw the registration statement. If a savings and loan holding company has registered a class of equity security under Section 12(g), it would need to continue that registration unless it is eligible to deregister under Section 12(g) or current rules.

Similarly as relates to the termination of registration:

If the class of equity security is held of record by less than 1,200 persons, the savings and loan holding company may file a Form 15 to terminate the Section 12(g) registration of that class. Until rule amendments are made to reflect the change to Section 12(g)(4), the savings and loan holding company should include an explanatory note in its Form 15 indicating that it is relying on Exchange Act Section 12(g)(4) to terminate its duty to file reports with respect to that class of equity security.

Pursuant to Section 12(g)(4), the Section 12(g) registration will be terminated 90 days after the savings and loan holding company files a Form 15. Until that date of termination, the savings and loan holding company is required to file all reports required by Exchange Act Sections 13(a), 14 and 16.

Alternatively, a savings and loan holding company could rely on Exchange Act Rule 12g-4, which permits the immediate suspension of Section 13(a) reporting obligations upon filing a Form 15, if it meets the requirements of that rule. Note that Rule 12g-4 has not yet been amended to incorporate the new 1,200 holder deregistration threshold.

Finally, as relates to the suspension of reporting obligations:

In general, the Section 15(d) reporting obligation is suspended if, and for so long as, the issuer has a class of security registered under Section 12. When an issuer terminates Section 12 registration, it must address any Section 15(d) obligation that would apply once the Section 15(d) suspension is lifted.

For the current fiscal year, a savings and loan holding company can suspend its obligation to file reports under Section 15(d) with respect to a class of security that was sold pursuant to a Securities Act registration statement and that was held of record by less than 1,200 persons as of the first day of the current fiscal year. Such suspension would be deemed to have occurred as of the beginning of the fiscal year in accordance with Section 15(d) (as amended by the FAST Act). If, during the current fiscal year, a savings and loan holding company has a registration statement that becomes effective or is updated pursuant to Securities Act Section 10(a)(3), then it will have a Section 15(d) reporting obligation for the current fiscal year.

If a savings and loan holding company with a class of security held of record by less than 1,200 persons as of the first day of the current fiscal year has a registration statement that was updated during the current fiscal year pursuant to Securities Act Section 10(a)(3), but under which no sales have been made during the current fiscal year, the savings and loan holding company may suspend its Section 15(d) reporting obligation consistent with the guidance in Staff Legal Bulletin No. 18 (March 20, 2010) and GlenRose Instruments Inc. (July 16, 2012).

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 Issues Report On Accredited Investor Definition FINRA Proposes New Category Of Broker-Dealer For “Capital Acquisition Brokers” »

SEC Issues Report On Accredited Investor Definition

Posted by Securities Attorney Laura Anthony | January 12, 2016 Tags: Accedited Investor, accredited investor definition, SEC

On December 18, 2015, the SEC issued a 118-page report on the definition of “Accredited Investor” (the “Report”). The report follows the March 2015 SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) recommendations related to the definition. The SEC is reviewing the definition of “accredited investor” as directed by the Dodd-Frank Act, which requires that the SEC review the definition as relates to “natural persons” every four years to determine if it should be modified or adjusted.

The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation.

Although the Report contains detailed discussions on the various aspects of the definition of an accredited investor, the history of the different aspects of the definition, a discussion of different approaches taken in other U.S. regulations and in foreign jurisdictions and an in-depth discussion on the reasoning behind its recommendations, the actual recommendations are only conceptual and broad-based and do not contain specifics. Accordingly, we will need to wait for a future proposed rule release to see what, if any, of the recommendations will be implemented and to what degree. This blog provides a broad summary of the Report.

Background

All offers and sales of securities must either be registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or be subject to an available exemption to registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration – thus the registration exemptions in Sections 3 and 4 of the Securities Act and the rules promulgated thereunder. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.

Regulation D provides the most commonly used transactional exemptions to registration. The SEC notes in its Report that $1.3 trillion was raised under Regulation D in 2014 alone. The definition of “accredited investor” provides the backbone to the Regulation D exemptions and is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”

In addition to investor protection, the SEC also has a mandate to assist businesses with capital formation and the definition of “accredited investor” must walk the line between these goals. An overly restrictive definition will damage the ability of businesses to access private capital, and an overly broad definition would be contrary to the SEC’s investor protection goals.

Qualifying as an accredited investor makes the difference between being able to participate in an exempt offering or not, and the ability for an issuer to rely on an exemption or not, and accordingly is a very important component of the securities regulations. For example, some exemptions like Rule 506(c) are limited to accredited investors only. Rules 505 and 506(b) limit offers and sales to no more than 35 unaccredited investors. Many state law exemptions limit offers and sales of securities based on the status of an investor as accredited or not.

An issuer’s required disclosure is also tied into whether investors and potential investors are accredited. For example, under Rules 505 and 506(b) issuers must provide certain delineated financial and non-financial disclosures if an offering will be made to any non-accredited investors.

The Current Definition of “Accredited Investor”

An “Accredited investor” is defined as any person who comes within any of the following categories:

Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;

Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;

Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and

Any entity in which all of the equity owners are accredited investors.

The SEC Report contains an interesting table comparing the regulatory approach to determining the status of investors that are not in need of certain investor protections. I’m reproducing the entire table as appears in the Report:

Standard	Financial Threshold for Natural Persons	Regulatory Purpose
Accredited Investor(Securities Act Rule 501(a))	$200,000 in income$300,000 in joint income $1 million in net worth, excluding the value of a primary residence	Exemption from Securities Act registration for offers and sales to accredited investors
Qualified Client(Advisers Act Rule 205-3)	$1 million in assets under management with an investment adviser$2 million in net worth, excluding the value of a primary residence Subject to inflation adjustment every 5 years	Exemption from Advisers Act’s prohibition on charging performance fees to clients
Qualified Purchaser(Investment Company Act Section 2(a)(51)(A))	$5 million in investments	Exemption from Investment Company Act registration for sales to qualified purchasers
Qualified Investor(Exchange Act Section 3(a)(54))	$10 million in asset-backed securities and loan participations$25 million in other investments	Exemption from broker-dealer registration for banks that sell certain securities to qualified investors
Eligible Contract Participant(Commodity Exchange Act Section 1a(18))	$10 million in investments$5 million in investments if hedging	Eligible contract participants are able to engage in certain derivatives and swaps transactions

The SEC Report discusses the different approaches and their respective histories. The Report also considers the approach taken by different countries including Australia, Canada, the EU, Israel, Singapore and the United Kingdom. The SEC considered these different approaches in making its recommendations. Although a synopsis of these discussions is beyond the scope of this blog, it does provide for interesting reading and insight into the regulatory regime.

SEC Recommendations Related to the Accredited Investor Definition

The Report considered numerous different approaches and potential changes and contains discussion supporting each element in determining an accredited investor and the recommended changes. The Report discusses the numerous different proposals considered, the input of commenters, the challenges that will be associated with each of its recommendations and the reasoning behind such recommendations. However, notably absent from the Report are specific recommendations associated with the broad concepts.

The SEC staff recommends a complete revision to the definition of accredited investor and in particular makes the following recommendations:

Leave the current income and net worth thresholds in place, subject to investment limitations;

Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations;

Index all financial thresholds for inflation on a going-forward basis;

Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors;

Add a new qualification for individuals based on measures of sophistication including parameters considering the person’s (i) amount of investments; (ii) professional credentials; (iii) experience investing in exempt offerings; and (iv) status as a knowledgeable employee of a private fund for investments in the employer’s fund. In addition, the SEC recommends permitting individuals who pass an accredited investor examination to qualify as an accredited investor.

Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than the specifically enumerated types of entities; and

Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

I agree with each of the proposed conceptual changes and in particular the addition of the sophistication qualifications; however, until actual proposals are made that include specifics, such as the specific investment limitations, specific criteria to establish sophistication and specific proposed adjustments, I remain as unspecific in my opinion as the SEC is in its recommendations!

Leaving a strict bright line financial test, without the additional sophistication test, is too restrictive to meet the goal of assisting businesses in accessing capital. According to the SEC Report, in 2013, only 10.1% of U.S. households qualified as accredited investors and adjusting the financial tests for inflation will drop that percent to 3.6%.

The SEC staff points out that there is currently no definition of the term “income” and very limited guidance on the matter. The recommendations do not offer further guidance or suggest any changes. From a practitioner’s perspective, we generally go by the individual’s tax return.

The SEC Report also discussed the net worth calculation. The only asset excluded from the calculation is the person’s primary residence. Many commenters have suggested changes such as the exclusion of retirement assets. The SEC rightfully points out the numerous problems with this approach including, but certainly not limited to, the obvious impact of discouraging retirement investments or encouraging the withdrawal of retirement funds to participate in private investments. Moreover, the Advisory Committee previously pointed out, and the SEC Report acknowledges, that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition.

I also like the reasoning behind adding investment limitations at certain thresholds and removing them at higher thresholds. Currently the income and net worth tests are absolute. An investor with a $999,999 net worth cannot invest and an investor with a $1,000,000 can invest an unlimited amount. Permitting all individuals that with a level of financial sophistication to be deemed accredited and invest in private offering subject to caps based on net worth or income, will greatly expand the pool of potential investors and be consistent with the need to protect investors.

The SEC Reports suggests a few methods of implementing investment limitations but does not make a specific, precise proposal. The SEC Report suggests examples of limitations such as: (i) an even percentage application across all investors (this approach is rejected); (ii) a gradual increase in investment limitation which limitation is eventually eliminated based on net worth and/or income; and (iii) either separately or in conjunction with other limitations, adding a per issuer limitation.

The SEC Staff recommendations in the Report are consistent with the Advisory Committee’s recommendations made to the SEC in March 2015. In particular, the Advisory Committee made four recommendations related to the definition of “accredited investor”:

(1) That if any change is made to the definition of “accredited investor,” such change should “have the effect of expanding, not contracting, the pool of accredited investors.” For example, they recommended that the definition include investors that satisfy a sophistication test that is not tied to income or net worth. In addition, the Advisory Committee recommended that that tax treatment of assets be excluded from any net worth calculation.

(2) That the SEC take into account the effect of inflation and adjust the accredited investor thresholds in accordance with the consumer price index.

(3) “Rather than attempting to protect investors by raising the accredited investor thresholds or excluding certain asset classes from the calculation to determine accredited investor… the Commission should focus on enhanced enforcement efforts and increased investor education” and

(4) The SEC should continue to gather data on the subject.

Additional History and Further Background

The vast majority of the SEC’s 118-page report provides a history of the Securities Act registration and exemption provisions and the role of the accredited investor definition. The SEC provides the background of the Section 4(a)(2) exemption and a summary of SEC vs. Ralston Purina Co., the leading Supreme Court case interpreting the provision. I’ve previously covered some of this history in my blogs HERE and HERE (written prior to renumbering 4(2) to 4(a)(2)). The following blog HERE on obstacles in depositing penny stocks also provides insight into the exemptions and investor qualifications and as such is beneficial ancillary reading with this blog.

The Advisory Committee Letter to the SEC in March 2015 contained a list of practical facts and realities related to small business and emerging company capital formation in support of its recommendations that I found informative and so am re-publishing. In particular:

Smaller and emerging companies are “critical to the economic well-being of the United States,” generating the majority of net new jobs in the last five years and continuing to add more jobs;

Rule 506 of Regulation D is the most widely used private offering exemption, resulting in $1 trillion of raised capital in 2013;

Most early-stage, venture capital and angel investments are made in reliance on Rule 506;

Other than Rule 506(b), which allows up to 35 unaccredited investors (when certain disclosures and financial information are provided), all investors in Rule 506 offerings must be accredited;

The Dodd-Frank Act requires the SEC to review the accredited investor definition to determine whether it “should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy”;

There are groups and commentators that advocate increasing the thresholds in the accredited investor definition to prevent fraud against investors. However, the SEC is not of “any substantial evidence suggesting that the current definition of accredited investor has contributed to the ability of fraudsters to commit fraud or has resulted in greater exposure for potential victims.” In addition, “the connection between fraud and the current accredited investor thresholds seems tenuous at best”;

Some groups and commentators advocate excluding “retirement assets” from the calculation of net worth. The Advisory Committee rightfully and logically points out that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition; and

There is little or no evidence to suggest that the existing definition of accredited investor has led to widespread fraud or other harm to investors; rather, there is substantial evidence that the current definition works.

The Advisory Committee concluded that if the income and net worth thresholds are increased, it “will materially decrease the pool of capital available for smaller businesses.” It continued by stating that such a change “would have a disparate impact on those areas having a lower cost of living, which areas often coincide with regions of lower venture capital activity.”

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 Guidance On Proxy Presentation Of Certain Matters In The Merger And Acquisition Context

Posted by Securities Attorney Laura Anthony | January 7, 2016 Tags: 14A Proxy Solicitation

In late October the SEC issued its first updated Staff Legal Bulletin on shareholder proposals in years – Staff Legal Bulletin No. 14H (“SLB 14H”). Please see my blog on SLB 14H HERE. On the same day the SEC published two new Compliance and Disclosure Interpretations (“C&DI”) related to the unbundling of matters presented for a vote to shareholders in merger and acquisition transactions. The new C&DI has in essence granted voting rights to target company shareholders, on acquiring company organizational documents, where none existed before and has in essence pre-empted state law on the issue.

Unbundling under Rule 14a-4(a)(3) in the M&A Context

Exchange Act Rule 14a-4 relates to the requirements for a proxy card general. Rule 14a-4(a) provides:

(A) The form of proxy:

(1) Shall indicate in bold-face type whether or not the proxy is solicited on behalf of the registrant’s board of directors or, if provided other than by a majority of the board of directors, shall indicate in bold-face type on whose behalf the solicitation is made;

(2) Shall provide a specifically designated blank space for dating the proxy card; and

(3) Shall identify clearly and impartially each separate matter intended to be acted upon, whether or not related to or conditioned on the approval of other matters, and whether proposed by the registrant or by security holders.

Part (b) continues with a requirement that the proxy shall provide a means “whereby the person solicited is afforded an opportunity to specify by boxes a choice between approval or disapproval of, or abstention with respect to each separate matter” other than director elections and votes on the frequency of votes on executive compensation (i.e., frequency of say-on-pay votes).

Exchange Act Rule 14a-4(a)(3) relates to the unbundling of separate matters that are submitted to a shareholder vote through proxy materials. The SEC previously issued C&DI guidance in January 2014. The new C&DI specifically addresses Rule 14a-4(a)(3) in the context of mergers, acquisitions and similar transactions. The SEC has historically been against bundling of proposals in a proxy and that trend continues with the new C&DI.

Following the January 2014 C&DI, the rules substantially provided that multiple matters that are inextricably intertwined need not be unbundled. However, separate matters do not rise to the level of “inextricably intertwined” just because they were negotiated as part of a single transaction with a third party. Moreover, matters that are immaterial may be bundled with other matters. Materiality is determined by considering whether a matter substantially affects shareholder rights or whether a shareholder would reasonably be expected to express or want to express a view on a matter.

The SEC has issued 2 new C&DI as follows:

Question: Rule 14a-4(a)(3) requires that the form of proxy “identify clearly and impartially each separate matter intended to be acted upon.” Rule 14a-4(b)(1) further requires that the form of proxy provide a means for shareholders “to specify by boxes a choice… with respect to each separate matter referred to therein as intended to be acted upon.” In a merger, acquisition, or similar transaction in which shareholders of the target are receiving equity securities of the acquirer, amendments to the organizational documents of the acquirer can often be required by the transaction agreement. Under these proxy rules, under what circumstances must a target seeking shareholder approval of such a transaction present separately on its form of proxy a proposal or proposals relating to the amendments to the organizational documents of the acquirer? In other words, when are these amendments which are embedded within the transaction agreement a “separate matter” for target shareholders?

Answer: As a preliminary matter, if a material amendment to the acquirer’s organizational documents would require the approval of its shareholders under state law, the rules of a national securities exchange, or its organizational documents if presented on a standalone basis, the acquirer’s form of proxy must present any such amendment separately from any other material proposal, including, if applicable, approval of the issuance of securities in a triangular merger or approval of the transaction agreement in a direct merger. See Question 101.02 relating to “Unbundling under Rule 14a-4(a)(3) Generally.” As a general principle, however, only material matters must be unbundled, and acquirers should consider whether the provisions in question substantively affect shareholder rights. Examples of provisions meeting this standard that may be adopted in connection with a transaction include governance and control-related provisions, such as classified or staggered boards, limitations on the removal of directors, supermajority voting provisions, delaying the annual meeting for more than a year, eliminating the ability to act by written consent, or changes in minimum quorum requirements. In contrast, provisions such as name changes, restatements of charters, or technical changes, such as those resulting from anti-dilution provisions, would likely be immaterial.

If, consistent with the guidance in Question 101.02, the acquirer is required under Rule 14a-4(a)(3) to present an amendment or multiple amendments separately on its form of proxy, or would be so required if it were conducting a solicitation subject to Regulation 14A, then a target subject to Regulation 14A also must present any such amendment separately on its form of proxy. This is because the amendment, which is a term of the transaction agreement that target shareholders are being asked to approve, would effect a material change to the equity security that target shareholders are receiving in the transaction. Target shareholders should have an opportunity to express their views separately on these material provisions that will establish their substantive rights as shareholders, even if as a matter of state law these provisions might not require a separate vote. Similarly, if the acquirer presents a material amendment on its form of proxy as the only matter to be approved by acquirer’s shareholders, then the target must present the amendment separately on its form of proxy. The target need not present as a separate matter on its form of proxy an amendment to increase the number of authorized shares of the acquirer’s equity securities, provided that the increase is limited to the number of shares reasonably expected to be issued in the transaction.

In all cases, the parties are free to condition completion of a transaction on shareholder approval of any separate proposals. Any such conditions should be clearly disclosed and indicated on the form of proxy.

Question 201.02

Question: Does the answer to Question 201.01 change if the parties form a new entity to act as an acquisition vehicle that will issue equity securities in the transaction?

Answer: No. In that case, the party whose shareholders are expected to own the largest percentage of equity securities of the new entity following consummation of the transaction would be considered the acquirer for purposes of this analysis. As in Question 201.01, the acquirer must present separately on its form of proxy any material provision or provisions of the new entity’s organizational documents that are a term of the transaction agreement, if the provision or provisions represent a material change from the acquirer’s organizational documents, and the change would require the approval of the acquirer’s shareholders under state law, the rules of a national securities exchange, or its organizational documents if proposed to be made directly to its own organizational documents. Provisions that are required by law in the jurisdiction of incorporation of the new entity need not be presented separately on the form of proxy. As in Question 201.01, if the acquirer is or would be required under Rule 14a-4(a)(3) to present separately on its form of proxy any provision of the new entity’s organizational documents that is a term of the transaction agreement, then a target subject to Regulation 14A must also present the same provision separately on its form of proxy.

Question 101.02 referred to in Question 201.01 provides:

Question: Management of a registrant intends to present an amended and restated charter to shareholders for approval at an annual meeting. The proposed amendments would change the par value of the common stock, eliminate provisions relating to a series of preferred stock that is no longer outstanding and is not subject to further issuance, and declassify the board of directors. Under Rule 14a‑4(a)(3), must the individual amendments that are part of the restatement be unbundled into separate proposals?

Answer: No. The staff would not ordinarily object to the bundling of any number of immaterial matters with a single material matter. While there is no bright-line test for determining materiality in the context of Rule 14a‑4(a)(3), registrants should consider whether a given matter substantively affects shareholder rights. While the declassification amendment would be material under this analysis, the amendments relating to par value and preferred stock do not substantively affect shareholder rights, and therefore both of these amendments ordinarily could be included in a single restatement proposal together with the declassification amendment. However, if management knows or has reason to believe that a particular amendment that does not substantively affect shareholder rights nevertheless is one on which shareholders could reasonably be expected to wish to express a view separate from their views on the other amendments that are part of the restatement, the amendment should be unbundled.

The staff notes that the analysis under Rule 14a-4(a)(3) is not governed by the fact that, for state law purposes, these amendments could be presented to shareholders as a single restatement proposal. If, for example, the restatement proposal also included an amendment to the charter to add a provision allowing shareholders representing 40% of the outstanding shares to call a special meeting, the staff would view the special meeting amendment as material and therefore required to be presented to shareholders separately from the similarly material declassification amendment.

In an M&A context the new guidance is a significant change. The SEC is in essence requiring that target company shareholders be afforded an opportunity to vote on changes to the acquiring company’s organizational documents, separate and apart from voting on the merger itself. The SEC reasons that since the target company shareholders will become acquiring company shareholders, they have an interest in the organizational documents. Although I understand that argument, I would think that the target company shareholders could consider the acquiring company’s organizational documents, or changes thereto, in deciding whether to vote on the merger or not. I fail to see the benefit of a separate vote, nor the practical result if, for instance, the target company shareholders approve a merger but not the organizational document changes (other than giving plaintiff’s attorneys another matter to litigate!)

From a company’s point of view, it can make more sense to present an integrated proposal for a full merger plan. By unbundling the various items to the plan, including corporate governance and structure changes, the company could have a shareholder approval of the corporate changes but not the merger itself or vice versa. Moreover and worse yet, the reconfigured pieces of the transaction, following a shareholder vote on the parts as opposed to the whole, may have an unintended result. The SEC suggests that one can be conditioned on the other, but if that is the case, why require the unbundling in the first place?

The new C&DI continues the trend that I have written of several times, of the federal government imposing on state corporate law regulations. I am a vocal advocate of federal pre-emption of state securities laws, but am also an advocate of leaving corporate law matters to the states. In this case the SEC clearly spreads its reach into state law with the statement “[T]arget shareholders should have an opportunity to express their views separately on these material provisions that will establish their substantive rights as shareholders, even if as a matter of state law these provisions might not require a separate vote.” In this instance, the target shareholders do not have the right to vote on the acquirer’s organizational documents under state law, but apparently do have such right if the acquirer is subject to the SEC proxy rules.

The new C&DI goes beyond the historical SEC requirements to provide information in a proxy related to corporate organizational changes, in advance of a merger (see my blog HERE for more on that topic) and grants voting rights where none existed previously.

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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