November 2016 - Reverse-Merger.com

SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

Posted by Securities Attorney Laura Anthony | November 29, 2016 Tags: SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amend Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). In addition, the SEC has created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC has amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC has repealed the rarely used and now redundant Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A will take effect on April 20, 2017. Amended Rule 504 will take effect on January 20, 2017, and the repeal of Rule 505 will be effective May 20, 2017. The rule changes had initially been proposed in October 2015. My two-part blog on the proposed amendments can be read HERE and HERE.

Background on Rule 147 and Rationale for Amendments

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption.

Rule 147 was adopted as a safe harbor under Section 3(a)(11) to provide further details on the application of the Intrastate Exemption. Rule 147 was adopted in 1974 and until now had not been updated since that time. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.

Section 3(a)(11) and Rule 147 has limitations that simply do not comport to today’s world. For example, the Rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and, if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.

Also, Rule 147 required that an issuer be incorporated in the state in which the offering occurs. In today’s world many company’s incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be overly burdensome.

The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 made it difficult for issuers to take advantage of these new state crowdfunding provisions.

At the same time, many current state intrastate exemptions are modeled after the language in Section 3(a)(11) and the existing Rule 147. As a result, simply amending Rule 147 to allow changes to the manner of offering to include advertising through Internet, television, radio and other forms of media that could be seen by out-of-state residents, would have left a disparity between state and federal rules. Accordingly, the SEC determined to amend Rule 147 within the statutory constraints of Section 3(a)(11) and add new Rule 147 without such constraints.

Summary of the New Rules

Amended Rule 147 remains a safe harbor under Section 3(a)(11) of the Securities Act allowing companies to continue to rely on the rule for current state law exemptions. New Rule 147A is a stand-alone rule not attached to Section 3(a)(11) and therefore not constrained by the specific language in that Section. New Rule 147A is substantially similar to amended Rule 147 but eliminates the restrictions on offers such that the Internet and websites can be used for such offers, and eliminates the requirement that a company be incorporated in the state in which it is conducting the offering as long as certain conditions are met. Sales will still be limited to residents of the company’s state.

Other than provisions allowing out-of-state offers (such as by use of a website) and offerings by states incorporated out of state, amended Rule 147 and new Rule 147A are substantially the same.

Both amended Rule 147 and new Rule 147A include the following: (i) a requirement that the issuer has its “principal place of business” in-state and satisfy at least one in-state “doing business” requirement; (ii) a new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser; (iii) a requirement that issuers obtain a written representation regarding residency from each purchaser; (iv) determining residency of an entity purchaser using the “principal place of business” standard; (v) limiting resales to persons within the same state for a period of six months; (vi) an integration safe harbor for any other prior offering and some subsequent offerings; and (vii) legend requirements for offerees and purchasers related to resale limitations.

Both amended Rule 147 and new Rule 147A remain intrastate exemptions and must comply with all state laws regarding any offerings. States are free to impose additional disclosure requirements, bad-actor prohibitions and other state-specific investor protections. No notice or Form D filing is required to be made to the SEC.

Rule 504 of Regulation D is a registration exemption for small offerings available to companies that are not Exchange Act reporting, investment companies or blank-check companies. Generally Rule 504 requires that the issuing company comply with state law as to the particular offer and exemption requirements, including, where required, a state level registration. The new rule maintains the structure, and bows to state law requirements but increases the aggregate offering amount from $1 million to $5 million and adds bad-actor disqualifications from reliance on the rule.

The SEC has repealed Rule 505 of Regulation D.

Amended Rule 147 and New Rule 147A – Specifics

Manner of Offering

New Rule 147A will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon.

Amended Rule 147 will continue to prohibit offers to out-of-state residents. Both Rules 147 and 147A will require that all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state. To accommodate space-constrained social media, such as Twitter, the SEC will allow the use of hyperlinks. In particular, where offering materials or information is distributed through a medium with limitations on the number of characters or text that may be included, and the information with disclaimers would exceed such limitations, the company can satisfy its disclosure obligation by including an active hyperlink to the required disclosures. The communication must prominently indicate that the required language is provided through the hyperlink. Where an electronic communication is capable of including the required statements, along with the other information, without exceeding the applicable limit on number of characters or amount of text, a hyperlink should not be used.

Determining Whether an Issuer is a “Resident” of a Particular State

Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual. Amended Rule 147 maintains this basic requirement, but supplants “principal office” with “principal place of business,” a term that is also used in new Rule 147A. Under amended Rule 147 a company will be deemed a “resident” of a particular state in which it is both incorporated and has its principal place of business.

An issuer’s “principal place of business” is defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” The concept of principal office has been eliminated.

Under new Rule 147A residence will be determined solely using the “principal place of business” test without regard to state of incorporation. Under both amended Rule 147 and new Rule 147A, companies may only sell securities to purchasers in the same state in which such company has its principal place of residence. As noted above, Rule 147A does not so limit “offers.”

Where a company changes state of residence, under both rules, it will not be able to conduct another offering until the securities sold in the first offering have “come to rest.” That is, both rules provide that where an issuer completes an offering in one state, it would not be able to conduct an offering in another state until six months after the last sale in the prior state. This six-month period is also used for the resale limitation in both rules, which is an amendment from the prior nine-month rule under old Rule 147.

Other than the above manner of offering and determination of residence provisions, amended Rule 147 and new Rule 147A are identical. Accordingly, each of the following discussed provisions apply equally to both Rule 147 and new Rule 147A.

Determining Whether an Issuer is “Doing Business” in a Particular State

In addition to issuer residency, a company must satisfy at least one test establishing that such company is “doing business” in the state of the offering. Old Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Amended Rule 147 and new Rule 147A add a fourth test based on majority of employees, and only require that a company satisfy one of the four test to qualify for the use of the offering within that state.

In particular, an issuer shall be deemed to be doing business within a state if the issuer meets one of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state; or (iv) a majority of the issuer’s employees are located within the state.

Presumably a majority is satisfied by a greater than 50% determination. An employee would be located in a state if he or she is based in an office located in the state. A particular example provided in the rule release is one where an employee services the Virginia, Maryland and Washington, D.C., area for a company with an office in Maryland. In such case, the employee would be deemed based in Maryland.

Amended Rule 147 eliminates an exception from the 80% rule previously in place for companies with $5,000 or less in revenues.

As with all provisions of amended Rule 147 and new Rule 147A, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

Amended Rule 147 and new Rule 147A define the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. Again, “principal place of business” is defined as the location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.

Amended Rule 147 and new Rule 147A add a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state at the time of the purchase of securities, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. As with 506(c), the SEC is reluctant to provide a firm list of requirements that satisfy the reasonable belief standard but rather urges a company to consider all facts and circumstances. However, the rule release does contain some example considerations, including (i) a pre-existing relationship between the company and prospective purchaser that includes knowledge of residency; (ii) evidence such as the address on utility and house bills; (iii) pay stubs; (iv) tax returns; (v) documents issued by a federal or state governmental authority including a driver’s license; and (vi) public records.

In addition to the reasonable belief requirements, a company must obtain a written representation of residency from the investor. The representation of the investor can serve as evidence of residency but is not dispositive. A self-attestation from an investor, without more, is not enough to create a reasonable belief.

The SEC provides examples of proof of residency. For individuals proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the intrastate offering. Amended Rule 147 and new Rule 147A shorten this holding period to six months from the date of the sale. Market makers or dealers desiring to quote such securities after the six-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information.

Bona fide gifts are specifically not subject to the resale limitations. However, the donee would still be bound by the same limitation. Accordingly, if an issuer conducted an intrastate offering in Florida, for example, and a purchaser than made a bona fide gift to a charity in California, that charity would be limited to resales to purchasers in Florida until the six-month period had expired. In this case, the charity could tack onto the holding period of the original purchaser.

The resale limitation is confined to the state in which the issuer conducts the offering. If an issuer changes its principal place of business following an offering, the resale limitations would stay in the state where the offering had been conducted.

Moreover, Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. In the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence. Finally, persons reselling will need to consider whether they could be considered an underwriter if they purchase with a view to distribution. For purposes of determining underwriter status, a purchaser can rely on the guidance in Rule 144.

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Current Rule 147(b)(2) provides an integration safe harbor based on a hard six-month rule. Amended Rule 147 and new Rule 147A amend the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, offers and sales under Rule 147 and Rule 147A will not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering.

The Rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test. As part of an integration analysis, an issuer will need to consider the particular offering exemptions and requirements, including the use of general solicitation and advertising. For instance, a regulation crowdfunding, which by its nature solicits residents in all states, would not be consistent with a Rule 147 offering, but may work with a Rule 147A offering.

Moreover, an issuer will need to be mindful of gun-jumping issues where a registered offering is begun immediately after the conclusion of a Rule 147 or 147A offering that involved solicitation and advertising. In such cases, like testing the waters under Rule 105(c) of the JOBS Act, solicitations will need to be limited to qualified institutional buyers and institutional accredited investors for the 30 days prior to filing the registration statement. In practice, I suspect most issuers will simply wait for a 30-day period after completing an intrastate offering, prior to filing a registration statement.

Disclosure/Legend Requirements

Under amended Rule 147 and new Rule 147A, a disclosure about the limitations on resale needs to be given to each offeree and purchaser at the time of any offer or sale. The disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser. In addition, a written disclosure must be provided to all purchasers a reasonable period of time before the date of the sale.

Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Such legend must also identify the state in which the intrastate offering was completed for purposes of the resale restrictions.

State Law Requirements

Although the SEC had initial proposed limitations as to the availability of the offering to states that, in turn, had registration or exemptions with particular specified provisions including limits on investment amounts, the final rules do not contain such provisions. The SEC believes the states can regulate such offerings without particular federal requirements. The SEC notes that most state crowdfunding or intrastate offering protections already contain total offering limits and per-investor investment limitations.

Intrastate Broker-dealer Exemption

Section 15 of the Exchange Act exempts any broker whose business is exclusively intrastate and who does not use any facility for a national securities exchange, from broker-dealer registration requirements (the “intrastate broker-dealer exemption”). At the request of commenters, the SEC clarifies that a broker will not lose its ability to rely on the intrastate broker-dealer exemption merely because it maintains a website that can be viewed by out-of-state persons so long as such broker takes reasonable steps to ensure that its business remains exclusively intrastate. Such reasonable measures can include disclosures and disclaimers and taking measures to determine the state of residency of a potential client or lead.

Section 12(g) Registration

Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors to register such class of securities with the SEC. After consideration, including the fact that intrastate offerings do not impose any ongoing reporting requirements, the SEC determined not to exempt securities sold in Rule 147 and 147A offerings from the Section 12(g) registration requirements.

Exclusion of Investment Companies

Under Section 24(d) of the Investment Company Act of 1940, Section 3(a)(11) is not available to investment companies registered or required to be registered under the Investment Company Act. Accordingly, investment companies will remain excluded from Section 3(a)(11) and amended Rule 147. For consistency, the SEC specifically excludes investments companies from the use of new Rule 147A.

Amendments To Rules 504 And 505

Overview of Current Rule

Currently Rule 504 of Regulation D provides an exemption from registration for offers and sales up to $1 million in securities in any twelve-month period. Current Rule 504, like Regulation A/A+, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Moreover, current rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

Rules 504, 505 and 506 together comprise Regulation D. Rule 506 is promulgated under Section 4(a)(2) of the Securities Act and preempts state law. Rules 505 and 506 are promulgated under Section 3(b) of the Securities Act and do not preempt state law. Currently Rules 505 and 506 have bad-actor disqualification provisions but Rule 504 does not.

The vast majority of states require the registration of Rule 504 offerings. Rule 504 is similar to the offering exemption found in Section 3(a)(11) in that on the federal level it defers to state legislation and oversight. In fact, of the 34 states that have recently passed state-based crowdfunding exemptions, Maine specifically allows an issuer to rely on Rule 504 in utilizing its crowdfunding provisions.

As Rule 504 is, in essence, a deferral to the states for small offerings, the SEC is of the position that it does not warrant imposing extensive regulation on the federal level. I agree. As stated by the SEC, the purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions and general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Amendments

The SEC has increased the amount of securities that may be offered and sold in reliance on Rule 504 to $5 million in any 12-month period, and has added bad-actor disqualification provisions to the rule. The SEC believes the change will help facilitate capital formation and give states greater flexibility in developing state-coordinated review programs for multi-state registrations. The proposed rule also corrects the technical reference to Section 3(b) of the Securities Act in the Rules 504 to Section 3(b)(1), which change was made by the JOBS Act in 2012.

The proposed bad-actor disqualification provisions are substantially the same as those in place for Rule 506 offerings. For a review of the Rule 506 bad-actor disqualification provisions, see my blog HERE.

Repeal of Rule 505

The SEC has repealed the almost never used Rule 505 in its entirety.

The Author

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

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

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« SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers” Yahoo Hacking Scandal And Obligations Related To Cybersecurity »

SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | November 22, 2016 Tags: Application; Associated Person Registration; Supervision, CAB, CABs, Conduct Rules for CABs, Description of Capital Acquisition Broker (“CAB”), Financial and Operational Rules for CABs, FINRA Rule 2121, FINRA Rule 3110, FINRA rules, M&A deals

On August 18, 2016, the SEC approved FINRA’s rules implementing a new category of broker-dealer called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. FINRA first published proposed rules on CABs in December 2015. My blog on the proposed rules can be read HERE. In March and again in June 2016, FINRA published amendments to the proposed rules. The final rules enact the December proposed rules as modified by the subsequent amendments.

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.

Description of 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 that 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 newly issued 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);

Qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer or control person in connection with a change of control of a privately held company. For purposes of this section, a control person is defined as a person that has the power to direct the management or policies of a company through security ownership or otherwise. A person that has the power to direct the voting or sale of 24% or more of a class of securities is deemed to be a control person; and/or

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; or

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; or 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; or

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 Rule 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 noncompliance. 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

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

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

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« House Passes Accelerated Access To Capital Act SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A »

House Passes Accelerated Access To Capital Act

Posted by Securities Attorney Laura Anthony | November 15, 2016 Tags: Accelerating Access to Capital Act, Access to Capital Act, Micro Offering Safe Harbor Act, Private Placement Improvement Act

On September 8, 2016, the U.S. House of Representatives passed the Accelerating Access to Capital Act. The passage of this Act continues a slew of legislative activity by the House to reduce regulation and facilitate capital formation for small businesses. Unlike many of the House bills that have been passed this year, this one gained national attention, including an article in the Wall Street Journal. Although the bill does not have a Senate sponsor and is not likely to gain one, the Executive Office has indicated it would veto the bill if it made it that far.

Earlier this year I wrote about 3 such bills, including: (i) H.R. 1675 – the Capital Markets Improvement Act of 2016, which has 5 smaller acts imbedded therein; (ii) H.R. 3784, establishing the Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee within the SEC; and (iii) H.R. 2187, proposing an amendment to the definition of accredited investor. See my blog HERE.

In early July, the House passed H.R. 2995, an appropriations bill for the federal budget for the fiscal year beginning October 1. No further action has been taken. The 259-page bill, which is described as “making appropriations for financing services and general government for the fiscal year ending September 30, 2017, and for other purposes” (“House Appropriation Bill”), contains numerous provisions reducing or eliminating funding for key aspects of SEC enforcement and regulatory provisions.
On September 13, 2016, the House passed the Financial Choice Act, which is an extreme anti-regulation act that would dramatically change the current SEC regime and dismantle a large portion of the Dodd-Frank Act. Read my blog on the Financial Choice Act HERE, which also contains thoughts and commentary that likewise apply here.

The Accelerating Access to Capital Act is actually comprised of three bills: (i) H.R. 4850 – the Micro Offering Safe Harbor Act; (ii) H.R. 4852 – the Private Placement Improvement Act; and (iii) H.R. 2357 – the Accelerating Access to Capital Act.

The Accelerating Access to Capital Act

The Accelerating Access to Capital Act would broaden the availability of a Form S-3 short-form registration statement to include:

(i) All companies listed on a national securities exchange (currently the eligibility is based on the size of the company and generally Form S-3 is not available to smaller reporting companies); and
(ii) Remove an instruction limiting the use of Form S-3 to offerings that (a) represent less than 1/3 of the aggregate market value of the non-affiliated common equity; (b) are not conducted by a shell company nor any company that has been a shell company within the last 12 months; and (c) by companies listed on a national exchange.

This Act would, in essence, open up the use of Form S-3 to penny stock issuers. A Form S-3 can be used for shelf offerings. Moreover, shelf takedowns are not subject to separate SEC review or approval.

The Micro Offering Safe Harbor Act

The Micro Offering Safe Harbor Act would add a new Section 4(f) to the Securities Act of 1933, as amended (“Securities Act”). Section 4 exempts certain transactions from the registration requirements of the Securities Act. The new Section 4(f) would exempt transactions by an issuer, including all entities controlled by or under common control with the issuer, that meet the following:

(i) Pre-existing relationship – each purchaser must have a substantive pre-existing relationship with an officer, director or 10% or greater shareholder of the issuer;
(ii) 35 or fewer purchaser – there are no more than 35 purchasers of securities sold in reliance on the exemption during the 12-month period preceding the transaction;
(iii) Small offering amount – the aggregate offering amount of securities sold by the company, including any amount sold under this exemption, during the 12 months preceding the transaction, does not exceed $500,000;
(iv) Bad Actor Disqualification – the exemption would not be available to any issuer that would be disqualified under the Rule 506 bad actor rules (see HERE) for a refresher); and
(v) State law pre-emption – securities sold under the exemption would be included as federally covered securities.

The Micro Offering Safe Harbor Act is obviously poorly drafted and raises many questions as to how it could be implemented and utilized within the current regulatory framework.
The Private Placement Improvement Act

The Private Placement Improvement Act requires the SEC to revise Regulation D to simplify the Form D filing requirements and to clarify that the filing of a Form D is not a condition to relying on the exemption. Moreover, it would become the SEC’s responsibility to notify states of the Form D filing. The Act also adds a “knowledgeable employee” of a private fund or the fund’s investment advisor to the definition of an accredited investor.

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.

« Changes In India’s Laws Related To Foreign Direct Investments- A U.S. Opportunity; Brief Overview For Foreign Private Issuers SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers” »

Changes In India’s Laws Related To Foreign Direct Investments- A U.S. Opportunity; Brief Overview For Foreign Private Issuers

Posted by Securities Attorney Laura Anthony | November 11, 2016

In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian owned and domiciled companies. The new rules continue a trend in laws supporting India as an open world economy. A large portion of the U.S. public marketplace is actually the trading of securities of foreign owned or held businesses. Foreign businesses may register and trade directly on U.S. public markets as foreign private issuers, or they may operate as partial or wholly owned subsidiaries of U.S. parent companies that in turn quote and trade on either the OTC Markets or a U.S. exchange.

Brief Overview for Foreign Private Issuers

Definition of Foreign Private Issuer

Both the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934, as amended (“Exchange Act”) contain definitions of a “foreign private issuer.” Generally, if a company does not meet the definition of a foreign private issuer, it is subject to the same registration and reporting requirements as any U.S. company.

The determination of foreign private issuer status is not just dependent on the country of domicile, though a U.S. company can never qualify regardless of the location of its operations, assets, management and subsidiaries. There are generally two tests of qualification as a foreign private issuer, as follows: (i) relative degree of U.S. share ownership; and (ii) level of U.S. business contacts.

As with many securities law definitions, the overall definition of foreign private issuer starts with an all-encompassing “any foreign issuer” and then carves out exceptions from there. In particular, a foreign private issuer is any foreign issuer, except one that meets the following as of the last day of its second fiscal quarter:

(i) a foreign government;

(ii) more than 50% of its voting securities are directly or indirectly held by U.S. residents; and any of the following: (a) the majority of the executive officers or directors are U.S. citizens or residents; (b) more than 50% of the assets are in the U.S.; or (c) the principal business is in the U.S. Principal business location is determined by considering the company’s principal business segments or operations, its board and shareholder meetings, its headquarters, and its most influential key executives.

That is, if fewer than a foreign company’s shareholders are located in the U.S., it qualifies as a foreign private issuer. If more than 50% of the record shareholders are in the U.S., the company must further consider the location of its officers and directors, assets and business operations.

Registration and Ongoing Reporting Obligations

Like U.S. companies, when a foreign company desires to sell securities to U.S. investors, such offers and sales must either be registered or there must be an available Securities Act exemption from registration. The registration and exemption rules available to foreign private issuers are the same as those for U.S. domestic companies, including, for example, Regulation D (with the primarily used Rules 506(b) and 506(c)) and Regulation S) and resale restrictions and exemptions such as under Section 4(a)(1) and Rule 144.

When offers and sales are registered, the foreign company becomes subject to ongoing reporting requirements. Subject to the exemption under Exchange Act Rule 12g3-2(b) discussed at the end of this blog, when a foreign company desires to trade on a U.S. exchange or the OTC Markets, it must register a class of securities under either Section 12(b) or 12(g) of the Exchange Act. Likewise, when a foreign company’s worldwide assets and worldwide/U.S. shareholder base reaches a certain level ($10 million in assets; total shareholders of 2,000 or greater or 500 unaccredited with U.S. shareholders being 300 or more), it is required to register with the SEC under Section 12(g) of the Exchange Act.

The SEC has adopted several rules applicable only to foreign private issuers and maintains an Office of International Corporate Finance to review filings and assist in registration and reporting questions. Of particular significance:

(i) Foreign private issuers may prepare financial statements using either US GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to US GAAP;

(ii) Foreign private issuers are exempt from the Section 14 proxy rules;

(iii) Insiders of foreign private issuers are exempt from the Section 16 reporting requirements and short swing trading prohibitions; however, they must comply with Section 13 (for a review of Sections 13 and 16, see my blog HERE);

(iv) Foreign private issuers are exempt from Regulation FD;

(v) Foreign private issuers may use separate registration and reporting forms and are not required to file quarterly reports (for example, Form F-1 registration statement and Forms 20-F and 6-K for annual and periodic reports); and

(vi) Foreign private issuers have a separate exemption from the Section 12(g) registration requirements (Rule 12g3-2(b)) allowing the trading of securities on the OTC Markets without being subject to the SEC reporting requirement.

Although a foreign private issuer may voluntarily register and report using the same forms and rules applicable to U.S. issuers, they may also opt to use special forms and rules specifically designed for and only available to foreign companies. Form 20-F is the primary disclosure document and Exchange Act registration form for foreign private issuers and is analogous to both an annual report on Form 10-K and an Exchange Act registration statement on Form 10. A Form F-1 is the general registration form for the offer and sale of securities under the Securities Act and, like Form S-1, is the form to be used when the company does not qualify for the use of any other registration form.

A Form F-3 is analogous to A Form S-3. A Form F-3 allows incorporation by reference of an annual and other SEC reports. To qualify to use a Form F-3, the foreign company must, among other requirements that are substantially similar to S-3, have been subject to the Exchange Act reporting requirements for at least 12 months and filed all reports in a timely manner during that time. The company must have filed at least one annual report on Form 20-F. A Form F-4 is used for business combinations and exchange offers, and a Form F-6 is used for American Depository Receipts (ADR). Also, under certain circumstances, a foreign private issuer can submit a registration statement on a confidential basis.

Once registered, a foreign private issuer must file periodic reports. A Form 20-F is sued for an annual report and is due within four months of fiscal year-end. Quarterly reports are not required. A Form 6-K is used for periodic reports and captures: (i) the information that would be required to be filed in a Form 8-K; (ii) information the company makes or is required to make public under the laws of its country of domicile; and (iii) information it files or is required to file with a U.S. and foreign stock exchange.

As noted above, a foreign private issuer may elect to use either U.S. GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to U.S. GAAP in the preparation and presentation of its financial statements. Regardless of the accounting standard used, the audit firm must be registered with the PCAOB.

All filings with the SEC must be made in English. Where a document or contract is being translated from a different language, the SEC has rules to ensure the translation is fair and accurate.

The SEC rules do not have scaled disclosure requirements for foreign private issuers. That is, all companies, regardless of size, must report the same information. A foreign private issuer that would qualify as a smaller reporting company or emerging growth company should consider whether it should use and be subject to the regular U.S. reporting requirements and registration and reporting forms. The company should also consider that no foreign private issuer is required to provide a Compensation Discussion & Analysis (CD&I). If the foreign company opts to be subject to the regular U.S. reporting requirements, it must also use U.S. GAAP for its financial statements. For further discussions on general reporting requirements and rules related to smaller reporting and emerging growth companies, see my blogs HERE, HERE, and HERE related to ongoing proposed changes and which includes multiple related links under the “further background” subsection.

Deregistration

The deregistration rules for a foreign private issuer are different from those for domestic companies. A foreign private issuer may deregister if: (i) the average daily volume of trading of its securities in the U.S. for a recent 12-month period is less than 5% of the worldwide average daily trading volume; or (ii) the company has fewer than 300 shareholders worldwide. In addition, the company must: (i) have been reporting for at least one year and have filed at least one annual report and be current in all reports; (ii) must not have registered securities for sale in the last 12 months; and (iii) must have maintained a listing of securities in its primary trading markets for at least 12 months prior to deregistration.

American Depository Receipts (ADRs)

An ADR is a certificate that evidences ownership of American Depository Shares (ADS) which, in turn, reflect a specified interest in a foreign company’s shares. Technically the ADR is a certificate reflecting ownership of an ADS, but in practice market participants just use the term ADR to reflect both. An ADR trades in U.S. dollars and clears through the U.S. DTC, thus avoiding foreign currency issuers. ADR’s are issued by a U.S. bank which, in turn, either directly or indirectly through a relationship with a foreign custodian bank, holds a deposit of the underlying foreign company’s shares. ADR securities must either be subject to the Exchange Act reporting requirements or be exempt under Rule 12g3-2(b). ADR’s are always registered on Form F-6.

OTC Markets

OTC Markets allows for the listing and trading of foreign entities on the OTCQX and OTCQB that do not meet the definition of a foreign private issuer as long as such company has its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days subject to OTC Markets’ ability to waive such requirement upon application. If the company does not meet the definition of foreign private issuer, it still must fully comply with Exchange Act Rule 12g3-2(b). For details on the OTCQX listing requirements for international companies, see my blog HERE and for listing requirements for OTCQB companies, including international issuers, see HERE.

India as an emerging market

India is widely considered the world’s fastest growing major economy. The small and micro-cap industry has been eyeing India as an emerging market for the U.S. public marketplace for several years now. In my practice alone, I have been approached by several groups that see the U.S. public markets as offering incredible potential to the exploding Indian start-up and emerging growth sector. Taking advantage of this opportunity, however, was stifled by strict Indian laws prohibiting or limiting foreign investment into Indian companies. In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian owned and domiciled companies opening up the country to foreign investment, including by U.S. shareholders.

The new rules allow for up to 100% foreign investment in certain sectors. U.S. investors who already invest heavily in Indian-based defense, aviation, pharmaceutical and technology companies will see even greater opportunity in these sectors, which will now allow up to 100% foreign investment. Although certain sectors, including defense, will still require advance government approval for foreign investment, most sectors will receive automatic approval. U.S. public companies will now be free to invest in and acquire Indian-based subsidiaries. Likewise, more India-based companies will be able to trade on U.S. public markets, attracting U.S. shareholders and the benefits of market liquidity and public company valuations.

Indian companies are slowly starting to take advantage of reverse merger transactions with U.S. public companies. In July 2016, online travel agency Yatra Online, Inc., entered into a reverse merger agreement with Terrapin 3 Acquisition Corp, a U.S. SPAC. The transaction is expected to close in October 2016. Yatra is structured under a U.S. holding company with operations in India though an India domiciled subsidiary.

Last year Vidocon d2h became the first India-based company to go public via reverse merger when it completed a reverse merger with a U.S. NASDAQ SPAC. In January, 2016 Bangalore-based Strand Life Sciences Pvt Ltd became the second India based reverse merger when it went public in the U.S. in a transaction with a NASDAQ company.

In addition, U.S.-based public companies, venture capital and private equity firms, and hedge funds and family offices have been investing heavily in the Indian start-up and emerging growth boom. Yatra and Strand Life had both received several rounds of U.S. private funding before entering into their reverse merger agreements. NASDAQ-listed firm Ctrip.com International recently invested $180 million into another India-based online travel company, MakeMyTrip.

India’s Mumbai/Bombay Stock Exchange is already a Qualified Foreign Exchange for purposes of meeting the standards to trade on the U.S. OTCQX International. For details on all OTCQX listing requirements, including for international companies, see my blog HERE and related directly to international companies including Rule 12g3-2(b), see HERE. At least 5 companies currently trade on the OTCQX, with their principal market being in India.

Exchange Act Rule 12g3-2(b)

Exchange Act Rule 12g3-2(b) permits foreign private issuers to have their equity securities traded on the U.S. over-the-counter market without registration under Section 12 of the Exchange Act (and therefore without being subject to the Exchange Act reporting requirements). The Rule is automatic for foreign issuers that meet its requirements. A foreign issuer may not rely on the rule if it is otherwise subject to the Exchange Act reporting requirements.

The Rule provides that an issuer is not required to be subject to the Exchange Act reporting requirements if:

(i) the issuer currently maintains a listing of its securities on one or more exchanges in a foreign jurisdiction which is the primary trading market for such securities; and

(ii) the issuer has published, in English, on its website or through an electronic information delivery system generally available to the public in its primary trading market (such as the OTC Market Group website), information that, since the first day of its most recently completed fiscal year, it (a) has made public or been required to make public pursuant to the laws of its country of domicile; (b) has filed or been required to file with the principal stock exchange in its primary trading market and which has been made public by that exchange; and (c) has distributed or been required to distribute to its security holders.

Primary Trading Market means that at least 55 percent of the trading in the subject class of securities on a worldwide basis took place in, on or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer’s most recently completed fiscal year.

In order to maintain the Rule 12g3-2(b) exemption, the issuer must continue to publish the required information on an ongoing basis and for each fiscal year. The information required to be published electronically is information that is material to an investment decision regarding the subject securities, such as information concerning:

(i) Results of operations or financial condition;

(ii) Changes in business;

(iii) Acquisitions or dispositions of assets;

(iv) The issuance, redemption or acquisition of securities;

(v) Changes in management or control;

(vi) The granting of options or the payment of other remuneration to directors or officers; and

(vii) Transactions with directors, officers or principal security holders.

At a minimum, a foreign private issuer shall electronically publish English translations of the following documents:

(i) Its annual report, including or accompanied by annual financial statements;

(ii) Interim reports that include financial statements;

(iii) Press releases; and

(iv) All other communications and documents distributed directly to security holders of each class of securities to which the exemption relates.

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The Author

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

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

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

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« SEC Issues New C&DI On Rule 701 House Passes Accelerated Access To Capital Act »

SEC Issues New C&DI On Rule 701

Posted by Securities Attorney Laura Anthony | November 1, 2016 Tags: C&DI, Rule 701

On June 23, 2016, the SEC issued seven new Compliance and Disclosure Interpretations (“C&DI”) related to Rule 701 of the Securities Act of 1933, as amended (“Securities Act”). On October 19, 2016, the SEC issued an additional three C&DI. The majority of the new C&DI focus on the effect on Rule 701 issuances following a merger or acquisition and clarify financial statement requirements under Rule 701. Two of the new C&DI address restricted stock awards including the disclosure requirements are triggered and when the holding period begins under Rule 144.

Rule 701 – Exemption for Offers and Sales to Employees of Non-Reporting Entities

Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. However, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701 a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12 month period exceeds $5 million, the company provide the following disclosures to investors a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors a reasonable time before the date of the irrevocable election to defer is made.

As with all other Securities Act registration exemptions, the company is still subject to the antifraud, civil liability and other provisions of the federal securities laws. In addition, Rule 701 is not available for plans or schemes to circumvent the purpose of the Rule, which is for compensatory purposes, and not to raise capital. Moreover, Rule 701 is not available to exempt any transaction that is in technical compliance with this section but is part of a plan or scheme to evade the registration provisions of the Securities Act.

Rule 701 does not preempt state law and accordingly, in addition to complying with Rule 701, the company also must comply with any applicable state law relating to the issuance.

New C&DI

On June 23, 2016, the SEC issued seven new C&DI and on October 19, 2016 an additional three new C&DI all related to Rule 701. The majority of the new C&DI focus on merger and acquisition transactions, including reverse mergers. In addition, the new C&DI clarify financial statement requirements under Rule 701. A summary of the new C&DI follows.

In a merger transaction where the acquirer assumes derivative securities of the target (such as options and warrants) and, as such, they become economically equivalent derivative securities of the acquirer, no exemption need be relied upon for the assumption and transfer of the obligation to the acquirer as long as the derivative securities (again, such as employee options and warrants) were properly issued under Rule 701 and the transfer to the acquirer does not require the consent of the holders of the derivative securities.

In other words, if a company issued options or warrants to its employees under a Rule 701 plan and that company is later acquired, such as through a reverse merger with a public shell company, the options or warrants could become obligations of the public company, without further registration or reliance on a registration exemption. As long as the options or warrants were properly issued under Rule 701 in the first place, the later exercise and conversion into other securities of the acquiring company, such as common stock, would also be exempt from registration. Moreover, where the acquiring company is subject to the Securities Exchange Act reporting requirements, the Exchange Act reports would satisfy any disclosure requirements under Rule 701(e)

Securities issued under Rule 701 would aggregate with securities issued under the same rule after a merger or acquisition. Rule 701 issuances by the target and acquirer aggregate for all purposes, including determining issuance limits under the rule and disclosure obligations to share recipients. Assuming the $1,000,000 limit, if the target company had issued Rule 701 securities up to $500,000, the combined post-merger entity would only be able to issue an additional $500,000 in that 12-month period. However, the combined companies could use a post-merger balance sheet in determining total assets for purposes of calculating allowable continued issuances under Rule 701. Likewise, the combined companies can use post-merger financial statements to satisfy the disclosure obligations required under Rule 701.

As a reminder from above, the amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption.

The new C&DI clarifies when disclosure delivery requirements are triggered when aggregate sales of a restricted stock award (commonly referred to as a restrictive stock unit or RSU) in a 12 month period exceeds the $5 million threshold. When a company grants a restricted stock award, the date of sale is the date of grant of the award and thus the disclosure must be provided a reasonable time before the date of grant. Unlike an option or warrant, the employee does not need to take additional action to convert or exercise a restricted stock award, rather the award vests and the stock becomes irrevocably granted to the employee by the satisfaction of conditions (such as time of employment). Accordingly, Rule 7(e)(6) requiring disclosure be delivered prior to the exercise of an option or warrant would not apply.

Rule 701 requires that the same financial statements required in Regulation A be provided as disclosure to share recipients. Rule 701 was not amended or modified when the new Regulation A/A+ rules came into effect on June 19, 2015, leaving open the question as to which of the different Regulation A+ financial statement requirements need be used in a Rule 701 disclosure. The new SEC C&DI clarifies that a company can elect to provide the financial statements required under either Tier 1 or Tier 2 of Regulation A, regardless of the value of securities being offered or issued under Rule 701.

Finally the SEC clarifies when the Rule 144 holding period begins for restricted stock awards. In particular, the holding period begins “when the person who will receive the securities is deemed to have paid for the securities and thereby assumed the full risk of economic loss with respect to them.” For negotiated employment agreements the holding period begins on the date the investment risk passes to the employee, which generally is the date of the agreement. For restricted awards that vest over time and are conditioned solely on continued employment or satisfaction of other conditions not tied to the employees performance, the holding period begins on the date of the agreement. Like any other derivative security, if the employee is required to pay additional consideration for the securities (such as through exercise of a warrant or option) a new holding period would begin on the date of that payment (i.e. the date of the new investment decision).

Application of Exchange Act Section 12(g) to Employee Compensation Plans; Determining Holders of Record

On May 3, 2016, the SEC issued final amendments to revise the rules related to the thresholds for registrations, termination of registration, and suspension of reporting under Section 12(g) of the Securities Exchange Act of 1934. The amendments revise the Section 12(g) and 15(d) rules to reflect the new, higher shareholder thresholds for triggering registration requirements and for allowing the voluntary termination of registration or suspension of reporting obligations.

In particular, a company that is not a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. The same thresholds apply to termination of registration and suspension of reporting obligations.

The rules establish a non-exclusive safe harbor that companies may follow to exclude persons who received securities pursuant to employee compensation plans when calculating the shareholders of record for purposes of triggering the registration requirements under Section 12(g). Exchange Act Section 12(g)(5) provides that the definition of “held of record” shall not include securities held by persons who received them pursuant to an “employee compensation plan” in exempt transactions. By its express terms, this new statutory exclusion applies solely for purposes of determining whether an issuer is required to register a class of equity securities under the Exchange Act and does not apply to a determination of whether such registration may be terminated or suspended.

The rule establishes a statutory exclusion for security holders who received their stock in unregistered employee stock compensation plans, and provides a safe harbor for determining whether holders of their securities received them pursuant to an employee compensation plan in exempt transactions.

In its Section 12(g) rules, the SEC incorporates Rule 701(c) and the guidance under that rule for issuers to rely on in their Section 12(g) analysis. The proposed safe harbor allows an issuer to conclude that shares were issued pursuant to an employee compensation plan in an unregistered transaction as long as all the conditions of Rule 701(c) are met, even if other requirements of Rule 701, such as 701 (b) (volume limitations) or 701(d) (disclosure delivery requirements), are not met.

Under the definition of “held of record,” for purposes of Section 12(g), an issuer may exclude securities that are either:

held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or

held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

The SEC also excludes securities issued under the “no-sale” exemption to registration theory from the “held of record” definition, including shares issued as a dividend to employees. That is, the SEC is excluding securities that did not involve a sale within the meaning of Section 2(a)(3), as well as exempt securities issued under Section 3 of the Securities Act. Examples of securities issued under Section 3 include exchange securities under sections 3(a)(9) and 3(a)(10).

The Author

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

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