SEC Expands Ability To File Confidential Registration Statements
Posted by Securities Attorney Laura Anthony | July 25, 2017 Tags:

On June 19, 2017, the SEC announced that the Division of Corporation Finance will permit all companies to submit draft registration statements, on a confidential basis. Confidential draft submissions will now be available for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting.

The SEC has adopted the change by staff prerogative and not a formal rule change. On June 29, 2017, the SEC issued guidance on the change via new FAQs. The new policy is effective July 10, 2017.

Title I of the JOBS Act initially allowed for confidential draft submissions of registration statements by emerging growth companies but did not include any other companies, such as smaller reporting companies. Regulation A+ as enacted on June 19, 2015, also allows for confidential submissions of an offering circular by companies completing their first Regulation A+ offering. The new policy does not change or limit the current process and procedures for confidential submissions by emerging growth (or Regulation A+) issuers.

In its press release, Director of the Division of Corporation Finance Bill Hinman stated, “[T]his is an important step in our efforts to foster capital formation, provide investment opportunities, and protect investors. This process makes it easier for more companies to enter and participate in our public company disclosure-based system.”

The SEC also considers this change as helpful in its efforts to improve the slow IPO market. SEC Chair Jay Clayton said, “By expanding a popular JOBS Act benefit to all companies, we hope that the next American success story will look to our public markets when they need access to affordable capital. We are striving for efficiency in our processes to encourage more companies to consider going public, which can result in more choices for investors, job creation, and a stronger U.S. economy.”

Background

Title I of the JOBS Act, initially enacted on April 5, 2012, created a new category of issuer called an “emerging growth company” (“EGC”).The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process. For a summary of the scaled disclosure available to an EGC as well as the differences in disclosure requirements between an EGC and a smaller reporting company, see HERE.

As a reminder, the definition of an EGC as first enacted on April 5, 2012, was a company with total annual gross revenues of less than $1 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011.  An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1 billion in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO (for example, if the issuer has a December 31 fiscal year-end and sells equity securities pursuant to an effective registration statement on May 2, 2016, it will cease to be an EGC on December 31, 2021); (iii) the date on which it has issued more than $1 billion in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more). EGC status is not available to asset-backed securities issuers (“ABS”) reporting under Regulation AB or investment companies registered under the Investment Company Act of 1940, as amended. However, business development companies (BDC’s) do qualify.

On March 31, 2017, the SEC made inflationary adjustments to the definition of an EGC by increasing the definition by $70,000. Accordingly, an EGC is now defined as a company with total gross revenues of less than $1,070,000,000.

Regulation A+ as enacted on June 19, 2015, also allows for confidential submissions of an offering circular by companies completing their first Regulation A+ offering.  Confidential submissions under Regulation A allow an issuer to get the process under way while soliciting interest of investors using the “test-the-waters” provisions without negative publicity risk if it alters or withdraws the offering before qualification by the SEC. However, the confidential filing, SEC comments, and all amendments must be publicly filed as exhibits to the offering statement at least 15 calendar days before qualification.

New Policy Guidelines

Confidential submissions to the SEC are completed by choosing a “confidential” setting in the EDGAR system.  The EDGAR filing manual has detailed instructions for filing confidential draft registration statements which instructions can be followed by all companies.

To satisfy the requirement to publicly file the previous confidential information, the company can file all prior confidential information as an exhibit to its non-confidential filing, or change the setting in the EDGAR system on its prior filings, from “confidential” to “public.” In the event the company chooses to change its EDGAR setting to “public,” it would not have to re-file all prior confidential material as an exhibit to a new filing.

A confidential registration statement is subject to the same rules related to content and financial statements as a public filing. For example, if the company would be able to omit historical financial statements pursuant to the provisions of Section 71003 of the FAST Act, they could also do so in the confidential submission. See HERE for more information on Section 71003.

Filing fees for registration are not due until a public registration statement is filed.

Securities Act Initial Public Offerings

The SEC will review draft registration statements and related revisions on a nonpublic basis if the company files a cover letter with the initial draft registration statement confirming that the company will file publicly file the registration statement and all nonpublic draft submissions at least 15 days prior to any road show, and in the absence of a road show, at least 15 days prior to the requested effective date of the registration statement.

Registration Under Section 12(b) of the Exchange Act

A registration statement under Section 12(b) of the Securities Exchange Act of 1934 is necessary to register a security for listing on a national securities exchange.  A Form 10 is used to register securities under Section 12(b).  It should be noted that a Form 10 is also used to register securities under Section 12(g) of the Exchange Act.  Section 12(g) requires registration under certain circumstances and also allows for voluntary registration.  For more on Section 12(g), see HERE.

Securities Act Follow-on Offerings

The SEC will also accept confidential draft registration statements for follow-on offerings that are submitted prior to the end of the twelfth month following the effective date of the company’s initial Securities Act registration statement or Section 12(b) Exchange Act registration statement.  In this case the company must submit a cover letter confirming that it was filing the registration statement and nonpublic draft submission at least 48 hours prior to any requested effective date.

In the case of a follow-on registration, the SEC will only allow a confidential submission of the first draft.  Any subsequent amendments responding to SEC comments would need to be filed publicly.  The company should also file the initial confidential filing, publicly, when it submits its first public filing of the registration statement.

Foreign Private Issuers

Foreign private issuers may follow the new guidance, may follow the process available to emerging growth companies (if they so qualify) or may elect the confidential review process only available to such foreign private issuers.  In particular, the SEC allows the nonpublic submission of draft registration statements for foreign issuers if the foreign registrant is: (i) a foreign government registering its debt securities; (ii) a foreign private issuer that is listed or is concurrently listing its securities on a non-U.S. securities exchange; (iii) a foreign private issuer that is being privatized by a foreign government; or (iv) a foreign private issuer that can demonstrate that the public filing of an initial registration statement would conflict with the laws of an applicable foreign jurisdiction.  Shell companies and blank-check companies may not utilize a confidential submission.

Rule 83 Confidentiality Request

If a company wants to keep certain information confidential, even after the required time to make such information public, it will need to submit two confidential requests, one as part of the registration review process and one when prior confidential filings are made public. During the confidential review process, the company should submit a request under Rule 83 in the same manner it would during a typical review of a registered offering. Once the company is required to make the prior filings “public” (15 days prior to qualification or effectiveness), the company would make a new request for confidential treatment under Rule 406 in the same manner other confidential treatment requests are submitted. In particular, for a confidential treatment request under Rules 83 and 406, a company must submit a redacted version of the document via EDGAR with the appropriate legend indicating that confidential treatment has been requested. Concurrently, the company must submit a full, unredacted paper version of the document to the SEC using the ordinary confidential treatment procedure (such filings are submitted via a designated fax line to a designated person to maintain confidentiality).

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.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.

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 2017

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SEC Chief Accountant Speaks On Financial Reporting
Posted by Securities Attorney Laura Anthony | July 11, 2017 Tags: , , ,

On June 8, 2017, the SEC Chief Accountant, Wesley R. Bricker, gave a speech before the 36th Annual SEC and Financial Reporting Institute Conference. The speech, which this blog summarizes, was titled “Advancing the Role of Credible Financial Reporting in the Capital Markets.” As usual, I’ve included commentary throughout.

Introduction and Role of the PCAOB

The speech begins with some general background comments and a discussion of the role of the PCAOB. Approximately half of Americans invest in the U.S. equity markets, either directly or through mutual funds and employer-sponsored retirement plans. The ability to judge the opportunities and risks and make investment choices depends on the quality of information available to the public and importantly, the quality of the accounting and auditing information. Mr. Bricker notes that “[T]he credibility of financial statements have a direct effect on a company’s cost of capital, which is reflected in the price that investors are willing to pay for the company’s securities.”

The quality of financial statements begins with the company’s internal accounting and audit committees; however, an audit by an independent accountant provides investor confidence in the financial statements themselves. Mr. Bricker notes the importance of having an independent auditor that is thorough in their review and testing of the financial statements to ensure that they are accurate and do not contain any misstatements. In order to ensure that this process works, both the profession itself and regulators must be actively involved.

The Public Company Accounting Oversight Board (“PCAOB”) has broad oversight and responsibility related to the audit and auditors of public companies and broker-dealers. The PCAOB sets accounting standards, completes registration and inspection of audit firms and has enforcement authority. The PCAOB inspection process includes a review of audit files and of internal controls and processes of audit firms.  The reports are made public via Staff Inspection Briefs and individual inspection reports. Also, a list of registered qualified PCAOB auditors is readily available on the PCAOB website.

The PCAOB completes an annual review of current and emerging audit issues and publishes and sets audit standards and changes. The PCAOB also publishes guidance for auditors and the audit process. As an example, the PCAOB recently proposed a new standard for audit reports. The proposed new standard would require auditors to describe “critical audit matters” that are communicated to a company’s audit committee. Critical matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.

The proposal would also add information to the audit report related to the audit firm tenure, and the auditor’s role and responsibilities.  Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks. The SEC has yet to approve the rule. If/when approved, the new rule would be implemented for large accelerated filers beginning mid-2019 and for all other companies starting in 2021. Mr. Bricker notes that this proposed change is significant as the audit report is the document in which the auditor itself communicates to the public and investors.

International Collaboration

Mr. Bricker then discusses international collaboration with foreign regulators and standard setters. He notes that “in today’s interconnected world economy, investors depend on high quality auditing and auditing standards around the world,” also noting that “U.S. investors routinely invest in companies based outside the United States and listed in non-U.S. jurisdictions to diversify their portfolio.”

Turning to some facts and figures, U.S. investors invested $9 trillion in foreign equity and long-term debt, including through mutual funds.  Investment in domestic equity and long-term debt comes in at $61.4 trillion. This number continues to increase. During the week ending May 17, 2017, U.S. investors added $9.9 billion to U.S.-based mutual and exchange traded funds which invest abroad. This was the largest weekly increase since July 2015.

It is important for investors to be aware of the processes, regulations, regulators and governance in place related to audits and auditing standards outside of the U.S. Although Mr. Bricker continues on the importance of international audit standards, and trust in the audit process, he does not refer to any specific initiatives or guidelines in that regard.

New GAAP Accounting Standards; Revenue Recognition

Recently there have been several changes to accounting processes and several other proposed changes. One that will have a material impact is related to revenue recognition. As requested by investors, businesses and the marketplace, FASB and IASB recently adopted new revenue-recognition standards which will be implemented over the next three years. Mr. Bricker does not get into the details of the new revenue-recognition standard but emphasizes that the audit committee and auditors need to participate in and have an understanding of how the company is implementing the changes, including a flow through to internal controls and procedures.

The following is my very high-level summary of the impact on contracts from the complex new revenue recognition standards. The revenue recognition changes are designed to assist an investor in understanding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts and customers. As revenue recognition is initially determined by the terms of a contract, it is important when drafting contracts to consider the financial statement impact. The new standard sets forth five steps to consider.

The first step is to identify the particular contract, which is an agreement between two or more parties that creates enforceable rights and obligations. The new standard requires that multiple contracts, between the same parties, entered into at or near the same time, must be combined and analyzed as one contract if (i) the contracts are negotiated as a package with a single commercial objective; (ii) the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or (iii) the goods or services promised in the contracts are a single performance obligation.

The second step is to identify the performance obligations, which is a promise in a contract with a customer to transfer to the customer either: (i) a good or service (or bundle of goods or services) that is distinct; or (ii) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. A good or service is distinct if both of the following conditions are met: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and (ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.

This step is vitally important as revenue is recognized when or as performance obligations are satisfied, and thus a contract must clearly identify those performance obligations. One blog I read gave a great example of where contract drafting can result in different revenue recognition—in particular, where a developer enters into a contract to build a completed building for a particular purpose for a customer.  The contract may be written whereby parts of the delivered project have distinct and independent value, such as engineering, site clearance, construction, installation of equipment and finishing such that revenue is recognized upon delivery of these distinct elements.  Contrarily the contract could be written such that the individual parts are not separately identifiable, but rather only the end product, such that revenue would not be recognized until such end product is provided.

The third step is determining the transaction price which is the amount of consideration to be paid in exchange for delivering the promised goods or services to a customer, excluding amounts collected on behalf of third parties. The two main considerations are: (i) variable consideration – if the consideration is variable, the company should estimate either the expected value or the most likely amount, depending on which will be the more likely; and (ii) constraining estimates of variable consideration – a company should include in the transaction price some or all of an estimate of variable consideration only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Transaction price can also vary based on non-cash consideration, discounts, rebates, refunds, performance bonuses, penalties, contingent payments and the like. An example would be where a custom asset is being built and the price is contingent upon a delivery deadline, with a performance bonus for early delivery and penalties for later delivery. An additional complexity may be where the price is based on an independent appraisal at the time of delivery. Complex variables may prohibit revenue recognition until a contract is fully performed.

The fourth step is to allocate the transaction price to the performance obligations in the contract. This amount should reflect the amount a company would be entitled to in exchange for satisfying each performance obligation. To be able to recognize revenue based on allocation, the contract should clearly identify a particular distinct delivered good or service on a stand-alone selling-price basis. The allocation can be very complex and the amount of revenue recognized could end up differing from a stated value in a contract, which may be arbitrary.

The fifth step is to recognize revenue when or as the company satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when or as the customer obtains control of that good or service. Where a good or service is transferred over time, revenue may be recognized if one of the following conditions is met: (i) the customer simultaneously receives and consumes the benefits provided by the company’s performance over time; (ii) the company’s performance creates or enhances an asset that the customer controls as it is being created or enhanced; or (iii) the company’s performance does not create an asset with an alternative use to that company, and the company has an enforceable right to payment for performance completed to date (customized products or services).

Where performance and delivery are not over time, a company should consider the following as to when to recognize revenue: (i) the company has a present right to payment for the asset; (ii) the customer has legal title to the asset; (iii) the company has transferred physical possession of the asset; (iv) the customer has the significant risks and rewards of ownership of the asset; or (v) the customer has accepted the asset.

Also not included in Mr. Bricker’s speech is that some companies have chosen to adopt the new standards already, including Ford Motor Company, General Dynamics, Raytheon, Alphabet, First Solar and United Health Group. The MD&A for each of these companies contains a summary of the changes and how they impact their particular company and its financial statements.

Internal Control over Financial Reporting

Internal controls over financial reporting are controls designed to provide reasonable assurance that the company’s financial statements are prepared in accordance with GAAP. Internal controls provide the guidance and road map for management to effectively ensure timely and accurate financial reporting.  All companies are required to maintain internal controls over financial reporting, whether or not such company is subject to the Sarbanes-Oxley Act.

Mr. Bricker advocates the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework for assessing the effectiveness of internal controls. The Treadway Commission is the National Commission on Fraudulent Reporting and has long been accepted as providing acceptable guidance on internal controls over financial reporting, and processes for management to assess same.

Mr. Bricker does not get into the specifics of the COSO framework for evaluating internal controls. However, I am providing a brief summary. In 1992 COSO developed a model for evaluating internal controls which has become the widely recognized standard for which companies measure the effectiveness of their systems of internal controls. COSO defines internal control as “a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance” of the achievement of objectives if the following categories: (i) effectiveness and efficiency of operations; (ii) reliability of financial reporting; and (iii) compliance with applicable laws and regulations.

From a very high level, COSO states that in an effective enterprise risk management (ERM) and effective internal control system, all of the following five components must be present:

  1. A Control Environment – which includes: (i) integrity and ethical values; (ii) a commitment to competence; (iii) a strong board of directors and audit committee; (iv) management’s philosophy and operating style; (v) organizational structure; assignment of authority and responsibility; and (vi) human resource policies and procedures;
  2. Risk Assessment – which includes: (i) company-wide objectives; (ii) process level objectives; (iii) risk identification and analysis; and (iv) managing change.
  3. Control Activities – which includes: (i) policies and procedures; (ii) security (application and network); (iii) application change management; (iv) business continuity/backups; and (v) outsourcing.
  4. Information and Communication – which includes (i) qualify of information; and (ii) effectiveness of communication; and
  5. Monitoring – which includes: (i) ongoing monitoring; (ii) separate evaluations; and (iii) reporting deficiencies.

Strong internal controls not only detect and prevent material errors or fraud in financial reporting but also contribute to better accountability and information flows. In other words, internal controls over financial reporting assist a company in better management and potential profitability in addition to the important reporting and securities-law matters. Where a company must disclose a material weakness in its internal controls, investors will discount the price accordingly, especially at the institutional level.  Moreover, where a company has reported a material weakness and plan of remediation, and then executes on such plan, the investor response is very positive, including a reduced cost of capital and improved operating performance.

Although not discussed by Bricker, both the NYSE and NASDAQ consider reported material weaknesses in internal controls when reviewing an application for listing on the exchange.

Auditor Independence

Public trust in financial reporting is maintained by protecting the independence of the outside auditor. A company’s audit committee plays an important role in overseeing and communicating with the outside auditor. Bricker states that in order for the system to be effective, the audit committee must “own the selection of the audit firm, make the final decision when it comes time to negotiate the audit fee, and oversee the auditor’s independence.”

As part of the independent auditor selection, the audit committee should be open to the possibility of circumstances that might require adjustments to prior-period financial statements. Mr. Bricker includes as examples the reporting of discontinued operations, a retrospective application of an adoption or change in accounting principle, or the correction of an error.

Reminders to the Audit Profession

Mr. Bricker points out that audit firms themselves are organizations with the inherent pressures that personnel of any organization can face. Audit firms themselves must monitor and have internal controls in place to ensure quality audits and audit relationships. One pressure that definitely can impact the quality of an audit is a deadline. Bricker points out that audit firms need to plan and allocate resources to ensure that there is time to address potential issues under the deadline of SEC filing requirements. I note that the biggest complaint my clients make about their auditors relates to issue spotting at the last minute and requested material changes to financial statements, such as revenue recognition, right before a filing is due, without the time to properly research and address the matter.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.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.

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 2017

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The Payment Of Finders’ Fees- An Ongoing Discussion
Posted by Securities Attorney Laura Anthony | July 5, 2017 Tags: , , , , , , ,

Introduction

As a recurring topic, I discuss exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services. I have previously discussed the no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act and the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer. I have also previously published a blog on the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders. I’ve included links to each of these prior articles in the conclusion to this blog.

A related topic with a parallel analysis is the use of finders for investors and investor groups, an activity which has become prevalent in today’s marketplace. In that case the investor group utilizes the services of a finder to solicit issuers to sell securities (generally convertible notes) to the investment group. These finders may also solicit current shareholders or convertible note holders to sell such holdings to a new investor or investor group.

Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.

As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black market industry has developed, and it is a large industry. Neither the SEC, FINRA or state regulators have the resources to police this prevalent industry of finders. The fact is that there are thousands of unlicensed finders that operate openly, and even advertise their services, making it impossible for practitioners to convince small issuers that they should not utilize the services of these groups.  As the saying goes, if everyone is doing it and doing it openly, it must be okay – but it is not okay.

As discussed further in this blog, I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.

SEC Advisory Committee on Small and Emerging Companies’ Recommendations

The SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) has once again made recommendations to the SEC regarding the regulation of finders and other intermediaries in small business capital formation transactions. The Advisory Committee previously submitted recommendations to the SEC on September 23, 2015.

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

The newest recommendations of the Advisory Committee are almost in the form of a plea to the SEC to recognize this very important issue and take some action, any action. The entire recommendation of the Advisory Committee is that the SEC do as follows:

“The Commission take action in the near future to provide certainty in the context of finders and platforms involved in primary and secondary securities transactions. The range of potential options includes compliance or enforcement efforts, rulemaking, or coordination with the states. Even staff guidance such as Q&A’s as to what constitutes broker-dealer activity would be tremendously helpful.”

In support of its recommendations, the Advisory Committee noted that:

  1. Identifying potential investors is one of the most difficult challenges for small businesses trying to raise capital;
  2. There is significant uncertainty in the marketplace about what activities require broker-dealer registration. Companies that want to play by the rules struggle to know in what circumstances they can engage a “finder” or platform that is not registered as a broker-dealer.
  3. For years, many interested parties have urged the SEC and its staff to take steps to address this ambiguity. As one recent example, in 2015, this Committee recommended that the Commission “take immediate intermediary steps to begin to address issues regarding the regulation of intermediaries in small business capital formation transactions….”; and
  4. The Committee is disappointed that the SEC has not taken actions to help to address these concerns despite repeated and long-standing requests.

Previously, on September 23, 2015, the Advisory Committee made the following four recommendations:

  1. The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act;
  2. The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level;
  3.  The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and
  4. The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

At the time of its recommendations in 2015, the Advisory Committee noted that:

Small businesses account for the creation of two-thirds of all new jobs, and are the incubators of innovation, generating the majority of net new jobs in the last five years and continuing to add more jobs;

Early-stage capital for these small businesses is raised principally through private offerings that are exempt from registration under the Securities Act of 1933 and state blue-sky laws;

More than 95% of private offerings rely on Rule 506 of Regulation D; however, less than 15% of those use a financial intermediary such as a broker-dealer. This is due in part to a lack of interest from registered broker-dealers given the legal costs and risk involved in undertaking a small transaction, ambiguities in the definition of “broker” and the danger of using unregistered finders. (For more on the topic of incentives for broker-dealers to work with smaller offerings, see my blog HERE)

As documented in the findings of an American Bar Association Business Law Section Task Force in 2005 and endorsed by the SEC Government Business Forum on Small Business Capital Formation: (i) failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies; (ii) the current broker-dealer registration system and FINRA membership process is a deterrent to meaningful oversight; (iii) appropriate regulation would enhance economic growth and job creation; and (iv) solutions are achievable through SEC leadership and coordination with FINRA and the states. For more on the ABA Task Force study, see my blog HERE.

The Advisory Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protections and safeguards on private placement intermediaries with limited activities that do not hold customer funds or securities and deal only with accredited investors, would enhance capital formation and promote job creation.

The Broker-Dealer Placement Agent Dilemma

Broker-dealers lack an incentive to engage in small private capital-raising transactions. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged.

From a regulatory perspective, when acting as placement agent in a private offering, broker-dealers must consider FINRA filing rules, general know-your-customer and suitability requirements as well as statutory liability under Dodd-Frank and the SEC antifraud provisions.  For more information on these rules, see HERE.

Even when a broker agrees to act as placement agent, it can often be difficult to locate investors for small companies. It would be helpful if unlicensed individuals could refer investors to such a broker-dealer, who would then ensure that proper disclosure has been made to the investor, and that the investment is suitable for such investor. However, FINRA Rule 2040 prohibits the payment of transaction-based compensation by member firms to unregistered persons. FINRA Rule 2040 expressly correlates with Section 15(a) of the Exchange Act (discussed below) and prohibits the payment of transaction-related compensation unless a person is licensed or properly exempt from such licensing.

Rule 2040 prohibits member firms from directly or indirectly paying any compensation, fees, concessions, discounts or commissions to:

any person that is not registered as a broker-dealer under SEA Section 15(a) but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or

any appropriately registered associated person, unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.

FINRA guidance on the Rule states that a member firm can (i) rely on published releases, no-action letters or interpretations from the SEC staff; (ii) seek SEC no-action relief; or (iii) obtain a legal opinion from an independent, reputable U.S. licensed attorney knowledgeable in the area.  This list is not exclusive and FINRA specifically indicates that member firms can take any other reasonable inquiry or action in determining whether a transaction fee can be paid to an unlicensed person.

FINRA Rule 2040 specifically allows the payments of finders’ fees to unregistered foreign finders where the finder’s sole involvement is the initial referral to the member firm of non-U.S. customers and certain conditions are met, including but not limited to that (i) the person is not otherwise required to be registered as a broker-dealer in the U.S.; (ii) the compensation does not violate foreign law; (iii) the finder is a foreign national domiciled abroad; (iv) the customers are foreign nationals domiciled abroad; (v) the payment of the finder’s fee is disclosed to the customer; (vi) the customers provide written acknowledgment of receipt of the notice related to the payment of the fee; (vii) proper records regarding the payments are maintained; and (viii) each transaction confirm indicates that the finder’s fee is being paid.

Current Rules on Finders’ Fees

The SEC generally prohibits the payments of commissions or other transaction-based compensation to individuals or entities that assist in effecting transactions in securities, including a capital raise, unless that entity is a licensed broker-dealer. The SEC considers the registration of broker-dealers as vital to protecting prospective purchasers of securities and the marketplace as a whole and actively pursues and prosecutes unlicensed activity. The registration process is arduous, including, for example, background checks, fingerprinting of personnel, minimum financial requirements, membership to SRO’s and ongoing regulatory and compliance requirements.  However, despite the SEC’s efforts, as mentioned in the introduction, a whole cottage industry of unlicensed finders has developed, simply overshadowing efforts by regulators.

Over the years, a “finder’s” exemption has been fleshed out, mainly through SEC no-action letters and some court opinions. Bottom line: an individual or entity can collect compensation for acting as a finder as long as the finder’s role is limited to making an introduction. The mere providing of names or an introduction without more has consistently been upheld as falling outside of the registration requirements.  The less contact with the potential investor, the more likely the finder is not required to be licensed.

The finder may not participate in negotiations, structuring, document preparation or execution. Moreover, if such finder is “engaged in the business of effecting transactions in securities,” they must be licensed. In most instances, a person that acts as a finder on multiple occasions will be deemed to be engaged in the business of effecting securities transactions, and needs to be licensed.

The SEC will also consider the compensation arrangement with transaction or success-based compensation weighing in favor of requiring registration. The compensation arrangement is often argued as the gating or deciding factor, with many commentators expressing that any success-based compensation requires registration. The reasoning is that transaction-based compensation encourages high-pressure sales tactics and other problematic behavior.  However, the SEC itself has issued no-action letters supporting a finder where the fee was based on a percentage of the amount invested by the referred people (see Moana/Kauai Corp., SEC No-Action Letter, 1974).

More recently, the U.S. District court for the Middle District of Florida in SEC vs. Kramer found that compensation is just one of the many factual considerations and should not be given any “particular heavy emphasis” nor in itself result in a “significant indication of a person being engaged in the business of a broker.”

Where a person acts as a “consultant” providing such services as advising on offering structure, market and financial analysis, holding meetings with broker-dealers, preparing or supervising the preparation of business plans or offering documents, the SEC has consistently taken the position that registration is required if such consultant’s compensation is commission-, success- or transaction-based.

As pertains to finders that act on behalf of investors and investor groups, there is a lack of meaningful guidance. On a few occasions, the SEC has either denied no-action relief or concluded that registration was required. However, the same basic principles apply.

The federal laws related to broker-dealer registration do not pre-empt state law. Accordingly, a broker-dealer must be licensed by both the SEC and each state in which they conduct business. Likewise, an unlicensed individual relying on an exemption from broker-dealer registration, such as a finder, must assure themselves of the availability of both a federal and state exemption for their activities.

The Exchange Act – Broker-Dealer Registration Requirement

Section 15(a)(1) of the Exchange Act requires any “broker” that makes use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security) to register with the SEC.

The text of Section 15(a)(1) – Registration of all persons utilizing exchange facilities to effect transactions  is as follows:

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.

Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flesh out, with inconsistent and uncertain results. As a securities attorney, I always advise to err on the conservative side where the activity is at all questionable.

The SEC’s Guide to Broker-Dealer Registration

Periodically, and most recently in April 2008, the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. On a daily basis, thousands of individuals and entities offer to raise money for companies as “finders” in return for a “finder’s fee.” Other than as narrowly set forth above, such agreements and transactions are prohibited and carry regulatory penalties for both the company utilizing the finders’ services, and the finders.

Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):

“finders,” “business brokers,” and other individuals or entities that engage in the following activities:

Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;

Finding investment banking clients for registered broker-dealers;

Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;

Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;

Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);

investment advisers and financial consultants;

persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;

persons that act as “placement agents” for private placements of securities;

persons that effect securities transactions for the accounts of others for a fee, even when those other people are friends or family members;

persons that provide support services to registered broker-dealers; and

persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer (for information on “associated persons,” see below).

Consequences for Violation

The SEC is authorized to seek civil penalties and injunctions for violations of the broker-dealer registration requirements. Egregious violations can be referred to the attorney general or Department of Justice for criminal prosecution.

In addition to potential regulatory problems, using an unregistered person who does not qualify for either the statutory or another exemption to assist with the sale of securities may create a right of rescission in favor of the purchasers of those securities. That is a fancy way of saying they may ask for and receive their money back.

Section 29(b) of the Exchange Act, provides in pertinent part:

Every contract made in violation of any provision of this title or of any rule or regulation thereunder… the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract…

In addition to providing a defense by the issuing company to paying the unlicensed person, the language can be interpreted as voiding the contract for the sale of the securities to investors introduced by the finder. The SEC interprets its rules and regulations very broadly, and so do the courts and state regulators. Under federal law the rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation.  Accordingly, for a period of at least three years, an issuer that has utilized an unlicensed finder could have a contingent liability on their books and as a disclosure item. The existence of this liability can deter potential investors and underwriters and create issues in any going public transaction.

In addition, SEC laws specifically require the disclosure of compensation and fees paid in connection with a capital raise. A failure to make such disclosure and to make it clearly and concisely is considered fraud under Section 10b-5 of the Securities Act of 1933 (see, for example, SEC vs. W.P. Carey & Co., SEC Litigation Release No. 20501). Fraud claims are generally brought against the issuing company and its participating officers and directors.

Moreover, most underwriters and serious investors require legal opinion letters at closing, in which the attorney for the company opines that all previously issued securities were issued legally and in accordance with state and federal securities laws and regulations. Obviously an attorney will not be able to issue such an opinion following the use of an unlicensed or non-exempted person. In addition to the legal ramifications themselves and even with full disclosure and the time for liability having passed, broker-dealers and underwriters may shy away from engaging in business transactions with an issuer with a history of overlooking or circumventing securities laws.

Historically, it was the person who had acted in an unlicensed capacity who faced the greatest regulatory liability; however, in the past ten years that has changed. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective and a better deterrent to prosecute the issuing company than an unlicensed person who is here today and gone tomorrow.

Conclusion

The payment of finders’ fees is a complex topic requiring careful legal analysis on a case-by-case and state-by-state basis. No agreements for the payment or receipt of such fees should be entered into or performed without seeking the advice of competent legal counsel.

I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.

I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.  For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the new FINRA Securities Industry Essentials Exam (see HERE) for finders that are otherwise exempt from the full broker-dealer registration requirements.

For reference, prior blogs on the topic of the broker-dealer registration requirements include (i) the no-action-letter-based exemption for M&A brokers (ii) the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act; (iii) the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer; and (iv) the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.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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