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Confidentially Marketed Public Offerings (CMPO)

Posted by Securities Attorney Laura Anthony | July 5, 2016 Tags: CMPO, Confidentially Marketed Public Offering, Confidentially Marketed Public Offerings, Form 8-K, NASDAQ Considerations, NASDAQ Rules, Regulation FD, S-3 Eligibility, S-3 Registration Statement, S-3 Shelf Registration

Not surprisingly, I read the trades including all the basics, the Wall Street Journal, Bloomberg, The Street,The PIPEs Report, etc. A few years ago I started seeing the term “confidentially marketed public offerings” or “CMPO” on a regular basis. The weekly PIPEs Report breaks down offerings using a variety of metrics and in the past few years, the weekly number of completed CMPOs has grown in significance. CMPOs count for billions of dollars in capital raised each year.

CMPO Defined

A CMPO is a type of shelf offering registered on a Form S-3 that involves speedy takedowns when market opportunities present themselves (for example, on heavy volume). A CMPO is very flexible as each takedown is on negotiated terms with the particular investor or investor group. In particular, an effective S-3 shelf registration statement allows for takedowns at a discount to market price and other flexibility in the parameters of the offering such as the inclusion of warrants and terms of such warrants. A CMPO is sometimes referred to as “wall-crossed,” “pre-marketed” or “overnight” offerings.

In a typical CMPO, an underwriter confidentially markets takedowns of an effective S-3 shelf registration statement to a small number of institutional investors. The underwriter will not disclose the name of the issuing company until the institutional investor agrees that they have a firm interest in receiving confidential information and agrees not to trade in such company’s securities until the offering is either completed or abandoned.

When an investor confirms their interest, the company and its banker will negotiate the terms of the offering with the investor(s), including amount, price (generally a discount to market price), warrant coverage and terms of such warrant coverage. The disclosure of the name of the issuer and confidential information related to the offering is referred to as bringing the investor “over the wall.” Once brought over the wall, the potential investor(s) will complete due diligence. This process is completed on a confidential basis.

Once the terms have been agreed upon, the offering is “flipped” from confidential to public and a prospectus supplement, free writing prospectus, if any, a Rule 134 press release and a Form 8-K are prepared and filed informing the market of the offering. These public documents are almost always filed after the market closes and the offering itself generally closes that night as well, though sometimes the closing occurs the next trading day. The closing is the same as a firm commitment underwritten offering, such that there is a single closing of the entire takedown. The closing process and documents are also the same as a firm commitment underwritten offering including an underwriting agreement, opinion of counsel and a comfort letter. As the public disclosure and closing of the offering generally occurs overnight, a CMPO earned the name an “overnight” offering.

Generally the necessary closing documents and public filings have been prepared and are on standby ready to be utilized when a deal is agreed upon. Both the company and investors will wait for a favorable market window, such as an increase in the price and volume of the company’s stock, to close the offering.

S-3 Eligibility; NASDAQ Considerations; FINRA

A CMPO requires an effective S-3 shelf registration statement and accordingly is only available to companies that qualify to use an S-3. Among other requirements, to qualify to use an S-3 registration statement a company must have timely filed all Exchange Act reports, including Form 8-K, within the prior 12 months. An S-3 also contains certain limitations on the value of securities that can be offered. Companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, may offer the full amount of securities under an S-3 registration. For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, the company can offer up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.”

To calculate the non-affiliate float for purposes of S-3 eligibility, a company may look back 60 days and select the highest of the last sales prices or the average of the bid and ask prices on the principal exchange. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold under the same S-3 in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases.

A company should be careful that a CMPO is structured to comply with the NASDAQ definition of “public offering,” thereby avoiding NASDAQ’s rules requiring shareholder approval for private placements where the issuance will or could equal 20% or more of the pre-transaction outstanding shares. In particular, NASDAQ requires advance shareholder approval when a company sells 20% or more of its outstanding common stock (or securities convertible into common stock) in a private offering, at a discount to the greater of the market price or book value per share of the common stock. A separate NASDAQ rule also requires shareholder approval where officers, directors, employees, consultants or affiliates are issued common stock in a private placement at a discount to market price. CMPO’s have been stopped in their tracks by NASDAQ requiring pre-closing shareholder approval.

A CMPO differs from a standard public offering as it is confidentially marketed and is completed with little or no advance market notice. Accordingly, in determining whether a CMPO qualifies as a public offering, NASDAQ will consider: (i) the type of offering including whether it is being completed by an underwriter on a firm commitment or best-efforts basis (firm commitment being favorable); (ii) the manner of offering and marketing, including number of investors marketed to and how such investors were chosen (the more broad the marketing, the better); (iii) the prior relationship between the investors and the company or underwriter (again, the more broadly marketed, the better, as public offerings are generally widely marketed); (iv) offering terms including price (a deeper discount is unfavorable); and (v) the extent to which the company controls the offering and its distribution (insider participation is unfavorable).

NASDAQ also has rules requiring an advance application for the listing of additional shares resulting from follow-on offerings. Generally NASDAQ requires 15 days advance notice, but will often waive this advance notice upon request.

A CMPO will need to comply with FINRA rule 5110, the corporate finance rule. Generally FINRA will process a 5110 clearance on the same day. Moreover, there are several exemptions to issuer 5110 compliance, including based on the size of the company’s public float. For a brief overview of Rule 5110, see my blogHERE.

Confidentiality; Regulation FD; Insider Trading

By nature a CMPO involves the disclosure of confidential information to potential investors, including, but not limited to, that the company is considering a public offering takedown, the pricing terms of the offering, warrant coverage, and the disclosure of potentially confidential information during the due diligence phase. To ensure compliance with Regulation FD and avoid insider trading, the company and its underwriters will obtain a confidentiality agreement from the potential investors. The agreement will include a trading blackout for a specific period of time, generally until the offering either closes or is abandoned.

Although the confidential portion of the CMPO usually occurs very quickly (a week or two), many institutional investors require that the company issue a public “cleansing” statement if the offering does not proceed within a specified period of time. The cleansing statement would need to disclose any material non-public information disclosed to the potential investor as part of the negotiation and due diligence related to the offering. In the event the offering proceeds to a close, the offering documents (including potential free writing prospectus or prospectus supplement, Rule 134 press release and 8-K) will include all material non-public information previously disclosed to potential investors during the confidential phase. Both the company and the investor need to be careful that the filed offering materials and/or cleansing statement contain all necessary information to avoid potential insider trading issues.

The company must be sure to also file with the SEC all written marketing offering materials associated with a registered offering either as part of the prospectus or as a free writing prospectus. Generally with a CMPO, the written materials provided to investors are limited to public filings and investor presentation materials such as a PowerPoint already in the public domain that do not, in and of themselves, contain any material non-public information and therefore do not need to be filed with the SEC as offering materials.

As a reminder, Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence (such as potential investors in a CMPO); and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings and, accordingly, generally does not include a CMPO).

Benefits of a CMPO

A CMPO offers a great deal of flexibility to a company and its bankers. Utilized correctly, a CMPO can have minimal market impact. It is widely believed that announcements of public offerings, and impending dilution and selling pressure, invite short selling and speculative short-term market activity. Since a CMPO is confidential by nature and the time between the public awareness and completion of a particular takedown is very short (oftentimes the same day), the opportunity for speculating and short sellers is minimized. Moreover, as a result of the confidential nature of a CMPO, if a particular offering or takedown is abandoned, the market is unaware, relieving the company of the typical downward pricing pressure associated with an abandoned offering. Likewise, this confidential process allows the company to test the waters and only proceed when investor appetite is confirmed.

As a registered offering, CMPO securities are freely tradable and immediately transferable, incentivizing investment activity and reducing the negotiated discount to market associated with restricted securities. Offering expenses for a CMPO are also less than a fully marketed follow-on public offering. The CMPO is based on an existing S-3 shelf registration, thus reducing drafting costs. Also, the expense of marketing an offering itself, including a road show, is reduced or eliminated altogether.

Although the structure of a CMPO requires that the issuing company be S-3 shelf registration eligible, CMPOs are often used by small and development-stage companies (such as technology and biotech companies) that have smaller market capitalizations and need to tap into the capital of the public markets on a more frequent basis to fund ongoing research and development of products.

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 Proposes Transfer Agent Rules

Posted by Securities Attorney Laura Anthony | February 23, 2016 Tags: DTC Eligibility, SEC, Transfer Agent Rules

On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. The transfer agent rules were adopted in 1977 and have remained essentially unchanged since that time. An advance notice of proposed rulemaking (ANPR) describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. The SEC indicates that following the comment process associated with this ANPR, it intends to propose actual new rules as soon as practicable.

To invoke thoughtful comment and response, the SEC summarized the history of the role of transfer agents within the securities clearing system as well as the current rules and proposed new rules. In addition, the SEC discusses and seeks comments on broader topics that may affect transfer agents and the securities system as a whole. This blog gives a high level review of the whole APNR and concept release with a more detailed focus on the proposed rules and discussions that will directly impact the transfer and deposit of restricted securities in the small-cap industry.

Introduction

As set out by the SEC, among other functions, transfer agents (i) track, record and maintain the official shareholders registrar and ownership records; (ii) cancel, issue and transfer securities, both in certificate and book entry form; (iii) communicate with shareholders on behalf of issuers; and (iv) process dividends and corporate actions such as reverse splits. In addition, from my own experience, transfer agents will act as mailing agent for proxy and other communications from the issuer, sometimes offer EDGAR agent services, and facilitate DTC eligibility applications with DTC member firms, obtain DWAC/FAST DTC eligibility for issuers and act as a front line where shareholders are attempting to remove a restrictive legend and deposit securities with brokerage firms.

Transfer agents are also seen as a gatekeeper in the prevention of fraud, and compliance with the registration and exemption provisions of the federal securities laws. In that regard, the SEC intends to impose obligations on a transfer agent in the processing and transfer of restricted securities. A major focus of the rulemaking is related to combatting microcap fraud. This is consistent with the recent SEC approach of increasing obligations and pressure on the gatekeepers, including brokerage firms related to the deposit of securities (see my blog HERE), attorneys and auditors, and transfer agents.

For the discussion of the proposed new rules related to the transfers of restricted securities, see the discussion below under the subheading “Restricted Securities and Compliance with Federal Securities Laws.”

History and Background

The SEC ANPR is lengthy and provides an in-depth discussion of the history of the clearing and settlement process and role of transfer agents in the process. Briefly, the ownership of securities represents certain property rights and the securities themselves are a negotiable instrument under state law allowing the owner to transfer such property to a third party. Where federal securities laws govern the registration and exemption provisions, the individual state’s Uniform Commercial Code (UCC) governs the transfer of certificates and securities as property. Accordingly, in addition to compliance with federal law, the daily activities of a transfer agent require knowledge of and compliance with the UCC.

Under the UCC, in order to obtain valid title to a security, the seller must voluntarily transfer possession of the security and the buyer must give value, not have notice of any adverse claim to the security and actually obtain control over the security. It is compliance with the UCC that requires that a certificate be endorsed, the signature guaranteed, instructions and authority from the seller, proof of payment/consideration from the buyer, proper cancellation of certificates and the proper registration and recording on the shareholder list. Moreover, it is the UCC that governs the process for replacing lost or stolen certificates and for an issuer or security holder to impose stop transfer restrictions.

Technology has helped streamline some of this process and for traded securities in DTC eliminated paper certificates altogether, but as all in the industry know, the paperwork is still extensive. Article 8 of the UCC governs the transfer of electronic or uncertificated securities. The SEC gives an interesting background discussion of the Paperwork Crisis beginning in the 1960s resulting from the massive volumes of paper needed to transfer securities associated with the growing and active trading markets. As a result of the Paperwork Crisis, the Depository Trust Company (DTC) and its securities holding arm, CEDE, were formed.

Moreover, for those interested, the APNR and concept release provides a thorough history of the creation and amendments to the national market system, national clearing and settlement system, SIPC, DTC the FAST program, and development of laws allowing for the holding and trading of book entry and electronic securities. Although this history is well beyond the scope of this blog, what I found particularly interesting is how recent many of these developments have been. For instance, it was only in 1996 that the Direct Registration System (DRS) was implemented that allowed investors to hold uncertificated securities in registered form on the books of the transfer agent and to utilize the FAST system to transfer shares to and from and brokerage account. It was during the late 1990s that DTC really flourished to become the largest depository and clearing house in the US. Today DTC provides the depository and book entry services for virtually all securities available for trading in the US.

Transfer Agent Role in Clearance and Settlement Processes

A transfer agent is an integral part of the National C&S System. The clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved. I will detail the clearing and settlement process in a future blog.

Security ownership can be either registered or beneficial. State corporate law conveys certain rights to registered owners that beneficial owners may not receive. For example, the right to examine a stockholder list at a meeting is limited to registered and not beneficial owners. Registered owners are listed on the stockholder list by name and are sometimes referred to as “holders of record.” In addition to state law rights, the holders of record is an important concept throughout the securities laws. For example, Section 12(g) of the Securities Exchange Act requires a company to register when it has 2,000 or more holders of record. Likewise, deregistration eligibility is determined in part by the number of holders of record.

A transfer agent often deals directly with a holder of record, including in the provision of transfer services, dividend payments and communications, such as the delivery of proxy forms. Record holders may hold their securities in either certificate or book entry form.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name which have been deposited with a brokerage firm and are in the DTC system. These securities usually show up on the shareholder list in the Cede account and sometimes in the name of the particular brokerage firm. Each brokerage and clearing firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Current Transfer Agent Regulations

Transfer agents have been regulated by federal securities laws since 1975. A “transfer agent” is defined as any person who engages in the following activities on behalf of an issuer: (i) countersigning securities upon issuance; (ii) monitoring issuances and preventing unauthorized issuances; (iii) registering the transfer of securities; (iv) exchanging or converting securities; or (v) processing transfer and maintaining book entry ownership records. Public company transfer agents are required to be registered with the SEC.

The SEC currently regulates (i) registration and annual reporting requirements; (ii) timing and certain notice and reporting requirements (the “turnaround rules”); and (iii) recordkeeping and record retention rules and safeguarding requirements for securities and funds. The current transfer agent rules are extensive, and below is just a very high-level brief overview.

Current Registration and Annual Reporting Requirements

The current registration and annual reporting requirements are found in Exchange Act Rules 17Ac2-1 through 17Ac3-1. All transfer agents must register with the SEC on Form TA-1. The rules include eligibility prohibitions against certain “bad actors” similar to other bad actor rules within the securities laws. All transfer agents must file an annual report on Form TA-2, including information on compliance with turnaround rules, number of accounts, items received, funds distributed and lost securities. Both the application and the annual report can be viewed by the public on EDGAR. In addition to reviewing these forms, the SEC performs site visits and examinations of transfer agents.

Current Processing, Reporting, Recordkeeping and Exemptions

Exchange Act Rules 17Ad-1 through 17Ad-7 set forth performance standards for transfer agents. In relation to these rules, transfer agents must have written internal controls and procedures. The rules focus on establishing minimum performance and recordkeeping standards for routine transfers, cancellations and issuances. Routine items must be processed within 3 business days of receipt and non-routine items must receive “diligent and continuous attention” and be “turned around as soon as possible.” Routine items are defined in the negative such that all items are routine except items (i) requiring the issuance of a new certificate that the transfer agent does not have; (ii) subject to stop order, adverse claim or other restriction; (iii) requiring additional documentation to review and complete; (iv) are part of a corporate action (such as split or dividend); (v) are part of a public or private offering; or (vi) certain warrants, options or other convertible securities. The performance rules contain certain exemptions, such as for the processing of limited partnerships and redemptions for registered investment companies and for certain very small transfer agents.

The performance rules also require a transfer agent to respond to certain written inquiries within prescribed time periods and, in particular, within 5, 10 or 20 days depending on the person making the inquiry and the subject of the inquiry.

Transfer agents are required to keep detailed, defined records including minimum delineated information that allows for the prompt delivery of information related to shareholders, ownership positions and historical records related to same. Records, funds and securities in a transfer agent’s custody must be safeguarded to prevent theft, loss, destruction or misuse.

Transfer agents are required to notify DTC when terminating or assuming transfer agent services for an issuer.

SRO Rules and Requirements

In addition to federal securities laws, transfer agents are regulated by SRO’s including, for example, the NYSE and DTC. The NYSE requirements include further regulation on turnaround times and recordkeeping as well as capitalization and insurance requirements.

All transfer agents that include electronic or book entry services (which is really all of them) must comply with DTC rules including (i) being “Limited Participants” in DTC; (ii) participate in the FAST program and agree to DTC’s Operational Arrangements; (iii) link with DTC’s electronic communication system; and (iv) participate in DTC’s Profile Surety Program.

State Law

As briefly discussed above, transfer agents must comply with state corporate statutes related to recordkeeping and notice requirements as well as each state’s Uniform Commercial Code.

Proposed New Rules

The SEC has issued an advance notice of proposed rulemaking (ANPR) which describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. Following the receipt of public comment on the ANPR, the SEC will publish proposed rules. The ANPR reveals a thorough revamping of the transfer agent rules.

The ANPR proposes rules to (i) increase the scope of information on the registration application (Form TA-1) and annual report (Form TA-2) for transfer agents; (ii) require all contracts between a transfer agent and issuer to be in writing, which includes a fee schedule and termination provisions, including provisions for handing over information to a new transfer agent; (iii) enhance transfer agent requirements for the safeguarding of funds and securities; (iv) apply anti-fraud provisions to specific transfer agent activities; (v) require transfer agents to establish business continuity and disaster recovery plans; (vi) require transfer agents to establish basic procedures regarding the use of information, including safeguarding personal information; (vii) revise recordkeeping requirements; and (viii) conform and update various terms and definitions and eliminate those that are obsolete.

Restricted Securities and Compliance with Federal Securities Laws

All sales of securities, including the re-sale of restricted securities held by a current shareholder, must either be registered under the Securities Act or there must be an available exemption. The most common exemption for the resale of restricted securities is Section 4(a)(1) of the Securities Act and Rule 144, which is a safe harbor under Section 4(a)(1). Since transfer agents are responsible for affixing a restrictive legend on stock certificates or making a restrictive notation on book entry securities and for processing the transfer and legend removal from such securities, they are an important gatekeeper in the prevention of fraud and unregistered distributions.

Transfer agents are subject to aiding and abetting liability for violations of the registration requirements under Section 5 of the Securities Act. In addition, like any market participant, a transfer agent could be charged with fraud violations under Section 10(b) and Rule 10b-5 under the Exchange Act and Section 17(a) of the Securities Act.

Currently a transfer agent must determine whether any particular request is routine and thus requires a 3-day turnaround, and whether the state UCC requires the processing of a request. Neither federal nor state UCC regulations require the processing of a request that does not comply with the federal securities laws. Accordingly, the transfer agent must determine whether a particular request complies with federal (or state) securities laws and thus what their particular processing requirements are. It is this determination that has made it an industry practice to require an opinion letter from counsel with each request to transfer or remove a legend from restricted securities. The SEC is concerned that reliance on opinion letters from a shareholder’s or issuer’s counsel does not offer enough protection against improper transfers or fraud.

Accordingly, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from directly or indirectly taking any action to facilitate a transfer of securities if such person knows or has reason to know that an illegal distribution of securities would occur in connection with the transfer. Such knowledge qualifier carries a duty to make reasonable inquiry.

Moreover, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from making any materially false statements or omissions or engaging in any other fraudulent activity in connection with the performance of their duties.

In addition, the SEC proposes new rules requiring each transfer agent to adopt internal controls, policies and procedures reasonably designed to ensure compliance with securities laws and requiring that each transfer agent designate a chief compliance officer.

There is no proposal to adopt rules that would provide specificity to a transfer agent related to the removal of a restrictive legend or transfer of restricted securities. However, the SEC does seek comment on same and, in particular, whether there should be requirements related to (i) obtaining an attorney opinion letter; (ii) obtaining issuer approval; (iii) requiring evidence of a registration statement or available exemption; (iv) requiring evidence of beneficial ownership; (v) requiring representations related to affiliation; and/or (vi) conducting some level of due diligence. I would advocate for such guidelines.

As the SEC notes, there is a potential conflict between a transfer agent’s duties to process a transfer and to ensure compliance with federal securities laws. However, in my opinion, from a transfer agent’s perspective, there are certain rules (turnaround rules and the UCC) requiring processing and only a vague fear of being charged with aiding and abetting related to ensuring compliance with federal securities laws. The proposed new rule generally increasing the potential liability on the transfer agent is likewise vague in the APNR. Without specific guidelines and standards, transfer agents will have a hard time navigating the new regulatory environment and all market participants will pay the price.

In fact, fear of regulatory retribution has already created a very challenging environment in the small-and mid-cap marketplace. The deposit of penny stock securities has become extremely difficult and expensive, but the flow of information to the market participants as to what is and is not acceptable has been slow and disjointed. At the same time that the OTC Markets has created self-imposed quantitative and qualitative standards to improve the marketplace and has been attempting to support small and emerging growth business capital formation, the secondary trading becomes increasingly difficult.

Moreover, there is a contrarian reality among the legislature, the SEC’s public position, and again, the actual small-cap secondary trading market, including the ability to deposit securities. The JOBS Act, including Regulation Crowdfunding, and the FAST Act are designed to improve capital formation in the small and emerging growth sectors, including a specific focus on allowing companies easier access to public markets and facilitating going public transactions. The advent of Regulation A+ and 506(c), the creation of the emerging growth company category, the various provisions of the FAST Act including improvements to the Form S-1 filing process and the SEC initiatives to modernize and update disclosure obligations are all meant to ease capital formation and public filings for micro- and small-cap companies.

Further, the active SEC Advisory Committee on Small and Emerging Companies 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 contrary side to all of this is the extreme difficulty in depositing securities for small- and micro-cap public companies and in creating a vibrant trading market. Although not comprehensive on the issues, see my blogs HERE regarding broker duties in depositing stocks and HERE regarding the need for a venture exchange.

The small- and micro-cap marketplace needs more definitive standards that companies and practitioners can rely upon. The fact is, it is relatively easy for a company to pass a footnote 32 type vehicle through the SEC and obtain a ticker symbol from FINRA and then extremely difficult to do anything with it. See my blog HERE. The fact that it is easy to create the vehicles in the first place creates a sort of confusion and disconnect in the marketplace. I’d rather see the SEC and FINRA be more stringent in their review process on these obvious vehicles and require that they label themselves a shell such that brokers and transfer agents have some comfort that when a company has cleared the SEC and FINRA, it is as labeled, subject of course to post effectiveness changes.

Of course, brokers and transfer agents still need to be gatekeepers, but the standards they are relying upon and the issues they are facing in their own SEC investigations and reviews need to be articulated and communicated to the marketplace. New proposed transfer agent rules is a step in the right direction and a very good start, but if those rules include a vague requirement that the transfer agent follow the law, we will not have made the type of headway that is badly needed to support real and viable small businesses and their capital formation.

I note that as part of the SEC request for comment there are some extreme thoughts. For instance, the SEC requests comment on whether a transfer agent should be required to (i) confirm the existence and legitimacy of an issuer’s business by reviewing contracts and corporate records; (ii) conduct credit and criminal background checks for issuers and their officers and directors; (iii) obtain information on shareholders before processing requests for legend removal; and (iv) review public news and information on issuers and principals. My view is that this level of review by a transfer agent is too extreme. I strongly oppose giving a transfer agent that level of independent power over an issuer and its shareholders. In addition to the shutdown in the small and micro-cap markets that would entail, the re-tooling of current transfer agents to adequately be able to satisfy this level of responsibility would be cost-prohibitive both to the transfer agents and their clientele.

Some of the other comment requests of interest (and my view in parentheses) include: (i) should the SEC enumerate red flags that would trigger a duty of further inquiry by a transfer agent (yes); (ii) should there be a heightened review for securities of non-reporting issuers (yes, if no current information); (iii) should a transfer agent be required to deliver securities only to the registered shareholder and not third parties (yes, unless the third party is an attorney or other proper representative of the shareholder); and (iv) should transfer agents be prohibited from accepting stock as compensation (no).

Registration and Annual Reporting

The purpose of the registration and annual reporting requirements is to assist the regulators, issuers and investors in determining whether a transfer agent is performing its functions properly, determining the nature of a particular transfer agent’s business, assisting the SEC in making examination and investigation decisions, including areas of concern, monitoring the transfer agents activities and ensuring compliance with rules and regulations.

The SEC proposes to add information to the registration and annual reporting requirements, including financial information, potential conflicts of interest and details about the types of services being provided and the transfer agent’s clientele. For example, it is proposed that a transfer agent disclose any past or present affiliations with or ownership of issuers or broker-dealers serviced by or affiliated with a transfer agent. I note that several small-cap broker-dealers have sister transfer agencies and do not believe such vertical business investment is problematic nor should it be construed as nefarious. However, I do see benefit in the disclosure of same.

The SEC also proposed to require a transfer agent to designate a chief compliance officer with responsibilities to ensure compliance with written internal controls and procedures.

Written Agreements Between Transfer Agents and Issuers

The APNR proposed to require written agreements between transfer agents and issuers. Although it is not now a legal requirement, I think most transfer agents do have such agreements. I am hard-pressed to think of any issuer clients that do not have a written contract with their transfer agent, and most are quick to require the signing of an addendum or updated contract where there is a change of management or control of the issuer.

However, the SEC rightfully points out that where there is either no written agreement or the agreement does not cover certain questions, there is an increase of disputes with respect to (i) the duration of the arrangement; (ii) termination rights; (iii) the disposition of records and transfer of records to a new transfer agent; and (iv) fees. These issues are most prevalent in the small-cap world, especially where a transfer agent “holds records hostage” in exchange for a large termination fee. The APNR does not suggest that the transfer agent be limited in allowable termination fees, nor that a transfer agent be required to turn over records regardless of sums owed or the payment of a termination fee, though it does seek comment on such issues.

Safeguarding Funds and Securities

Transfer agents often provide administrative and processing services in relation to dividends, payouts associated with splits (paying agent services) and other transactional escrow services. The APNR proposes a more robust set of standards for transfer agents acting as a paying agent or providing escrow services. The APNR indicates the SEC will provide new rules such as (i) maintaining secure vaults; (ii) installing theft and fire alarms; (iii) having written procedures related to access and control over accounts and information; (iv) greater bookkeeping requirements; (v) and specific unclaimed property procedures. In addition, the SEC intends to impose rules similar to those for broker-dealers, requiring internal controls, annual reporting and independent audits related to these services.

Cybersecurity, Information Technology and Related Issues

Cybersecurity is a big concern for the SEC. In 2014 the SEC adopted Regulation Systems, Compliance and Integrity requiring covered entities to test their automated systems for vulnerabilities, test their business continuity and disaster recovery plans and notify the SEC of intrusions. In particular, the SEC intends to propose new or amended rules requiring registered transfer agents to, among other things: (i) create and maintain a written business continuity plan; (ii) create and maintain basic procedures and guidelines governing the transfer agent’s use of information technology, including methods of safeguarding data and personally identifiable information; and (iii) create and maintain appropriate procedures and guidelines related to a transfer agent’s operational capacity, such as IT governance and management.

Concept Release and Request for Additional Comment

The SEC concept release contains discussion and seeks comment from the public on issues outside of and in addition to the APNR. The SEC highlights different questions and issues such as whether brokerage firms should also be required to be registered as transfer agents when they hold securities in nominee accounts; specific issues affecting transfer agents for mutual funds and transfer agents that serve as administrators for employee stock option and similar plans. The concept release also seeks comment on a transfer agent’s role in a Regulation Crowdfunding offering (Title III Crowdfunding).

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.

« SEC’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies State Blue Sky Concerns; Florida and New York »

SEC’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies

Posted by Securities Attorney Laura Anthony | February 16, 2016 Tags: SEC

As required by the JOBS Act, in 2013 the SEC launched its Disclosure Effectiveness Initiative and has been examining disclosure requirements under Regulation S-K and Regulation S-X and methods to improve such requirements. In September 2015, the SEC issued a request for comment related to the Regulation S-X financial disclosure obligations for certain entities other than the reporting entity. In particular, the SEC is seeking comments on the current financial disclosure requirements for acquired businesses, subsidiaries not consolidated, 50% or less owned entities, issuers of guaranteed securities, and affiliates whose securities collateralize the reporting company’s securities.

It is important to note that the SEC release relates to general financial statement and reporting requirements, and not the modified reporting requirements for smaller reporting companies or emerging growth companies. In particular, Article 8 of Regulation S-X applies to smaller reporting companies and Article 3 to those that do not qualify for the reduced Article 8 requirements. The SEC discussion and request for comment specifically addresses certain Article 3 rules.

As my clients are, for the most part, either smaller reporting companies or emerging growth companies, I have provided information related to those entities where applicable. In the request for comment, the SEC does ask for input and comments on the correlating Article 8 rules where applicable.

Specific rules being addressed

The SEC request for comment is specifically related to the following rules and their related requirements:

Rule 3-05, Financial Statements of Businesses Acquired or to be Acquired;

Rule 3-09, Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons;

Rule 3-10, Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered; and

Rule 3-16, Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered.

The comments sought and the SEC review are centered on how these requirements assist and inform investors and potential investors in making investment and voting decisions on the one hand, and the challenges and issues of the reporting company in preparing and providing the information on the other hand. Moreover, as required by the Exchange Act in all SEC rulemaking, the SEC must consider how any changes will promote efficiency, competition and capital formation.

Rule 3-05 of Regulation S-X – Financial Statements of Businesses Acquired or to be Acquired

Summary of current rule

Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue producing assets will likely be treated as the purchase of a business.

In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X. The investment test considers the value of the purchase price relative to the value of the total assets of the company prior to the purchase. The asset test considers the total value of the assets of the company pre and post purchase. The income test considers the change in income of the company as a result of the purchase.

Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal year and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.

Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.

Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.

An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.

The Rule 3-05 or Rule 8-04 financial statements will also be required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.

In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.

Reason for the rules and request for comment

Clearly financial disclosure regarding acquired businesses is important for an investor to understand the impact of transactions. An acquisition will change a company’s financial condition, results of operation, liquidity and future prospects. However, the SEC admits that the type of information currently required may have limitations vis-à-vis the intended purpose. Many commentators have questioned the need and utility of historical financial information on the acquired business. Historical financial statements do not reflect the new accounting basis resulting from the acquisition, changes in management, changes in business plan, the efficiencies of scale of the combined entities (such as workforce reductions and facility closings), etc.

Related to the financial statement requirements, the SEC specifically requested comments associated with (i) how investors use the financial information; (ii) what changes would make the information more useful to investors and what challenges are there to providing this information; (iii) what challenges companies have in providing the currently required financial information and how these could be addressed; (iv) whether the current requirements include information that is not useful; (v) how pro forma requirements could be changed to make them more useful; (vi) whether the 75-day rule should be shortened; and (vii) whether the pre-closing requirements for registration statements and Section 14 (Schedule 14C or 14A) filings should be modified.

Related to the investment, asset and income tests, the SEC specifically requested comments on (i) whether the current significance tests are the appropriate measure to determine the nature, timing and extent of financial statement disclosure requirements; (ii) what changes or alternatives the SEC should consider; (iii) whether the current test thresholds should be modified; (iv) whether additional or different tests should be implemented (such as purchase price compared to market cap); and (v) whether companies should be given more judgment in determining what is significant.

The SEC has also asked for comment on the application of changes to Rule 8-04 for smaller reporting companies and application of the rules to different issuers such as investment companies and foreign private issuers.

Rule 3-09 of Regulation S-X – Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons

Summary of current rule

Rule 3-09 does not apply to smaller reporting companies or emerging growth companies at all and, as such, I am only providing a very brief review. Rule 3-09 requires that certain separate financial statements be provided for subsidiaries and persons even if the reporting company owns less than 50% if the investment is significant. Significance is determined using modifications of the investment and income tests. If neither of the tests exceed 20%, no Rule 3-09 financial statements are required, but if either exceeds 20%, all financial statements are required and such statements must be audited for each year that a test exceeds the 20% threshold.

Separately Rule 4-08 requires summarized financial information in the notes to financial statements if a Rule 3-09 test exceeds 10%. This summarized financial information is not required if the full separate financial statements are otherwise provided.

Reason for the rules and request for comment

Even investments in businesses that are not controlling (over 50%) impact financial condition, results of operation, liquidity and future prospects – hence, the Rule 3-09 requirements. However, as with Rule 3-05, the SEC recognizes the limited utility of the current requirements. One of the biggest concerns is the inability to reconcile separate financial statements for these investment entities, with the value of such investment on the financial statement on the registrant’s balance sheet. Moreover, the aggregation of investments in the summary presentations further dilutes the ability to discern particular value for any one individual entity’s separate financial statements.

The SEC is requesting comment on (i) how investors use Rule 3-09 financial information; (ii) what changes could be made to make the information more useful to investors; (iii) what challenges companies face in obtaining and preparing this financial information; (iv) how those challenges can be addressed or improved; and (v) whether there are parts of the current requirements that are not useful.

Related to the investment and income tests, the SEC specifically requested comments on (i) whether the current significance tests are the appropriate measure to determine the nature, timing and extent of financial statement disclosure requirements; (ii) whether the Rule 3-09 tests should be modified to correlate more closely with other financial statement requirements in Regulation S-X (such as Rule 10-01); (iii) what changes or alternatives the SEC should consider; (iv) whether the current test thresholds should be modified; (v) whether additional or different tests should be implemented (such as purchase price compared to market cap); and (vi) whether companies should be given more judgment in determining what is significant.

The SEC has also requested comment on whether Rule 3-09 should be expanded to include smaller reporting companies and emerging growth companies. My view on this is a definite “no.” The SEC has asked comment on whether Rule 3-09 should be modified for business development companies and, if so, in what way. My view on this is “yes,” but an in-depth discussion on business development companies is beyond the scope of this blog.

Rule 3-10 of Regulation S-X – Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered

Summary of current rule

A guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, must file their own audited annual and reviewed stub period financial statements under Rule 3-10 of Regulation S-X. Rule 3-10 provides certain exemptions, including (i) where a parent company offers securities guaranteed by one or more of its subsidiaries; or (ii) where a subsidiary offers securities guaranteed by another subsidiary.

Also, if the subsidiary issuer and guarantor satisfy certain conditions, the parent company can provide disclosures in its regular annual and interim consolidated financial statements for each subsidiary and guarantor (called “Alternative Disclosure”). Without getting into the minutiae of how to qualify for Alternative Disclosure, generally to qualify the subsidiary issuer/guarantor must be 100% owned by the parent and the guarantees must be full and unconditional.

In simple terms, usually a parent company merely consolidates the financial statements of its subsidiaries and no separate financial statement information is provided for individual operating subs. Where a sub or parent becomes a separate issuer or guarantor, separate financial information must be filed for those subsidiaries. Where qualified, Rule 3-10 allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.

The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.

To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. The parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.

Reason for the rules and request for comment

The rule is designed to provide investors with information to evaluate the likelihood of payment by the issuer and guarantors. The format and content of the Alternative Disclosure is unique and not found elsewhere in SEC rules or accounting standards.

The SEC has requested comment on (i) how investors use Rule 3-10 financial information; (ii) what changes could be made to make the information more useful to investors; (iii) what challenges companies face in obtaining and preparing this financial information; (iv) how those challenges can be addressed or improved; and (v) whether there are parts of the current requirements that are not useful.

In addition, the SEC has requested comments on the conditions that must be satisfied to qualify for Alternative Disclosure and the time periods for providing such disclosure.

Rule 3-16 of Regulation S-X – Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered

Summary of current rule

Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities act as a substantial part of collateral for securities being registered. The financial statements must be provided as if that affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required. Similarly, but separately, Rule 4-08 requires financial statement footnote disclosure of amounts of assets mortgaged, pledged or otherwise subject to a lien.

Reason for the rules and request for comment

The disclosures are meant to provide information on the ability of an affiliate to meet an obligation where the registrant defaults. However, many believe that the financial disclosure is confusing and not very useful to meet its intended purpose.

The SEC has requested comment on (i) whether the Rule 3-16 requirements influence the structure of collateral arrangements and, if so, what the consequences are to investors and registrants; (ii) how investors use Rule 3-16 financial information; (iii) what changes could be made to make the information more useful to investors; (iv) what challenges companies face in obtaining and preparing this financial information; (v) how those challenges can be addressed or improved; and (vi) whether there are parts of the current requirements that are not useful.

Additional information and further reading

The SEC has received many comment letters in response to its request and, on January 13, 2016, met with representatives of Deloitte & Touche on the subject. This blog summarizes the current rules and the SEC request for comment but does not include a discussion of the comment letters submitted to the SEC. Although many of the comment letters themselves contain useful and thought-provoking information, they are numerous and lengthy and such discussions may or may not ultimately influence the actual rules we practitioners work with. I will, of course, blog about future rules and rule amendments resulting from these discussions. For those interested in reading the comment letters, they can be found HERE.

I have written several times on the SEC initiative and the subject of improving the disclosure requirements for reporting companies. Several of the provisions in the recent FAST Act were related to these initiatives. In particular, The FAST Act adopted many of the provisions of a bill titled the Disclosure Modernization and Simplification Act, including rules to: (i) allow issuers to include a summary page to Form 10-K (Section 72001); and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for EGCs, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K (Section 72002). In addition, the SEC is required to conduct yet another study on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information (Section 72003). See my blog on the FAST Act and these provisions HERE.

In September 2015, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. My blog on these recommendations can be read HERE.

Prior to that, in March 2015, the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For a review of these recommendations, see my blog HERE.

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.

« SEC Study On Unregistered Offerings SEC Proposes Transfer Agent Rules »

SEC Study On Unregistered Offerings

Posted by Securities Attorney Laura Anthony | February 9, 2016 Tags: SEC, Unregistered Offerings

In October 2015, the SEC Division of Economic and Risk Analysis issued a white paper study on unregistered securities offerings from 2009 through 2014 (the “Report”). The Report provides insight into what is working in the private placement market and has been on my radar as a blog since its release, but with so many pressing, timely topics to write about, I am only now getting to this one. The SEC Report is only through 2014; however, at the end of this blog, I have provided supplemental information from another source related to PIPE (private placements into public equity) transactions in 2015.

Private offerings are the largest segment of capital formation in the U.S. markets. In 2014 private offerings raised more than $2 trillion. The SEC study used information collected from Form D filings to provide insight into the offering characteristics, including types of issuers, investors and financial intermediaries that participate in offerings. The Report focuses on Regulation D offerings and in particular Rules 504, 505, 506(b) and 506(c).

A summary of the main findings in the Report includes:

In 2014, there were 33,429 Regulation D offerings reported on Form D filings, accounting for more than $1.3 trillion raised.

Issuers in non-financial industries reported raising $133 billion in 2014. Among financial issuers, hedge funds raised $388 billion, private equity funds raised $316 billion and non-pooled investment funds (such as banks, insurance companies and investment banks) raised $375 billion.

Foreign issuers accounted for 20% of the 2014 total. Most foreign issuers are based on Canada, the Cayman Islands or Israel.

Rule 506 accounts for 99% of all private offerings. Rule 506 was used 97% of the time for offerings below the Rule 504 and 505 limits, showing that Rule 506 is preferred regardless of the amount of the offering (I believe this is firmly as a result of the state law pre-emption in a 506 offering).

Since the effectiveness of Rule 506(c) on September 23, 2013, allowing for general solicitation and advertising, only a small portion of raises – i.e., 2% of the total or $33 billion – relied on this exemption.

Capital raised through private markets correlates with the strength of public markets. The strength of the private market is closely tied to the health of the public market.

The median offer size of non-financial issuers is less than $2 million, indicating that small businesses rely on private, unregistered offerings the most.

Approximately 301,000 investors participated in Regulation D offerings during 2014. A large majority of these investors participated in offerings by non-financial issuers (presumably because financial issuers relied on a small number of institutional investors). Non-accredited investors participated in only 10% of the offerings.

Background on private offerings

All offers and sales of securities must be either registered under the Securities Act of 1933, as amended (“Securities Act”) or made in reliance on an available exemption from registration. Public offerings generally must always be registered (with the exception of a Rule 506(c) offering) and private offerings can generally be completed in reliance on an exemption. The private offering rules have various investor restrictions (limits on sales to unaccredited investors), information requirements and/or offering limits to balance the competing directives of the SEC to assist with capital formation and protect investors.

The exemptions for private offerings are found in Sections 3 and 4 of the Securities Act. In particular, most private offerings are governed by Sections 4(a)(2), 3(b) and 3(a)(11) of the Securities Act. Rules 506(b) and 506(c) of Regulation D, Regulation S and 144A provide safe harbors under Section 4(a)(2). Section 3(b) provides the authority for Rules 504 and 505 of Regulation D. Section 3(a)(11) provides statutory authority for intrastate offerings.

Even after the JOBS Act, private offerings remain the biggest source of capital formation for small and emerging companies, which companies are the largest source for creating new jobs, driving innovation and accelerating economic growth. At $1.3 trillion raised in 2014, private offerings represented more than what was raised in public equity and debt offerings combined.

From 2009 – 2014, there were more than 64,000 offerings by small businesses with a median offer size of less than $2 million. Only 21% of private offerings reported using a financial intermediary such as a broker-dealer. For those that did use such a placement agent, the average commission size was 5%.

Although the Report was issued in October 2015, it only examines the private offering market through 2014. The Report indicates that the vast majority of offerings are completed under Rule 506(b) with Rule 506(c) being only a very small percentage.

The analysis in the Report takes into consideration factors that may affect an issuer’s choice of private offering exemption, including pre-emption of state securities laws, ability to advertise, ability to sell to non-accredited investors, limits on amount of capital raise, geographical constraints, and levels of required disclosure. The Report is organized by discussions on the overall private offering market; capital formation in the market for Regulation D offerings and characteristics of market participants. This blog maintains that order of discussion.

The size of the private offerings market

The SEC Report does not give complete information on the size of the private offerings market. The information in the Report is based on Form D filings, which does not necessarily include offerings relying on straight Section 4(a)(2) or Regulation S as neither of these require a Form D filing. Moreover, many issuers that rely on Regulation D neglect to file a Form D and accordingly, the market size is somewhat larger than as stated in the SEC report.

In 2014 registered offerings accounted for $1.35 trillion compared to $2.1 trillion raised in private offerings. As reported by the SEC, Regulation D and Rule 144A are the most common offering methods, being primarily equity and Rule 144A being primarily debt. The Report includes comparative information on registered offerings as well. During the years 2009-2014, registered debt offerings far outweighed equity offerings.

The number of private offerings per year also far outweighs the number of registered offerings, though this is to be expected. A private offering can be completed far quicker and with greater frequency than a public offering that is subject to SEC filings, comment process and effectiveness procedures. As Regulation D is commonly used by smaller entities, it follows that there are significantly more of such offerings at smaller dollar values. Rule 144A, on the other hand, usually involves institutional investors at a much higher dollar amount and lower frequency. For instance, there were approximately 33,429 Regulation D offerings in 2014 compared to 1,534 Rule 144A offerings in the same year. In 2014 there were 1,176 registered public equity offerings and 1,576 registered public debt offerings.

The Report gives comparable information for each year from 2009 through 2014 as well. As a summary, 2010 was a very big year in the offering marketplace (both private and public), skewing the results somewhat, but other than that, the number of all offerings has increased year over year since 2009.

The Regulation D market

The Regulation D market is comprised of Rules 504 and 505 promulgated under Section 3(b) of the Securities Act and Rules 506(b) and 506(c), both of which are safe harbors under Section 4(a)(2) of the Securities Act. Again, the SEC Report is only based on Form D filings and, accordingly, is subject to deviation for offerings that did not file and/or inaccurate or incomplete information reported by issuers.

Both the number of and dollar value of Regulation D offerings has been increasing from 2009 through 2014. For instance, there were 13,764 reported Regulation D offerings in 2009 and 22,004 in 2014. The total amount sold in 2009 was $595 billion and in 2014 was $1,332 billion. Interestingly, the average offering size was larger in 2009 at $36 million than in 2014 at $24 million.

The SEC Report discussed the cyclicality of offerings as well. Although it is well documented that public markets are cyclical and depend on such factors as business cycle, investor sentiment and time varying information asymmetry, comparable information is not available for the private offering markets. Just based on Form D filings, the SEC Report considers whether there is support for the theory that companies rely on private markets when public markets are in distress, such as during a recession. There is not. In fact, rather it appears that the private offering market increases during strong public markets and decreases during weak public markets. The health of the private offering market correlates with the health of the public market.

As noted in the Report, “there is a strong, positive correlation of the incidence of new Regulation D offerings with the economic condition of the public markets. In particular the level of Regulation D offering activity closely follows the level of the S&P 500 index.” From 2009-2014 there has been an increase in Regulation D offering activity consistent with the steady increase in the S&P 500.

The Regulation D marketplace for non-financial issuers generally comprises equity offerings as opposed to debt offerings, which are more common in the public market. Moreover, equity is usually indicative of new money and capital whereas debt is often used as a refinancing tool for existing debt. Financial issuers generally use Rule 144A and such offerings are generally debt. In other words, small businesses looking to grow with new capital rely on Regulation D equity offerings.

Rule 506 of Regulation D continues to be the most common exemption. Since 2009, 95% of private offerings are completed under Rule 506. It is clear to me, and the SEC, that the reason for this is that Rule 506 pre-empts state law, avoiding state registration and other arduous blue sky process. The SEC points out that depending on state law, Rule 504 and 505 offerings can be sold to non-accredited investors and, under Rule 504, can be freely tradeable. Despite this benefit, issuers clearly find the state law pre-emption as a more important deciding factor and are willing to accept the restrictions under Rule 506 as a trade-off (i.e., either accredited only or a limit of 35 unaccredited, restricted securities, no general solicitation or advertising under 506(b) and added accredited verification under 506(c), etc.).

From September 23, 2013, the date of enactment, through December 31, 2014, a total of 2,117 Rule 506(c) offerings were reported on Form D by a total of 1,911 issuers (some issuers had multiple offerings). During this time a total of $32.5 billion was reported as being raised. As a comparison, during the same time period there were 24,500 Rule 506(b) offerings that raised $821.3 billion. Moreover, even after the enactment of Rule 506(c), the number of new 506(b) offerings continues to increase and vastly outpace the number of new Rule 506(c) offerings.

I am not surprised by this information as I think that the 506(c) marketplace has taken its time to find its place in the private offering market as a whole, and continues to do so. From my own experience it is clear that accredited investors do not just look at a website and send money! Offerings are sold, not bought, and the advertising and marketing is good for lead generation, ease of information flow, and general exposure, but does not cause a sophisticated investor to part with their money without more. Even though the accredited verification process has become easier with services such as Crowdcheck, it is clear that issuers, placement agents, and the investing public still prefer the old-fashioned Rule 506(b) and avoiding the accredited verification process. See, for example, my blog HERE discussing new SEC guidance and the Citizen VC no action letter.

I still strongly believe in the benefits of Rule 506(c) and its viability. The SEC Report does as well, pointing out that issuers will become more comfortable with market practices, accredited investor verification procedures, and methods of advertising and solicitation over time.

During this same time period there continues to be a decline in the use of Rules 504 and 505. For example, there were only 544 Rule 504 offerings and 289 Rule 505 offerings in 2014. The SEC Report contains quite a bit of comparative information on Rules 504 and 505 for those interested in further information. As I’ve previously written about, the SEC has proposed new amendments for Rules 504 and 505 which may increase their use, though I do not expect a big impact. My blog on these proposed rules can be read HERE.

Both foreign issuers and public companies rely on Regulation D. For example, 20% of all Regulation D offerings from 2009-2014 were completed by foreign issuers. Public issuers are active in PIPE transactions as well, with 13% of Regulation D offerings being completed by public companies. At the end of this blog I have a section with 2015 data on the PIPE market from other sources.

Regulation D market participants

Pooled investment funds such as hedge funds, venture capital and private equity funds represent the largest business category, by amount raised, utilizing Regulation D. From 2009-2014 pooled investment funds raised $4.8 trillion as compared to $905 billion by non-funds. Non-funds, however, use Rule 506(c) more than pooled funds, representing 75% of those offerings. Moreover, non-funds account for a much higher percentage of total offerings by number of offerings, representing 60% of all new Form D filings.

Companies completing Rule 506(c) offerings usually check the “other,” “other technology,” “other real estate,” “oil and gas,” or “commercial” industry boxes of their Form D filings. Counting all non-funds using all Regulation D offerings, the industries in order of most often used are banking, technology, real estate, health care and energy. Interestingly, the number of offerings by banking entities and manufacturing industries have both decreased during the study period. There has been a big uptick in real estate offerings in 2013 and 2014, which makes sense in light of the improved real estate market since 2008.

The median offering size for these non-fund issuers is $1 million compared to $11 million for hedge funds and $30 million for private equity funds. As mentioned above, this information indicates that small businesses are utilizing Regulation D, which the Report finds is consistent with the regulatory objectives.

The majority of issuers decline to disclose revenue and of those that did, most disclosed less than $1 million. This is consistent with the findings that Regulation D is widely used by small businesses. Beyond that, I can’t find a lot of meaning in that information, other than that smaller issuers are most likely to file a Form D without the assistance of counsel, and counsel usually recommends not disclosing revenue.

The Form D’s do show that a majority (67%) of companies that file a Form D are less than 3 years old. This is true for both fund and non-fund entities. I note that this is consistent with the SEC Advisory Committee on Small and Emerging Companies’ consistent message that new entities are the most in need of methods to raise capital and secondarily that those same new entities create the most new jobs.

Most U.S. companies that file Form D’s have their principal place of business in California and New York with Texas, Florida and Massachusetts following. These are also the most common states of investor location. Most investors are accredited.

Less than a fifth of all issuers reported repeat offerings but 25% of non-fund issuers had repeat offerings. Form D filings do not tell of the success of an offering; however, 31% of issuers had raised 100% of their offering at the time they filed the Form D, which is typical of PIPE transactions offerings with a small handful of investors.

Form D’s will also not tell the final investor count or breakdown, but compiling Form D information shows that only 300,000 investors participated in Regulation D offerings in 2014 and only 110,000 in non-financial issuers. That seems to be a very small number of investors overall and clearly shows the importance of properly packaging an offering and presenting it to the right audience.

Only 21% of offerings for the period 2009-2014 used a placement agent, with a decrease in their use in 2014 compared to 2009-2013. Issuers in non-financial industries paid an average of 6% commission and in financial industries, an average of 1.4%. This is likely because the size of the offering is much larger and number of investors much smaller in the financial industry. On average, higher fees are paid for Rule 506(c) offerings than 506(b), which makes sense in light of additional work (verification of accreditation) and risk associated with advertising.

2015 PIPE Market

A PIPE is a private placement into public equity, or in other words, a private placement by a public company. According to PrivateRaise, a private placement data service, PIPE’s raised $89.97 billion in 2015, up 14.8% from 2014. The amount was spread over approximately 1,000 offerings.

The Author

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

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

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« SEC Issues Rules Implementing Certain Provisions Of The FAST Act SEC’s Financial Disclosure Requirements For Sub-Entities Of Registered Companies »

SEC Issues Rules Implementing Certain Provisions Of The FAST Act

Posted by Securities Attorney Laura Anthony | February 2, 2016 Tags: Fast Act, SEC, The Fast Act

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

On January 13, 2016, the SEC issued interim final rules memorializing two provisions of the FAST Act. In particular, the SEC revised the instructions to Forms S-1 and F-1 to allow the omission of historical financial information and to allow smaller reporting companies to use forward incorporation by reference to update an effective S-1. This blog summarizes these rules.

On December 10, 2015, the SEC Division of Corporate Finance addressed the FAST Act by making an announcement with guidance and issuing two new Compliance & Disclosure Interpretations (C&DI). My blog on the FAST Act and the first two C&DI on the Act can be read HERE. On December 21, 2015, the SEC issued 4 additional C&DI on the FAST Act. Each of the new C&DI addresses the FAST Act’s impact on Section 12(g) and Section 15(d) of the Exchange Act as related to savings and loan companies. My blog on this guidance can be read HERE.

The Amendments – an Overview

Form S-1 is the general form for the registration of securities under the Securities Act of 1933, as amended (“Securities Act”) and Form F-1 is the corresponding form for foreign private issuers.

Section 71003 of the FAST Act

Section 71003 of the FAST Act allows an emerging growth company (“EGC”) that is filing a registration statement under either Form S-1 or F-1 to omit financial information for historical periods that would otherwise be required to be included, if it reasonably believes the omitted information will not be included in the final effective registration statement used in the offering, and if such final effective registration statement includes all up-to-date financial information that is required as of the offering date. This provision automatically went into effect 30 days after enactment of the FAST Act. As directed by the FAST Act, the SEC has now revised the instructions to Forms S-1 and F-1 to reflect the new law.

The Section 71003 provisions do not allow for the omission of stub period financial statements if that stub period will ultimately be included in a longer stub period or year-end audit before the registration statement goes effective. In a C&DI, the SEC clarified that the FAST Act only allows the exclusion of historical information that will no longer be included in the final effective offering. The C&DI clarifies that “Interim financial information ‘relates’ to both the interim period and to any longer period (either interim or annual) into which it has been or will be included.” For example, an issuer could not omit first-quarter financial information if that first quarter will ultimately be included as part of a second- or third-quarter stub period or year-end audit.

An SEC C&DI has clarified that Section 71003 allows for the exclusion of financial statements for entities other than the issuer if those financial statements will not be included in the final effective registration statement. For example, if the EGC has acquired a business, it may omit that acquired business’ historical financial information as well. In a C&DI, the SEC confirms that: “Section 71003 of the FAST Act is not by its terms limited to financial statements of the issuer. Thus, the issuer could omit financial statements of, for example, an acquired business required by Rule 3-05 of Regulation S-X if the issuer reasonably believes those financial statements will not be required at the time of the offering. This situation could occur when an issuer updates its registration statement to include its 2015 annual financial statements prior to the offering and, after that update, the acquired business has been part of the issuer’s financial statements for a sufficient amount of time to obviate the need for separate financial statements.”

As a reminder, an EGC is defined as an issuer with less than $1 billion in total annual gross revenues during its most recently completed fiscal year. If an issuer qualifies as an EGC on the first day of its fiscal year, it maintains that status until the earliest of the last day of the fiscal year of the issuer during which it has total annual gross revenues of $1 billion or more; the last day of its fiscal year following the fifth anniversary of the first sale of its common equity securities pursuant to an effective registration statement; the date on which the issuer has, during the previous 3-year period, issued more than $1 billion in non-convertible debt; or the date on which the issuer is deemed to be a “large accelerated filer.”

Section 84001 of the FAST Act

Section 84001 of the FAST Act requires the SEC to revise Form S-1 to permit smaller reporting companies to incorporate by reference, into an effective registration statement, any documents filed by the issuer following the effective date of such registration statement. That is, Section 84001 allows forward incorporation by reference. At first, I thought this would be a significant change, as currently smaller reporting companies are specifically prohibited from incorporating by reference and must prepare and file a post-effective amendment to keep a resale “shelf” registration current, which can be expensive. However, the SEC rule release includes eligibility requirements, including a prohibition for use by penny stock issuers, which will greatly limit the use of forward incorporation by reference, significantly reducing the overall impact of this change.

As a reminder, a “smaller reporting company” is defined as an issuer that had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter or had annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

As directed by the FAST Act, the SEC has now revised Item 12 of Form S-1 to reflect the changes and to include eligibility requirements for an issuer to be able to avail itself of the new provisions. That is, there are currently eligibility requirements for an issuer to be able to use historical incorporation by reference in a Form S-1. The new rules do not alter these existing eligibility requirements and rather attach the existing eligibility requirements related to historical incorporation by reference to the ability to be able to utilize the new provisions, allowing forward incorporation by reference.

The instructions to Form S-1 include the eligibility requirements to use historical, and now forward, incorporation by reference and include:

The company must be subject to the reporting requirements of the Exchange Act (not a voluntary filer);

The company must have filed all reports and other materials required by the Exchange Act during the prior 12 months (or such shorter period that such company was reporting);

The company must have filed an annual report for its most recently completed fiscal year;

The company may not currently be, and during the past 3 years neither the company nor any of its predecessors were, (i) a blank check company; (ii) a shell company; (iii) have offered a penny stock;

The company cannot be registering an offering for a business combination transaction; and

The company must make its reports filed under the Exchange Act that are incorporated by reference, available on its website, and include a disclosure of such availability that it will provide such document upon request.

The Author

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

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

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« FINRA Proposes New Category Of Broker-Dealer For “Capital Acquisition Brokers” SEC Study On Unregistered Offerings »

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

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

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

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

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

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

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

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

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

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

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

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

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

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

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

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

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

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

Government entity or subdivision thereof;

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

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

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

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

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

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

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

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

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making;

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

Application; Associated Person Registration; Supervision

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

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

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

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

Conduct Rules for CABs

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

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

Financial and Operational Rules for CABs

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

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

The Author

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

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

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

SEC Small Business Advisory Committee Public Company Disclosure Recommendations

Posted by Securities Attorney Laura Anthony | October 27, 2015 Tags: Non-Accelerated Filer

On September 23, 2015 , the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies.

By way of reminder, the 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 topic of disclosure requirements for smaller public companies under the Securities Exchange Act of 1934 (“Exchange Act”) has come to the forefront over the past year. In early December the House passed the Disclosure Modernization and Simplification Act of 2014, but the bill was never passed by the Senate and died without further action.

In March of this year the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For a review of these recommendations see my blog Here.

The Advisory Committee discussed the topic at its meetings on June 3, 2015 and again on July 15, 2015 before finalizing its recommendations, which were published on September 23, 2015. In formulating its recommendations, the Advisory Committee gave specific consideration to the following facts:

The SEC has provided for simplified disclosure for smaller reporting companies for over 30 years. Under the current rules a “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues. Similarly, a company is considered a non-accelerated filer if it has a public float of less than $75 million as of the last day of the most recently completely second fiscal quarter.

The JOBS Act, enacted on April 5, 2012, created a new category of company called an “emerging growth company” for which certain scaled-down disclosure requirements apply for up to 5 years after an initial IPO. An emerging growth company is one that has total annual gross revenues of less than $1 billion during its most recent completed fiscal year.

Emerging growth companies are provided with a number of other accommodations with respect to disclosure requirements that would also be beneficial to smaller reporting companies.

The Advisory Committee then made the following specific recommendations:

The SEC should revise the definition of “smaller reporting company” to include companies with a public float of up to $250 million. This will increase the class of companies benefitting from a broad range of benefits to smaller reporting companies, including (i) exemption from the pay ratio rule; (ii) exemption from the auditor attestation requirements; and (iii) exemption from providing a compensation discussion and analysis.

The SEC should revise its rules to align disclosure requirements for smaller reporting companies with those for emerging growth companies. These include (i) exemption from the requirement to conduct shareholder advisory votes on executive compensation and on the frequency of such votes; (ii) exemption from rules requiring mandatory audit firm rotation; (iii) exemption from pay versus performance disclosure; and (iv) allow compliance with new accounting standards on the date that private companies are required to comply.

The SEC should revise the definition of “accelerated filer” to include companies with a public float of $250 million or more but less than $700 million. As a result, the auditor attestation report under Section 404(b) of the Sarbanes Oxley Act would no longer apply to companies with a public float between $75 million and $250 million.

The SEC should exempt smaller reporting companies from XBRL tagging; and

The SEC should exempt smaller reporting companies from filing immaterial attachments to material contracts.

My Thoughts

I completely agree with the recommendations. The disclosure rules are complicated, and compliance is expensive. Moreover, the numerous new rules related to executive compensation including pay ratio, say on pay, pay vs. performance, executive clawback and compensation disclosure and analysis are a huge deterrent for companies that currently do not qualify as a smaller reporting company, but are still small in today’s financial world. These companies need an opportunity to grow and generate jobs while still providing meaningful disclosure to the marketplace and investors. The proposed changes in the definition of smaller reporting company to a much more modern reasonable $250 million will greatly assist in that regard.

I especially applaud the recommendation related to XBRL tagging. I firmly believe it is an analytic tool that is not used at all by smaller reporting companies or the small cap marketplace.

Refresher on Public Company Reporting Requirements

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Reports filed with the SEC can be viewed by the public on the SEC EDGAR website. The required reports include an annual Form 10-K, quarterly Form 10Q’s and current periodic Form 8-K, as well as proxy reports and certain shareholder and affiliate reporting requirements.

A company becomes subject to the Reporting Requirements by filing an Exchange Act Section 12 registration statement on either Form 10 or Form 8-A. A Section 12 registration statement may be filed voluntarily or per statutory requirement if the issuer’s securities are held by either (i) 2,000 persons or (ii) 500 persons who are not accredited investors and where the issuer’s total assets exceed $10 million. In addition, companies that file a Form S-1 registration statement under the Securities Act of 1933, as amended (“Securities Act”) become subject to Reporting Requirement; however, such obligation becomes voluntary in any fiscal year at the beginning of which the company has fewer than 300 shareholders.

A reporting company also has record-keeping requirements, must implement internal accounting controls and is subject to the Sarbanes-Oxley Act of 2002, including the CEO/CFO certifications requirements, prohibition on officer and director loans, and independent auditor requirements. Under the CEO/CFO certification requirement, the CEO and CFO must personally certify the content of the reports filed with the SEC and the procedures established by the issuer to report disclosures and prepare financial statements. For more information on that topic, see my blog Here.
All reports filed with the SEC are subject to SEC review and comment and, in fact, the Sarbanes-Oxley Act requires the SEC to undertake some level of review of every reporting company at least once every three years.

The following are the reports that generally make up a public company’s reporting requirements and which are applicable to smaller reporting companies. A “smaller reporting company” is an issuer that is not an investment company or asset-backed issuer or majority-owned subsidiary and that (i) had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter; or (ii) in the case of an initial registration statement, had a public float of less than $75 million as of a date within days of the filing of the registration statement; or (iii) in the case of an issuer whose public float as calculated by (i) or (ii) is zero, had annual revenues of less than $75 million during the most recently completed fiscal year for which audited financial statements are available.

Annual Reports on Form 10-K

All smaller reporting companies are required to file an annual report with the SEC on Form 10-K within 90 days of the end of its fiscal year. An extension of up to 15 calendar days is available for a Form 10-K as long as the extension notice on Form 12b-25 is filed no later than the next business day after the original filing deadline.

A Form 10-K includes the company’s audited annual financial statements, a discussion of the company’s business results, a summary of operations, a description of the overall business and its physical property, identification of any subsidiaries or affiliates, disclosure of the revenues contributed by major products or departments, and information on the number of shareholders, the management team and their salaries, and the interests of management and shareholders in certain transactions. A Form 10-K is substantially similar to a Form 10 registration statement and updates shareholders and the market on information previously filed in a registration statement, on an annual basis.

Quarterly Reports on Form 10-Q

All smaller reporting companies are required to file a quarterly report on Form 10-Q within 45 days of the end of each of its fiscal quarters. An extension of up to 5 calendar days is available for a Form 10-Q as long as the extension notice on Form 12b-25 is filed no later than the next business day after the original filing deadline.

The quarterly report includes unaudited financial statements and information about the company’s business and results for the previous three months and for the year to date. The quarterly report compares the company’s performance in the current quarter and year to date to the same periods in the previous year.

Current Reports on Form 8-K

Subject to certain exceptions, a Form 8-K must be filed within four (4) business days after the occurrence of the event being disclosed. No extension is available for an 8-K. Companies file this report with the SEC to announce major or extraordinary events that shareholders should know about, including entry into material agreements, mergers and acquisitions, change in control, changes in auditors, the issuance of unregistered securities, amendments in company articles or bylaws, company name changes, issues with reliance on previously issued financial statements, changes in officer or directors, bankruptcy proceedings, change in shell status regulation F-D disclosures and voluntary disclosures (voluntary disclosures have no filing deadline).

The Fair Disclosure Regulation, enacted in 2000 (“Regulation FD”), stipulates that publicly traded companies broadly and publicly disseminate information instead of distributing it selectively to certain analysts or investors only. Companies are encouraged to use several means of information dissemination including Form 8-K, news releases, Web sites or Web casts, and press releases. A Form 8-K under Regulation FD must be filed (i) simultaneously with the release of the material that is the subject of the filing (generally a press release); or (ii) the next trading day.

Other than when there has been a change of shell status, the financial statements of an acquired business must be filed no later than 71 calendar days after the date the initial Form 8-K was filed reporting the closing of the business acquisition (which initial Form 8-K is due with 4 days).

Consequences and Issues Related to Late Filing

Late filings carry severe consequences to small business issuers. Generally the shareholders of late filing issuers cannot rely on Rule 144 for the sale or transfer of securities while the issuer is delinquent in its filing requirements. Rule 144(c) requires that adequate current public information with respect to the company must be available. The current public information requirement is measured at the time of each sale of securities. That is, the issuer, whether reporting or non-reporting, must satisfy the current public information requirements as set forth in Rule 144(c) at the time that each resale of securities is made in reliance on Rule 144. For reporting issuers, adequate current public information is deemed available if the issuer is, and has been for a period of at least 90 days immediately before the sale, subject to the Exchange Act reporting requirements and has filed all required reports, other than Form 8-K, and has submitted electronically and posted on its website, if any, all XBRL data required to be submitted and posted.

An issuer that is late or has failed to maintain its reporting requirements is disqualified from use of Form S-3, which is needed to conduct at-the-market direct public offerings, shelf registrations and types of registered securities. Likewise, a Form S-8 cannot be filed while an issuer is either late or delinquent in its reporting requirements. Late or delinquent filings may also trigger a default in the terms of contracts, including corporate financing transactions. Finally, the SEC can bring enforcement proceedings against late filers, including actions to deregister the securities.

Proxy Statements

All companies with securities registered under the Exchange Act (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act proxy requirements found in Section 14 and the rules promulgated thereunder. Companies required to file reports as a result of an S-1 registration statement that have not separately registered under the Exchange Act are not subject to the proxy filing requirements. The proxy rules govern the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the approval of any corporate action requiring shareholder approval. The information contained in proxy materials must be filed with the SEC in advance of any solicitation to ensure compliance with the disclosure rules.

Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which shareholders are asked to vote. The disclosure information filed with the SEC and ultimately provided to the shareholders is enumerated in SEC Schedule 14A.

Where a shareholder vote is not being solicited, such as when a company has obtained shareholder approval through written consent in lieu of a meeting, a company may satisfy its Section 14 requirements by filing an information statement with the SEC and mailing such statement to its shareholders. In this case, the disclosure information filed with the SEC and mailed to shareholders is enumerated in SEC Schedule 14C. As with the proxy solicitation materials filed in Schedule 14A, a Schedule 14C Information Statement must be filed in advance of final mailing to the shareholder and is reviewed by the SEC to ensure that all important facts are disclosed. However, Schedule 14C does not solicit or request shareholder approval (or any other action, for that matter), but rather informs shareholders of an approval already obtained and corporate actions which are imminent.

In either case, a preliminary Schedule 14A or 14C is filed with the SEC, who then review and comment on the filing. Upon clearing comments, a definitive Schedule 14A or 14C is filed and mailed to the shareholders as of a certain record date.

Generally, the information requirements in Schedule 14C are less arduous than those in a Schedule 14A in that they do not include lengthy material regarding what a shareholder must do to vote or approve a matter. Moreover, the Schedule 14C process is much less time-consuming, as the shareholder approval has already been obtained. Accordingly, when possible, companies prefer to utilize the Schedule 14C Information Statement as opposed to the Schedule 14A Proxy Solicitation.

Reporting Requirements for Company Insiders

All executive officers and directors and 10%-or-more shareholders of a company with securities registered under the Exchange Act (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act Reporting Requirements related to the reporting of certain transactions. The initial filing is on Form 3 and is due no later than ten days of becoming an officer, director, or beneficial owner. Changes in ownership are reported on Form 4 and must be reported to the SEC within two business days. Insiders must file a Form 5 to report any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting. If a form must be filed, it is due 45 days after the end of the company’s fiscal year. For more information on these Section 16 reporting requirements, see my blog Here.

Additional Disclosures

Other federal securities laws and SEC rules require disclosures about a variety of events affecting the company. Under the Exchange Act, parties who will own more than five percent of a class of the company’s securities after making a tender offer for securities registered under the Exchange Act must file a Schedule TO with the SEC. The SEC also requires any person acquiring more than five percent of a voting class of a company’s Section 12 registered equity securities directly or by tender offer to file a Schedule 13D. Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D. For more information on Schedules 13D/G, see my blog Here.

Termination of Reporting Requirements

To deregister and suspend Reporting Requirements, an eligible issuer can file a Form 15. To qualify to file a Form 15, an issuer must either have (i) fewer than 300 shareholders; or (ii) fewer than 500 shareholders and the issuer’s assets do not exceed $10 million.

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 OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony 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 producer and host of LawCast, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington D.C., Denver, Tampa, Detroit and Dallas.

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

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« Mergers And Acquisitions – The Merger Transaction The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance »

Mergers And Acquisitions – The Merger Transaction

Posted by Securities Attorney Laura Anthony | October 20, 2015 Tags: Mergers and Acquisitions, the merger transaction

Although I have written about document requirements in a merger transaction previously, with the recent booming M&A marketplace, it is worth revisiting. This blog only addresses friendly negotiated transactions achieved through share exchange or merger agreements. It does not address hostile takeovers.

A merger transaction can be structured as a straight acquisition with the acquiring company remaining in control, a reverse merger or a reverse triangular merger. In a reverse merger process, the target company shareholders exchange their shares for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the target company own a majority of the acquiring public company and the target company has become a wholly owned subsidiary of the public company. The public company assumes the operations of the target company.

A reverse merger is often structured as a reverse triangular merger. In that case, the acquiring company forms a new subsidiary which merges with the target company. The primary benefits of the reverse triangular merger include the ease of shareholder consent and certain perceived tax benefits. The specific form of the transaction should be determined considering the relevant tax, accounting and business objectives of the overall transaction.

An Outline of the Transaction Documents

The Confidentiality Agreement

Generally the first step in an M&A deal is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.

In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality, such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

The Letter of Intent

A letter of intent (“LOI”) is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with the “who do” identification.

Many clients ask me how to protect their interests while trying to negotiate a merger or acquisition. During the negotiation period, both sides will incur time and expense, and will provide the other with confidential information. The way to protect confidential information is through a confidentiality agreement, but that does not protect against wasted time and expense. Many other protections can be used to avoid wasted time and expense.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” or “window shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential transaction, for a specific period of time. That period of time may be set in calendar time, such as sixty days, or based on conditions, such as completion of an environmental study, or a combination of both.

A “window shop” provision allows for some level of third-party negotiation or inquiry. An example of a window shop provision may be that a party cannot solicit other similar transactions but is not prohibited from hearing out an unsolicited proposal. A window shop provision may also allow the board of directors of a party to shop for a better deal, while giving a right of first refusal if such better deal is indeed received. Window shop provisions generally provide for notice and disclosure of potential “better deals” and either matching or topping rights.

Generally, both no shop and window shop provisions provide for a termination fee or other detriment for early termination. The size of the termination fee varies; however, drafters of a letter of intent should be cognizant that if the fee is substantial, it likely triggers an SEC reporting and disclosure requirement, which in and of itself could be detrimental to the deal.

Much different from a no shop or window shop provision is a “go shop” provision. To address a board of directors’ fiduciary duty and, in some instances, to maximize dollar value for its shareholders, a potential acquirer may request that the target “go shop” for a better deal up front to avoid wasted time and expense. A go shop provision is more controlled than an auction and allows both target and acquiring entities to test the market prior to expending resources. A go shop provision is common where it is evident that the board of directors’ “Revlon Duties” have been triggered.

Another common deal protection is a standstill agreement. A standstill agreement prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning off subsidiaries, hiring or firing management teams and the like.

Finally, many companies protect their interests by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The Merger Agreement

In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being purchased and provides for rights and remedies in the event that this description proves to be materially inaccurate. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.

The main components of the Merger Agreement and a brief description of each are as follows:

Representations and Warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The seller also represents and warrants its legal ability to enter into the agreement. Both parties represent as to the accuracy of public filings, financial statements, material contract, tax matters and organization and structure of the entity.

Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a seller must continue to operate the business in the ordinary course and maintain assets pending closing and, if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.

Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Generally for public companies these conditions include the filing of appropriate shareholder proxy or information statements under Section 14 of the Securities Exchange Act of 1934 and complying with shareholder appraisal rights provisions. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.

Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.

Deal Protections – Like the LOI, the merger agreement itself will contain deal protection terms. These deal protection terms can include no shop or window shop provisions, requirements as to business operations by the parties prior to the closing; breakup fees; voting agreements and the like.

Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.

In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no shop provisions, breakup fees, non-compete and confidentiality provisions if not previously agreed to separately.

Disclosure Matters

In a merger or acquisition transaction, there are three basic steps that could invoke the disclosure requirements of the federal securities laws: (i) the negotiation period or pre-definitive agreement period; (ii) the definitive agreement; and (iii) closing.

(i) Negotiation Period (Pre-Definitive Agreement)

Generally speaking, the federal securities laws do not require the disclosure of a potential merger or acquisition until such time as the transaction has been reduced to a definitive agreement. Companies and individuals with information regarding non-public merger or acquisition transactions should be mindful of the rules and regulations preventing insider trading on such information. However, there are at least three cases where pre-definitive agreement disclosure may be necessary or mandated.

The first would be in the Management, Discussion and Analysis section of a company’s quarterly or annual report on Form 10-Q or 10-K, respectively. Item 303 of Regulation S-K, which governs the disclosure requirement for Management’s Discussion and Analysis of Financial Condition and Results of Operations, requires, as part of this disclosure, that the registrant identify any known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, the registrant’s liquidity increasing or decreasing in any material way. Furthermore, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the Instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”

It seems pretty clear that a potential merger or acquisition would fit firmly within the required MD&A discussion. However, realizing that disclosure of such negotiations and inclusion of such information could, and often would, jeopardize completing the transaction at all, the SEC has provided guidance. In SEC Release No. 33-6835 (1989), the SEC eliminated uncertainty regarding disclosure of preliminary merger negotiations by confirming that it did not intend for Item 303 to apply, and has not applied, and does not apply to preliminary merger negotiations. In general, the SEC’s recognition that companies have an interest in preserving the confidentiality of such negotiations is clearest in the context of a company’s continuous reporting obligations under the Exchange Act, where disclosure on Form 8-K of acquisitions or dispositions of assets not in the ordinary course of business is triggered by completion of the transaction (more on this below). Clearly, this is a perfect example and illustration of the importance of having competent legal counsel assist in interpreting and unraveling the numerous and complicated securities laws disclosure requirements.

In contrast, where a company registers securities for sale under the Securities Act, the SEC requires disclosure of material probable acquisitions and dispositions of businesses, including the financial statements of the business to be acquired or sold. Where the proceeds from the sale of the securities being registered are to be used to finance an acquisition of a business, the registration statement must disclose the intended use of proceeds. Again, accommodating the need for confidentiality of negotiations, registrants are specifically permitted not to disclose in registration statements the identity of the parties and the nature of the business sought if the acquisition is not yet probable and the board of directors determines that the acquisition would be jeopardized. Although beyond the scope of this blog, many merger and/or acquisition transactions require registration under Form S-4.

Accordingly, where disclosure is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the company’s view, inclusion of such information would jeopardize completion of the transaction. Where disclosure is otherwise required or has otherwise been made by or on behalf of the company, the interests in avoiding premature disclosure no longer exist. In such case, the negotiations would be subject to the same disclosure standards under Item 303 as any other known trend, demand, commitment, event or uncertainty.

The second would be in Form 8-K, Item 1.01 Entry into A Material Definitive Agreement. Yes, this is in the correct category; the material definitive agreement referred to here is a letter of intent or confidentiality agreement. Item 1.01 of Form 8-K requires a company to disclose the entry into a material definitive agreement outside of the ordinary course of business. A “material definitive agreement” is defined as “an agreement that provides for obligations that are material to and enforceable against the registrant or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions.” Agreements relating to a merger or acquisition are outside the ordinary course of business. Moreover, although most letters of intent are non-binding by their terms, many include certain binding provisions such as confidentiality provisions, non-compete or non-circumvent provisions, no shop and exclusivity provisions, due diligence provisions, breakup fees and the like. On its face, it appears that a letter of intent would fall within the disclosure requirements in Item 1.01.

Once again, the SEC has offered interpretative guidance. In its final rule release no. 33-8400, the SEC, recognizing that disclosure of letters of intent could result in destroying the underlying transaction as well as create unnecessary market speculation, specifically eliminated the requirement that non-binding letters of intent be disclosed. Moreover, the SEC has taken the position that the binding provisions of the letter, such as non-disclosure and confidentiality, are not necessarily “material” and thus do not require disclosure. However, it is important that legal counsel assist the company in drafting the letter, or in interpreting an existing letter to determine if the binding provisions reach the “materiality” standard and thus become reportable. For example, generally large breakup fees or extraordinary exclusivity provisions are reportable.

The third would be in response to a Regulation FD issue. Regulation FD or fair disclosure prevents selective disclosure of non-public information. Originally Regulation FD was enacted to prevent companies from selectively providing information to fund managers, big brokerage firms and other “large players” in advance of providing the same information to the investment public at large. Regulation FD requires that in the event of an unintentional selective disclosure of insider information, the company take measures to immediately make the disclosure to the public at large through both a Form 8-K and press release.

(ii) The Definitive Agreement

The definitive agreement is disclosable in all aspects. In addition to inclusion in Form 10-Q and 10-K, a definitive agreement must be disclosed in Form 8-K within four (4) days of signing in accordance with Item 1.01 as described above. Moreover, following the entry of a definitive agreement, completion of conditions, such as a shareholder vote, will require in-depth disclosures regarding the potential target company, including their financial statements.

(iii) The Closing

The Closing is disclosable in all aspects, as is the definitive agreement. Moreover, in addition to item 1.01, the Closing may require disclosures under several or even most of the Items in Form 8-K, such as Item 2.01 – Completion of disposal or acquisition of Assets; Item 3.02 – Unregistered sale of securities; Item 4.01 – Changes in Certifying Accountant; Item 5.01 Change in Control; Item 5.06 – Change in Shell Status, etc.

Due Diligence in a Merger Transaction

Due diligence refers to the legal, business and financial investigation of a business prior to entering into a transaction. Although the due diligence process can vary depending on the nature of a transaction (a relatively small acquisition vs. a going public reverse merger), it is arguably the most important component of a transaction (or at least equal with documentation).

At the outset, in addition to requesting copies of corporate records and documents, all contracts, asset chains of title documents, financial statements and the like, due diligence includes becoming familiar with the target’s business, including an understanding of how they make money, what assets are important in revenues, who are their commercial partners and suppliers, and common off-balance-sheet and other hidden arrangements in that business. It is important to have a basic understanding of the business in order to effectively review the documents and information once supplied, to know what to ask for and to isolate potential future problems.

In addition to determining whether the transaction as a whole is worth pursuing, proper due diligence will help in structuring the transaction and preparing the proper documentation to prevent post-closing issues (such as making sure all assignments of contracts are complete, or where an assignment isn’t possible, new contracts are prepared).

In addition to creating due diligence lists of documents and information to be supplied, counsel for parties should perform separate checks for publicly available information. In today’s internet world, this part of the process has become dramatically easier. Counsel should be careful not to miss the basics, such as UCC lien searches, judgment searches, recorded property title and regulatory issues with any of the principals or players involved in the deal, including any bad actor issues that could be problematic going forward.

The Author

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

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

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SEC Footnote 32 and Sham S-1 Registration Statements

Posted by Securities Attorney Laura Anthony | September 20, 2015 Tags: s-1 registration statement, sec footnote 32

Over the past several years, many direct public offering (DPO) S-1 registration statements have been filed for either shell or development-stage companies, claiming an intent to pursue and develop a particular business, when in fact, the promoter intends to create a public vehicle to be used for reverse merger transactions. For purposes of this blog, I will refer to these S-1 registration statements the same way the SEC now does, as “sham registrations.” I prefer the term “sham registrations” as it better describes the process than the other used industry term of art, “footnote 32 shells .”

Footnote 32 is part of the Securities Offering Reform Act of 2005 (“Securities Offering Reform Act”). In the final rule release for the Securities Offering Reform Act, the SEC included a footnote (number 32) which states:

“We have become aware of a practice in which the promoter of a company and/or affiliates of the promoter appear to place assets or operations within an entity with the intent of causing that entity to fall outside of the definition of blank check companies in Securities Act Rule 419. The promoter will then seek a business combination transaction for the company, with the assets or operations being returned to the promoter or affiliate upon the completion of that business combination transaction.

It is likely that similar schemes will be undertaken with the intention of evading the definition of shell company that we are adopting today. In our view, when promoters (or their affiliates) of a company that would otherwise be a shell company place assets or operations in that company and those assets or operations are returned to the promoter or to its affiliates (or an agreement is made to return those assets or operations to the promoter or its affiliates) before, upon completion of, or shortly after a business combination transaction by that company, those assets or operations would be considered ‘nominal’ for purposes of the definition of shell company.”

An entity created for the purposes of entering into a merger or acquisition transaction with an as of yet unidentified target, is called a “blank check company.” All registrations by blank check companies are required to comply with Rule 419 under the Securities Act of 1933, as amended (“Securities Act”). Further down in this blog, I have included a discussion of Rule 419, which requires that funds raised and securities sold be held in escrow until a merger or acquisition transaction is completed. An entity relying on Rule 419 would not receive a trading symbol or be able to apply for DTC eligibility until after it completes a merger or acquisition transaction.

A public vehicle with a trading symbol and DTC eligibility has greater value for a target asset or company, and accordingly, some unscrupulous industry players file sham registrations in an effort to avoid Rule 419.

As discussed further below, a shell company is one with no or nominal assets and operations. Although a DPO may legally be completed by a company that meets the definition of a “shell company,” a public vehicle which is not and never was a shell company is more valuable to a reverse merger or acquisition target. In particular, as I have written about many times, companies that are or ever were a “shell company” face prohibitions and ongoing limitations related to the use of Rule 144 (for further discussion on Rule 144 related to shell companies see my blog HERE. As with avoiding Rule 419, some unscrupulous industry players file sham registrations in an effort to avoid shell status.

Sham registrations have become increasingly prevalent with the newly public company being offered for sale and for use in reverse merger transactions. In a typical sham registration, 99.9% of the total issued and outstanding shares are offered for sale. Typically the company has a single (or possibly two) owner(s) of the control block and a single (or possibly two) person(s) serving in all officer and director roles. There are usually approximately 30 “free trading” shareholders offering to sell their shares as registered freely tradable shares, to a new group of shareholders associated with the reverse merger target. Generally, the only shares not offered in the transfer are a small number that have been deposited into DTC as part of the DTC application process.

From a legal perspective, the person(s) filing the sham registration is violating Section 17(a) of the Securities Act, which is the counterpart to Rule 10(b)(5) of the Securities Exchange Act of 1934. Section 17(a) prohibits, in conjunction with the offer or sale of securities: (i) the use of any device, scheme or artifice to defraud; or (ii) obtaining money or property using any untrue statement related to, or any omission of, a material fact; or (iii) engaging in any transaction, practice or course of business that would operate as a fraud or deceit on the purchaser. That is, the person(s) filing the sham registration are aware that there is no present intent to pursue the disclosed business, but rather the intent is to sell the public entity to a new business or group. In addition, the participants violate Rule 10(b)(5) of the Exchange Act and Exchange Act recordkeeping and internal control provisions.

Moreover, those involved would be liable for similar state securities law violations. In addition to an action by both the SEC and state regulatory agencies, the public company would be liable for civil actions against purchasers of securities. As with any securities fraud violation, egregious cases can be referred to the Department of Justice or State Attorney for criminal action.

Until now, the SEC has only taken action against the promoter, individual or group behind the sham registration and not the third-party reverse merger target, which has generally been a real business that has innocently purchased one of these public entities to be used in a reverse merger transaction. However, I believe that is about to change. These sham registration public companies are so blatant and easy to identify that a third party can no longer claim innocence in its purchase or use.

I believe the SEC is going to begin imposing trading suspensions and/or registration revocations against the public companies after a purchaser has taken over with a valid operating business. Industry insiders are aware that the SEC is taking action to prevent any active trading market from developing from these vehicles, and it is my belief that the SEC is gearing up to file an example-setting case that will include the purchaser of one of these sham public vehicles. The risk to the sham public vehicle purchaser goes beyond a trading suspension or registration revocation, and could include aiding and abetting liability for the sham registration itself.

Action to Prevent Active Trading Market

As I’ve blogged about many times, the SEC views broker-dealers as gatekeepers in the compliance with federal securities fraud. For more on this topic, see my blog HERE about the ongoing issues of depositing penny stocks with broker-dealers.

In the past few weeks, regulators have imposed a barrier to the deposit of securities purchased from a participant in a sham registration or issued by a company involved in a sham registration. Although I do not have a copy of the memo, based on a source, the SEC has provided certain penny stock broker-dealers with a memo outlining red flags indicating that a company may have been involved in a “sham registration” and warning against the deposit and offer of sale of shares issued by such company.

Sham registration red flags include:

A company formed immediately preceding filing a registration statement and commencing its public offering;

Proposed business consisting of actual activities in a described line of business, without concrete expenditures, contracts, operating assets, or other indicia of actual operations in that business;

A relatively small S-1 registered public offering—e.g., $40,000;

The registration statement prepared by legal counsel who has a history of several similar registration statements with similar business and offering profiles as set forth above;

Low costs of offering, including legal fees—e.g., $3,500 for the entire organization, audit, and SEC registration work;

Cash invested to organize and launch the offering but not enough to conduct substantial activities in the proposed business;

The entire offering sold offshore—e.g., Ukraine;

No actual business conducted after the offering to employ the offering proceeds in the proposed business;

A significant portion of the stock sold in the registered public offering sold back into the United States to U.S. residents, frequently at prices equal to, at a slight premium to, or a low multiple of the public offering price;

The terms, prices, and closing of the sale at the same terms or even closed through a common escrow stock back into the United States. The offshore “registered” stock flowing back into the US through some orchestrated mechanism (in some cases a single escrow closed simultaneously with, and contingent upon, the closing of the reverse merger) so that all or a substantial amount of the publicly sold stock passes to persons aware of or acting in concert with the group controlling the reverse merger company;

A reverse merger with an operating business in which the owners of the operating business take over management, acquire a substantial majority of the outstanding stock, and undertake only the business of the acquired enterprise, abandoning the proposed business activities initially described in the prospectus;

Without respect to when the stock was first DTC eligible, when it first obtained a trading symbol, or the date on which the public offering was completed, material public trading in the company’s securities does not commence with material volume until the reverse merger. Typically the stock sold in the offshore public offering is not traded in any public market that develops. Instead, the trading market is prepared to launch with DTC eligibility and trading symbol in place for trading to commence when the reverse merger is complete, using stock that has been acquired by US persons from the offshore initial purchasers in the registered offering; and

Stock acquired by US purchasers from the offshore investors now being presented for resale.

The SEC warns broker-dealers that even when the legitimacy of the current business is not an issue, any trading market established after a sham registration is at issue and that the fundamental free tradability of such shares is problematic. As a result, some broker-dealers are simply refusing to deposit and resell securities issued in companies with indicia of a sham registration.

Examples of SEC Enforcement Actions

On April 16, 2015, the SEC filed an action against 10 individuals involved in a scheme to manufacture at least 22 public companies without relying on Rule 419 or properly disclosing shell company status (the “McKelvey Case”). The number of provisions in which the SEC claimed violations, and therefore sought relief, included a full laundry list of any and all possible actions. The language in the McKelvey case was also much stronger than in prior actions filed by the SEC for similar violations.

On February 3, 2014, the SEC initiated administrative proceedings against 19 companies that had filed S-1 registration statements. The 19 registration statements were all filed within an approximate 2-month period around January 2013. Each of the companies claimed to be an exploration-stage entity in the mining business without known reserves, and each claimed that they had not yet begun actual mining. Each of the 19 entities used the same attorney. Each of the entities was incorporated at around the same time using the same registered agent service. Each of the 19 S-1’s read substantially the same.

Importantly, each of the 19 S-1’s lists a separate officer, director and sole shareholder, and each claims that this person is the sole control person. The SEC complains that contrary to the representations in the S-1, a separate single individual was the actual control person behind each of these 19 entities and that person is acting through straw individuals, as he is subject to a penny stock bar and other SEC injunctive orders which would prevent him from legally participating in these S-1 filings. In addition, the SEC alleges that the claims of a mining business were false. The SEC believes that the S-1’s were filed to create public companies to be used for either reverse merger transactions or worse, pump-and-dump schemes.

The SEC played hardball with this group, as well. An S-1 generally contains language that it may be amended or modified (or even withdrawn) until it is declared effective by the SEC. A pre-effective S-1 is not deemed filed by the SEC or a final prospectus for Section 5 of the Securities Act. Upon initiation of the SEC investigation, all 19 S-1 filers attempted to withdraw their S-1 registration statements. The SEC suggested that each withdraw their requests to withdraw the S-1 and cooperate fully with the investigation. The entities did not comply. Accordingly, in addition to claims related to the filing of false statements in the S-1, the SEC has also alleged that “Respondent’s seeking to withdraw its Registration Statement constitutes a failure to cooperate with, refusal to permit, and obstruction of the staff’s examination under Section 8(e) of the Securities Act.”

Separately on January 15, 2015, the SEC filed an action against the individual behind each of the sham registrations, the attorney and the auditing firm for “a scheme to create sham public shell companies.”

Sham registrations are not new, just more prevalent. In September 2012, the SEC filed an action against a group of promoters for creating 15 sham public companies. One-off actions are consistently being filed, as well.

Rule 419 and Blank Check Companies

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company. Rule 419 requires that the blank check company filing such registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger.

In addition, the registrant is required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement, upon the execution of an agreement for such acquisition or merger. The rule provides procedures for the release of the offering funds in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and resale or secondary offerings.

Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected not to remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon enough funds remaining in escrow to close the transaction.

The definition of “blank check company” as set forth in Rule 419 of the Securities Act is a company that:

Is a development-stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and

Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.

Shell Companies

The definition of “shell company” as set forth in Rule 405 of the Securities Act (and Rule 12b-2 of the Securities Exchange Act of 1934) means a company that has:

No or nominal operations; and

Either:

No or nominal assets;

Assets consisting solely of cash and cash equivalents; or

Assets consisting of any amount of cash and cash equivalents and nominal other assets.

Clearly the definitions are different. Although a shell company could also be a blank check company, it could be a development-stage company or start-up organization or an entity with a specific business plan but nominal operations. Until recently, however, the SEC has firmly held the position that Rule 419 applies equally to shell and development-stage companies.

In fact, the SEC Staff Observations in the Review of Smaller Reporting Company IPO’s published by the SEC Division of Corporate Finance contain the following comments:

“Rule 419 applies to any registered offering of securities of a blank check company where the securities fall within the definition of a penny stock under the Securities Exchange Act of 1934. We frequently reviewed registration statements of recently established development stage companies with a history of losses and an expectation of continuing losses and limited operations. These companies often stated that they may expand current operations through acquisitions of other businesses without specifying what kind of business or what kind of company. In other cases, the stage of a company’s development, when considered in relation to the surrounding facts and circumstances, may raise questions regarding the company’s disclosed business plan. We generally asked companies like these to review Rule 419 of Regulation C. We asked these companies either to revise their disclosure throughout the registration statement to comply with the disclosure and procedural requirements of Rule 419 or to provide us with an explanation of why Rule 419 did not apply.”

The SEC will now allow a shell company, as long as it is not also a blank check company, to embark on an offering using an S-1 registration statement without the necessity to comply with Rule 419. As noted above, an entity can be a shell company, but not a blank check company, as long as it has a specific business purpose and plan and is taking steps to move that plan forward, such as a start-up or development-stage entity.

Conclusion

I regularly caution reverse merger clients against companies that appear in violation of footnote 32 or appear to have originated via a sham registration. However, I continue to believe in reverse merger transactions, DPO’s for legitimate companies in all stages of their development and the overall small business public marketplace.

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

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Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions

Posted by Securities Attorney Laura Anthony | August 11, 2015

Although the federal government and FINRA have become increasingly active in matters of corporate governance, the states still remain the primary authority and regulator of corporate law. State corporation law is generally based on the Delaware Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters, considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances.

On June 24, 2015, Delaware amended the Delaware General Corporation Law (“DGCL”) to prohibit fee shifting provisions. The DGCL amendments also allow Delaware corporations to adopt exclusive (and non-exclusive) forum selection provisions in their corporate charters. The amendments went into effect August 1, 2015.

Fee Shifting Provisions

As a result of increasing shareholder activism and filed or threatened shareholder lawsuits, corporations have started adding provisions in their corporate charters (articles and/or bylaws) whereby the non-prevailing party in an inter-company lawsuit must pay the prevailing parties’ attorneys’ fees. Prevailing party attorney’s fees provisions are standard in contracts. In adding such provisions to corporate charter documents, a corporation is taking the position that if a person becomes a shareholder of the corporation, they are agreeing to be bound by the terms of the corporate charter documents, much like being bound by a contract, including the prevailing party attorney fee provision.

Absent a contractual (or statutory) prevailing party fee provision, parties to litigation are required to each pay their own attorneys’ fees. The prevailing party fee provision acts to shift the fees to the shareholder/plaintiff in the event they are not successful. In addition, the fee-shifting provisions define “successful” in most cases as the substantial achievement, in substance and amount, of the full remedy sought. For example, a plaintiff can ask for $1,000,000, win $750,000 and be a non-prevailing party under a fee-shifting provision. Typically, the fee-shifting provisions extend beyond just the plaintiff to all those with a financial interest in the outcome, or those which assist the plaintiff. With such a broad extension, the plaintiff’s attorneys could find themselves also directly responsible for the defendant’s attorney’s fees in the event the plaintiff is not successful.

Much like an anti-takeover poison pill, these fee-shifting provisions are an anti-shareholder-lawsuit poison pill. Not only do such provisions apply to standard derivative lawsuits for such matters as a corporate breach of fiduciary duty, but they can be broadly applied to inter-company lawsuits, including those involving claims of securities law violations.

The legal basis relied upon by corporations for adding such a provision is that when a shareholder buys stock, they are agreeing to be bound by the corporate charter documents. This theory is not far-fetched and is actually supported by a broad array of legal dicta. For instance, when a shareholder buys stock in a company, they are agreeing to be bound by the voting rights (including number of votes, notice and similar provisions related to shareholder and director meetings), information rights, dividend and participation rights, liquidation rights, and recently choice of law and jurisdiction provisions. It seemed a natural progression to add other standard contractual provisions to such corporate charter documents, but the fee-shifting provisions were instantly met with a great deal of opposition, including by the Delaware legislature.

In May 2014, the fee-shifting provision was challenged and the Delaware Supreme Court upheld the provision as valid, at least in that case. The court did note that the validity of the provision included an analysis of the “circumstances surrounding its adoption and use” and whether it was “adopted or used for an inequitable purpose.” The intent to deter litigation is not an improper purpose.

The court ruling faced a great deal of opposition, including from the Delaware corporate bar and the Delaware legislature.

The Delaware legislature in turn drafted a bill to make it unlawful to include fee-shifting provisions in corporate charters and bylaws. The bill was tabled until January 2015 and finally was passed into law on June 24, 2015. The two primary proxy advisory firms, Institutional Shareholder Services, Inc., and Glass Lewis & Co., both recommended that shareholders vote against fee-shifting provisions and generally against forum selection provisions subject to a consideration of certain facts related to the company’s rationale and history with shareholder lawsuits.

The DGCL amendment adds new Sections 102(f) and 115, and amends current section 109(b) to invalidate any provision in the certificate of incorporation or bylaws that shifts the corporation’s or any other party’s attorney’s fees or expenses to the shareholder in an “internal corporate claim.” New Section 115 defines an “internal corporate claim” as “claims including claims in the right of the corporation, (i) that are based upon a violation of a duty by a current or former director of officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.”

My Thoughts on Fee Shifting

I agreed with the Delaware Supreme court and think the provisions should be allowed, though their scope may have needed an adjustment. Shareholder lawsuits have become so commonplace that they are practically a method of communication—sue now, talk later. Predatory plaintiffs’ attorneys comb for pending merger transactions and/or decreases in stock prices and then solicit shareholders looking for a plaintiff or representative plaintiff for a class action. Whether there has actually been a corporate wrongdoing is secondary and often not even a consideration. As a transactional attorney, I think litigation should be a last, not first, option.

I’m not insensitive to the counter-argument. Fee-shifting provisions can have a chilling effect on valid cases to enforce real securities law violations or breaches of corporate fiduciary duty. Broad provisions that include potential attorneys’ fee liability for plaintiffs’ counsel and expert witnesses could effectively wipe out private lawsuits against Delaware corporations.

However, by narrowing the scope of allowable fee-shifting provisions to limit liable non-prevailing parties to the parties themselves, or their counsel only in egregious cases, and by limiting the definition of “success,” a balance could be reached.

Some opponents of the fee-shifting provisions called for SEC intervention. Professor John Coffee and Professor Lawrence Hammermesh both gave testimony to the SEC’s Investor Advisory Committee pushing for SEC action. In other words, some called for greater federal regulation of corporate law. I disagree with this approach. Over the years the federal government, or quasi-governmental regulators, has enacted regulations that have the effect of imposing on state corporate law. The result has been a piecemeal corporate federalism, often with unintended results. A prime example is illustrated in my blog regarding FINRA’s Rule 6490, which can be read HERE.

The amendments to the DGCL take the issue out of the hands of the courts (absent a challenge to the amendment itself) and the SEC. However, corporations resorted to these provisions for a reason, and that reason still exists. I’m interested to see what the next defensive measure brings.

Forum Selection

A forum selection clause limits the jurisdiction in which a corporation can sue or be sued in certain types of actions, including but not limited to (i) derivative actions or proceedings brought on behalf of the corporation, (ii) actions asserting a claim of breach of fiduciary duty owed by a director, officer or other employee of the corporation to the corporation or its shareholders, (iii) actions asserting a claim under the applicable state corporate law, or (iv) actions asserting a claim governed by the internal affairs doctrine.

In 2013, the Delaware Chancery Court found that forum selection provisions are facially valid and may be adopted unilaterally by a board of directors as long as they are reasonable and fair. The court concluded that enforceability should be assessed on a case-by-case basis using a reasonableness standard of analysis.

The newly enacted legislation will allow Delaware corporations to include a Delaware choice of law provision in their certificates of incorporation and bylaws provided that a Delaware corporation cannot designate a state other than Delaware as the exclusive forum for an internal corporate claim. In particular, the DGCL amendment includes a provision in new Section 115 that “the certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State, and no provision of the certificate of incorporation or the bylaws may prohibit bringing such claims in the courts of this State.”

The Author

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

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

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Download our mobile app at iTunes.

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