SEC Whistleblower Awards Pass $100 Million As It Continues To Crack Down On Confidentiality Provisions In Employment Agreements
The SEC has proudly announced that including a $22 million award on August 30, 2016, its whistleblower awards have surpassed $100 million. The news comes in the wake of two recent SEC enforcement proceedings against companies based on confidentiality and waiver language in employee severance agreements. Like two prior similar actions, the SEC has taken the position that restrictive language in confidentiality, waiver or settlement agreements with employees violates the anti-whistleblower rules adopted under Dodd-Frank.
Background – The Dodd-Frank Act Whistleblower Statute
The Dodd-Frank Act, enacted in July 2010, added Section 21F, “Whistleblower Incentives and Protection,” to the Securities Exchange Act of 1934 (“Exchange Act”). As stated in the original rule release, the purpose of the rule was “to encourage whistleblowers to report possible violations of the securities laws by providing financial incentives, prohibiting employment related retaliation, and providing various confidentiality guarantees.” Upon enactment of Section 21F, the SEC established the Office of the Whistleblower and created the SEC Whistleblower Program (“Whistleblower Program”).
The whistleblower regulations are comprised of Section 21F of the Exchange Act and Rules 21F-1 through 21F-17 promulgated thereunder. The bulk of the whistleblower regulations relate to the submission of original information leading to successful enforcement actions, and the eligibility, calculation and payment of awards to the whistleblower. The regulations also implement measures to protect the whistleblower from retaliatory actions.
Rule 21F-2, “Whistleblower status and retaliation protection,” defines a whistleblower as follows:
(a)(1) “You are a whistleblower if, alone or jointly with others, you provide the Commission with information pursuant to the procedures set forth in § 240.21F-9(a) of this chapter, and the information relates to a possible violation of the Federal securities laws (including any rules or regulations thereunder) that has occurred, is ongoing, or is about to occur. A whistleblower must be an individual. A company or another entity is not eligible to be a whistleblower.”
(b) Prohibition against retaliation. (1) “[F]or purposes of the anti-retaliation protections…, you are a whistleblower if: (i) you possess a reasonable belief that the information you are providing relates to a possible securities law violation… that has occurred, is ongoing, or is about to occur, and; (ii) you provide that information in a manner described in Section 21F(h)(1)(A); (iii) The anti-retaliation protections apply whether or not you satisfy the requirements, procedures and conditions to qualify for an award.”
Rule 21F-17, “Staff communications with individuals reporting possible securities law violations,” which is the subject of the enforcement actions, provides:
(a) “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement… with respect to such communications.”
Enforcement Proceedings
The SEC brought two enforcement proceedings against companies during the month of August based on restrictive language in confidentiality and waiver provisions in employee severance agreements. The two new proceedings are similar to two prior proceedings based on the same issue. The SEC enforcement proceedings claim that the restrictive language acts as a method to stifle or retaliate against whistleblowers.
In early 2016, the SEC began issuing requests to companies for copies of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and settlement agreements entered into with employees and former employees of the companies. The initiative specifically requested copies of documents since the enactment of the Dodd-Frank provisions that grant awards and protections for whistleblowers. The SEC was also asking for copies of company human resource policies, employee memos, training guides and any and all documents that discuss “whistleblowers” either directly or indirectly.
The SEC’s concern is that corporations are retaliating against potential whistleblowers and attempting to curb the whistleblowing incentives in the Dodd-Frank Act by providing detriments to employment in contracts and policies veiled as confidentiality protections. The Dodd-Frank Act directly prohibits retaliatory conduct by companies.
In the action filed on April 1, the SEC charged KBR, Inc., with violating Rule 21F-17 under the Dodd-Frank Act. In this case, KBR required employees participating in internal investigations related to potential securities law violations, to sign confidentiality agreements that prohibited the employee from discussing the matter with outside parties without KBR approval with a consequence of discipline or termination in the event of a violation of such confidentiality agreement. As the investigations included allegations of securities law violations, the terms in the agreement were found to violate Rule 21F-17 of the Dodd-Frank Act, which specifically prohibits companies from taking any action to impede whistleblowers from reporting possible securities law violations to the SEC. KBR agreed to pay a penalty of $130,000 and to amend its confidentiality statement to make it clear that employees are free to report possible violations to the SEC and other federal agencies without KBR approval or fear of retaliation.
In its press release on the matter, Andrew J. Ceresney, SEC Director of the Division of Enforcement, was quoted as saying, “By requiring its employees and former employees to sign confidentiality agreements imposing pre-notification requirements before contacting the SEC, KBR potentially discouraged employees from reporting securities violations to us. SEC rules prohibit employers from taking measures through confidentiality, employment, severance, or other type of agreements that may silence potential whistleblowers before they can reach out to the SEC. We will vigorously enforce this provision.”
The SEC enforcement action came despite the factual conclusion that no employee had actually been prevented from reporting a violation to the SEC or had sought to do so.
On August 10, 2016, the SEC brought a settled administrative proceeding against BlueLinx Holdings, Inc., ordering a $265,000 penalty for a violation of Rule 21F-17 by illegally using severance agreements requiring outgoing employees to waive their rights to seek monetary compensation under the SEC Whistleblower Program. A violation of the agreement would result in a loss of severance payments and other post-employment benefits. Similarly, in a settled administrative proceeding on August 16, 2016, the SEC ordered Health Net, Inc., to pay a $340,000 penalty for violating Rule 21F-17 with a similar provision.
In both cases, the agreements specifically did not preclude a former employee from participating in an investigation, communicating with or cooperating with investigators or reporting wrongdoing, but it did prevent the employee from seeking monetary compensation for doing so. Like the earlier KBT case, there was no evidence that an employee had actually been deterred from taking action as a result of the provision in the severance agreements. However, the SEC notes that the financial incentive portion of the Whistleblower Program is “a critical component of the Whistleblower Program… that any individual could look towards in determining whether to take the enormous risk of blowing the whistle in calling attention to fraud.”
The SEC is sending a clear message that any efforts to chill whistleblowers will be considered a violation of the rules.
Success of Whistleblower Program
As indicated, the Whistleblower Program has been a resounding success since its inception, resulting in over $500 million in financial remedies against wrongdoers and the payout of $111 million in awards to 34 whistleblowers. On August 30, 2016, the second-largest award, at $22 million, was granted to a whistleblower. On September 20, 2016 a $4 million dollar award was announced. The funds to pay out the awards come from an investor protection fund entirely financed through monetary sanctions paid to the SEC from securities law violators.
Whistleblowers may be eligible to receive an award when they voluntarily provide unique and useful information to the SEC that results in an enforcement action and monetary penalty against a wrongdoer. The awards range from 10% to 30% of the amount collected when sanctions ordered are in excess of $1 million.
In an August 30, 2016 press release, SEC Chair Mary Jo White stated, “[T]he SEC’s whistleblower program has proven to be a game changer for the agency in its short time of existence, providing a source of valuable information to the SEC to further its mission of protecting investors while providing whistleblowers with protections and financial rewards.”
The same press release contains some interesting facts, including that the Whistleblower Office has received more than 14,000 tips. Moreover, to help ensure that employees continue to utilize the statute without fear of repercussions, the SEC has now brought a total of 5 enforcement actions against companies related to retaliation. One of these actions was for actual retaliatory conduct, and the other 4 related to confidentiality and severance agreements as discussed herein.
Conclusion
The SEC has found the whistleblower statute to be extremely beneficial in uncovering and prosecuting large-scale securities fraud. In essence, the whistleblower statute, and potential monetary awards for successful prosecutions, provides the SEC with an army of investigators well beyond what the agency could afford using its own resources. Several states have taken notice of the success of the program and enacted their own version of the . Recently the State of Indiana awarded $95,000 to a whistleblower for helping bring an enforcement action against JP Morgan Chase for failing to disclose certain conflicts of interest to RIA clients.
When the SEC filed its first action back in April 2016, this firm made particular modifications to its forms of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and employee settlement agreements. We urge all companies to seek the advice of competent counsel prior to entering into any such contracts, and of course, when conducting internal investigations which include allegations of potential securities law violations. Additional enforcement actions are expected as the SEC continues to review documents requested and provided by various employer companies.
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.
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.
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.
© Legal & Compliance, LLC 2016
« SEC Issues Proposed Amendments To Item 601 Of Regulation S-K Related To Exhibits House Continues To Push For Reduced Securities Regulation »
SEC Issues Proposed Amendments To Item 601 Of Regulation S-K Related To Exhibits
On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format.
This newest proposed rule change to Regulation S-K is part of the SEC Division of Corporation Finance’s Disclosure Effectiveness Initiative. At the end of this blog, I include an up-to-date summary of the proposals and request for comment related to the ongoing Disclosure Effectiveness Initiative.
Background
On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). The S-K Concept Release contained a discussion and request for comment on exhibit filing requirements. Item 601 of Regulation S-K specifies the exhibits that must be filed with registration statements and SEC reports. Item 601 requires the filing of certain material contracts, corporate documents, and other information as exhibits to registration statements and reports.
A particular area of discussion recently has been the need to file schedules to contracts. These schedules can be lengthy and lack materiality. Likewise, a recent area of discussion has been the necessity of filing an immaterial amendment to a material exhibit. The S-K Concept Release contains a lengthy discussion on exhibits, including drilling down on specific filing requirements. Many of the exhibit filing requirements are principle-based, including, for example, quantitative thresholds for contracts. Consistent with the rest of the S-K Concept Release, the SEC discusses whether these standards should be changed to a straight materiality approach. The SEC also discusses eliminating some exhibit filing requirements altogether, such as where the information is otherwise fleshed out in financial statements or other disclosures (for example, a list of subsidiaries).
Companies are allowed to reference exhibits filed in prior filings as opposed to refiling the exhibit with the SEC. The current proposed rule amendment is limited to the presentation of such information and, in particular, including a hyperlink to the actual filed exhibit. I suspect the SEC shall issue further amendments related to exhibits as it continues its initiative and rule changes related to Regulation S-K.
Proposed Amendments
In addition to the filing of exhibits and schedules, Item 601 of Regulation S-K requires each company to include an exhibit index list that lists each exhibit included as part of the filing. Once an exhibit has been filed once, the company can incorporate by reference by including a footnote as to which filing the original exhibit can be found in. Unfortunately, I find that companies often will indicate that an exhibit has been previously filed, without giving a specific reference as to which filing or when, leaving an investor or reviewer to go fish. The SEC rightfully asserts that requiring companies to include hyperlinks from the exhibit index to the actual exhibits filed would allow much easier access to these filings.
The proposed rule change would require companies to include a hyperlink to each filed exhibit on the exhibit index for virtually all filings made with the SEC, including XBRL exhibits. An active hyperlink would be required in all filings made under the Securities Act or Exchange Act, provided however, that if the filing is a registration statement, the active hyperlinks need only be included in the version that becomes effective.
Currently exhibits may be filed in the EDGAR system in either ASCII or HTML format. HTML format allows for hyperlinks to another place within the same document or to a separate document. ASCII does not support such hyperlinks. Over the years HTML has become the standard used for EDGAR filings, with 99% of filings in 2015 using HTML. The current proposed rule would prohibit the use of ASCII for exhibits and require onlyHTML with the newly required hyperlinks.
In addition, the proposed rule changes would include conforming changes to Rule 105 of Regulation S-T. Rule 105 sets forth the limitations and liabilities for the use of hyperlinks. Rule 105 allows hyperlinks to other documents within the same filing or previously filed documents on EDGAR but prohibits hyperlinks to sites, locations, or documents outside the EDGAR system.
Further Background
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE. On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.
That proposed rule changes and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
As part of the same initiative on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE ). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.
As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
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.
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.
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.
© Legal & Compliance, LLC 2016
« SEC Requests Comment On Changes To Subpart 400 To Regulation S-K SEC Whistleblower Awards Pass $100 Million As It Continues To Crack Down On Confidentiality Provisions In Employment Agreements »
SEC Requests Comment On Changes To Subpart 400 To Regulation S-K
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. The request for comment is part of the ongoing SEC Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72003 of the FAST Act.
Background
The topic of disclosure requirements under Regulations S-K and S-X as pertains to financial statements and disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has come to the forefront over the past couple of years. The purpose of the Disclosure Effectiveness Initiative is to assess whether the business and financial disclosure requirements continue to provide the information investors need to make informed investment and voting decisions.
Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act. Regulation S-X contains specific financial statement preparation and disclosure requirements.
In addition to affecting companies filing registration statements (including on Form 1-A in a Regulation A/A+ offering) and those filing reports with the SEC, any changes to Regulations S-K or S-X will affect acquired entities, acquirees, investment advisers, investment companies, broker-dealers and nationally recognized statistical rating organizations.
In accordance with its mandate under Section 72003 of the FAST Act, the SEC is studying and seeking comment to:
Determine how to modernize and simplify disclosure requirements to reduce the costs and burdens to the company while still providing all material and necessary information to investors;
Further a principles-based approach whereby companies and their management can determine the relevancy and materiality of information provided instead of just including boilerplate language or filling space to meet a static requirement. Of course, this needs to be balanced with the need to ensure completeness and comparability of information among different companies; and
Evaluate information delivery methods and explore ways to eliminate repetition and the disclosure of immaterial information.
Request for Comment
Subpart 400 of Regulation S-K, including Items 401 through 407, require disclosures on directors, executive officers, control persons and promoters; executive compensation; security ownership of certain beneficial owners and management; transactions with related persons, promoters and control persons; ethics and corporate governance.
The SEC’s request for comment does not provide any commentary about particular concerns, thoughts, or questions by the SEC, but is a short general request on “existing requirements in these rules as well as on potential disclosure issues that commenters believe the rules should address.”
Overview of Subpart 400
Item 401 – Directors, Executive Officers, Promoters and Control Persons
Item 401 of Regulation S-K requires the disclosure of the identity and ages of all directors and persons nominated to become a director. In addition, Item 401 requires disclosure of all positions held at the company by that director or nominee, their term of office, and any arrangement or understanding between that person and another person “pursuant to which he was or is to be selected as a director or nominee.” The instructions provide some clarity. Compensation for service as a director is not included in arrangements with other persons. A person must consent to being included as a nominee. No information need be provided on an outgoing director.
Item 401 requires the disclosure of the identity and ages of all executive officers. In addition, Item 401 requires disclosure of all positions held at the company by that executive officer, their term of office, and any arrangement or understanding between that person and another person pursuant to which he was or is to be selected as an officer. A person must consent to being included as an executive officer.
For a first-time registration statement or a registration statement by a company not subject to the reporting requirements under the Securities Exchange Act, Item 401 requires the identification of certain significant employees – in particular, where a person is not an executive officer but otherwise makes a significant contribution to the company’s business. The same information required for executive officers is required for significant employees. Similarly, for a first-time registration statement or registration statement by a company that has not been subject to the reporting requirements for at least 12 months, the same information must be provided for promoters and control persons.
In addition, family relationships, business experience for the past five years, and disclosures of certain legal proceedings must be made for each director and executive officer. The legal proceeding disclosure is a scaled-down version of the bad-actor requirements found elsewhere in the rules, such as Rule 506 and Regulation A. Also, Item 401 requires disclosure of bankruptcy proceedings involving the person or a company for which they were an executive officer during the past five years.
Item 402 – Executive Compensation
An entire treatise could be written on Item 402. From a high level, Item 402 requires disclosure of all compensation awarded to, earned by, or paid to a company’s executive officers and directors. Item 402 also requires disclosures related to pay ratio and require “say on pay” advisory votes. See my blog HERE.
Compensation must be disclosed in tabular form and is meant to encompass any and all benefits received by an executive officer or director, including salary, bonuses, stock awards (including under a plan or not, qualified or non-qualified), option awards, non-equity incentive plans, pension value, benefits, perquisites and all other forms of compensation. Moreover, Item 402 requires a compensation discussion and analysis explaining the presented information.
Item 402 requires details of outstanding stock awards and options, including exercise dates and prices, the market value of underlying securities and vesting schedules. Detailed information is also required regarding pension benefits.
Emerging-growth and smaller reporting companies provide a scaled-down disclosure under Item 402. For details on the Item 402 scaled-down requirements related to emerging growth and smaller reporting companies, see my blog HERE.
Item 403 – Security Ownership of Certain Beneficial Owners and Management
Item 403 requires disclosure of the security ownership of officers, directors and 5% or greater shareholders, including the beneficial owner or natural person behind any entity ownership. Ownership is disclosed in tabular form and includes name, address, number of securities owned and percentage owned of that class. Item 403 requires disclosure of all classes of outstanding equity regardless of whether such class is registered or publicly trades.
Item 404 – Transactions with Related Persons, Promoters, and Certain Control Persons
Item 404 requires the disclosure of material related party transactions. For purposes of Item 404, related parties include officers or officer nominees, directors or director nominees, a family member of a director or executive office, 5% or greater shareholders, or any person that has a direct or indirect material interest in the company. Companies other than emerging-growth or smaller reporting companies must also disclose the company’s policy for the review, approval or ratification of related party transactions. Item 404 also requires the disclosure of compensations, assets or benefits to be received by promoters where the company is filing an S-1 or Form 10 registration statement.
A “promoter” has a specific definition in the securities laws and is not tied to stock promotion in the sense that many may think. A “promoter” is defined in Rule 405 of the Securities Act as including:
(1) Any person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer; or
(2) Any person who, in connection with the founding and organizing of the business or enterprise of an issuer, directly or indirectly receives in consideration of services or property, or both services and property, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of such securities. However, a person who receives such securities or proceeds either solely as underwriting commissions or solely in consideration of property shall not be deemed a promoter within the meaning of this paragraph if such person does not otherwise take part in founding and organizing the enterprise.
(3) All persons coming within the definition of promoter in paragraph (1) of this definition may be referred to as founders or organizers or by another term provided that such term is reasonably descriptive of those persons’ activities with respect to the issuer.
Item 404 expands the definition of promoter to include “any person who acquired control of a registrant that is a shell company, or any person that is part of a group, consisting of two or more persons that agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of a registrant, that acquired control of a registrant that is a shell company.”
Item 405 – Compliance with Section 16(a) of the Exchange Act
Section 16(a) of the Exchange Act requires the filing of Forms 3 and 4 by officers, directors or 10%-or-greater shareholders. For a review of the Section 16 filing requirements, see my blog HERE. Item 405 requires a company to disclose failures to meet these filing requirements.
Item 406 – Code of Ethics
Item 406 requires a company to disclose whether it has adopted a code of ethics for the executive officers and accounting controller. A copy of the code of ethics must also be filed with the SEC and included on the company’s website.
Item 407 – Corporate Governance
Item 407 requires disclosure of corporate governance standards, including those related to director independence; board committees, including audit compensation, and nominating committees; and annual meeting attendance. Item 407 requires detailed information for each category of corporate governance as well as the policies and procedures of each board committee.
Further Background
The request for comment follows the July 13, 2016 proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. That proposed rule change followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept ReleaseHERE and HERE.
As part of the same initiative on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.
Prior to the S-K Concept Release and current Regulation S-K and S-X proposed amendments, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
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.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
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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.
© Legal & Compliance, LLC 2016
« FinCEN Updates Due Diligence Rules SEC Issues Proposed Amendments To Item 601 Of Regulation S-K Related To Exhibits »
FinCEN Updates Due Diligence Rules
On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued new final rules under the Bank Secrecy Act requiring financing institutions, including brokerage firms, to adopt additional anti-money laundering (AML) procedures that include specific due diligence and ongoing monitoring requirements related to customer risk profiles and customer information. In addition, the new rules require financial institutions to collect and verify information about beneficial owners and control person of legal entity customers.
The Securities Exchange Act of 1934 (“Exchange Act”) specifically requires brokerage firms to comply with the Bank Secrecy Act. FinCEN provides minimum rules. Brokerage firms are also required to comply with AML rules established by FINRA, including FINRA Rule 3310. The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. FINRA also provides a template to assist small firms in establishing and complying with AML procedures. As of the date of this blog, FINRA has not updated Rule 3310 or its form template.
The new rules will make the difficult process of opening brokerage accounts even more difficult, especially for foreign individuals and entities and U.S. individuals and entities operating through offshore entities. The new rules could impact the ongoing process of depositing and trading in penny stocks, even for existing brokerage firm clients. FinCEN initially issued advance notice of proposed rulemaking in March 2012 and issued proposed rules in August 2014. A push to issue final rules gained momentum following the release of the Panama Papers. The new rules become effective for new customer accounts opened on or after May 11, 2018; however, as discussed below, where appropriate it may have retroactive application.
FinCEN requires that financial institutions address the following four key elements in all of their AML programs: (i) customer identification and verification; (ii) beneficial ownership identification and verification; (iii) understanding the nature and purpose of customer relationships to develop risk profiles; and (iv) ongoing monitoring for reporting suspicious transactions and maintaining and updating customer information.
Obligation to identify and verify beneficial ownership
The USA Patriot Act grants authority to FinCEN to establish rules for financial institutions to identify and verify customer information and establish AML procedures in general. All financial institutions are required to have minimum AML procedures, and the application of these procedures has been the subject of many enforcement proceedings. The initial customer identification program rule (CIP Rule) was enacted in 2003 and required financial institutions to identify any individual or entity that opened an account but did not require identification of beneficial ownership.
A “legal entity” is defined as a corporation, limited liability company, partnership or other entity that is created by the filing of a public document with a U.S. state or foreign governmental body. Under the new rules, the financial institution will need to identify beneficial owners of a legal entity that own (i) 25% or more of the equity of the legal entity; and (ii) any control persons over the legal entity, including officers, directors and senior management. Certain entities are excluded from the definition of an “entity” for purposes of the CIP rules, including financial institutions, banks, bank holding companies, certain pooled investment funds, state regulated insurance companies and foreign financial institutions.
Subject to certain exclusions, the new rule requires financial institutions to identify and verify the beneficial owners of their legal entity customers. The rulemaking process included numerous comments on this requirement. As a concession, the final rule generally does not contain a requirement that the financial institution verify that a listed beneficial owner in fact holds the disclosed ownership interest or exerts actual control over the entity.
As with most such rules, the financial institution can establish written processes and procedures tailored to that institution and its operations. Such processes and procedures must include a consideration of both the ownership test and control test of beneficial ownership. A financial institution must collect information on all individuals who either directly or indirectly own 25% or more of the equity of an entity. Where a financial institution has questions or determines there are risk factors, they may collect identifying information on owners with a lower percentage as well. In addition, the financial institution must collect information on all individuals that have the ability to control, manage or direct the entity, including officers, directors and key management.
The terms “direct and indirect” and “control” remain undefined and are to be broadly construed based on facts and circumstances to encompass all forms of potential ownership and control. Likewise, when making risk and knowledge assessments, the financial institution must consider all facts and circumstances and is held to a “reasonableness” standard.
Financial institutions must verify the collected information. The original CIP Rule established verification requirements based on risk. The same risk-based verification processes remain in place, with some modifications. In essence, the financial institution must gather due diligence, including corporate records, ownership records and the like, and continue such process until it is satisfied it has enough information on the beneficial owners of that particular entity, considering the risk imposed by that entity.
There are two significant modifications from the CIP Rule. In particular, a financial institution may rely on photocopies of documents rather than originals, and the institution may rely on disclosures of ownership from the entity itself except where it has knowledge of facts that would call into question the reliability or veracity of such information.
The risk assessment in the CIP Rule includes a consideration of all relevant facts and circumstances, including, but not limited to: (i) type of account; (ii) method of opening account; (iii) size of account and trading activity; (iv) type of identifying customer information; (v) relationship with the customer, including other accounts with the same beneficial owners, length of relationship, personal knowledge, and account activity; (vi) whether the customer has a physical address or physical business location; (vii) whether the customer has a U.S. tax identification number; and (viii) historical activity, including a suspicious activity.
Although the rule sets a firm requirement that financial institutions complete written procedures and apply them to all accounts opened on or after May 11, 2018, FinCEN is clear that a financial institution has a broad requirement to monitor and know its customers. Where risks are identified, additional procedures as outlined in the new rules should be applied to accounts, effective immediately. In addition, financial institutions should have ongoing monitoring procedures and may, where appropriate, go back and ask for information on existing accounts, as well as require updated information for accounts on a continuing basis. For instance, if an account has suspicious activity or contradictory ownership or control information is brought to the financial institution’s attention, there would be an obligation to conduct further due diligence and update and verify ownership and control information.
Basic AML Procedure Requirements
The USA Patriot Act sets out the basic requirements for effective AML policies and procedures. In particular, an effective AML program requires: (i) written policies and procedures; (ii) a designated compliance officer; (iii) an ongoing training program; (iv) an independent audit; and (v) customer due diligence. The new rules are focused on the fifth element: customer due diligence.
An effective customer due diligence process must have procedures for effectively understanding a customer relationship and establishing a customer risk profile, and for ongoing monitoring and compliance procedures, including those related to detecting and reporting suspicious activities and updated customer beneficial ownership and control information.
The Bank Secrecy Act imposes an obligation on broker-dealers to file a SAR with FinCEN to report any transaction (or a pattern of transactions) involving $5,000 or more, in which it “knows, suspects, or has reason to suspect” that it “(1) involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade any requirements of the Bank Secrecy Act; (3) has no business or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts; or (4) involves use of the broker-dealer to facilitate criminal activity.”
SEC guidance points out red flags that should cause a broker to conduct further investigation as to whether a SAR needs to be filed, including:
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host ofLawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes.
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.
© Legal & Compliance, LLC 2016
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