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SEC Cracks Down On Failure To File 8-K For Financing Activities; An Overview Of Form 8-K

Posted by Securities Attorney Laura Anthony | December 13, 2016

Introduction and Background

On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these two actions, I have been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. Using this as a backdrop, this blog will also address Form 8-K filing requirements in general.

Back in August 2014, the SEC did a similar sweep related to 8-K filing failures associated with 3(a)(10) transactions. See my blog HERE for a discussion of those actions and 3(a)(10) proceedings in general. The 8-K filing deficiency actions were a precursor to a larger SEC investigation on 3(a)(10) transactions themselves which culminated in two well-known enforcement actions against active 3(a)(10) participants (the Ironridge companies and IBC Funds) and resulted in a chill on the 3(a)(10) activity in the industry as a whole. 3(a)(10) actions continue today but the volume of transactions has dramatically reduced and the attention to due diligence, detail and reporting requirements has likewise increased.

The SEC rarely takes enforcement action or expends time or resources on investigating the failure to file an 8-K. When such issues arise, it is usually in connection with a routine review of a company’s SEC reports or as part of the comment and review process associated with the filing of a registration statement. All reports filed with the SEC are subject to SEC review and comment and the Sarbanes-Oxley Act requires that the SEC undertake some level of review of every reporting company at least once every three years.

As was the case with the SEC’s investigation into 3(a)(10) transactions, it is my belief that the SEC is reviewing the PIPE industry as a whole and in particular the process, procedure and effects associated with convertible instruments. The majority of these transactions involve the issuance of convertible notes which then convert into common stock following a holding period in reliance on Rule 144 and Section 3(a)(9) of the Securities Act of 1933 (“Securities Act”). For a review of the use of Section 3(a)(9) related to convertible notes, see my blog HERE. Any convertible instrument can be used in the same manner, such as preferred stock and warrants.

The use of convertible instruments in PIPE transactions is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. My belief is that the SEC is using the investigation into the failure to file 8-K’s in association with these transactions to assist in a larger investigation into related fraud and other violations. If a company is failing to file an initial 8-K for the transaction and subsequent 8-K’s to report the issuance of securities upon a conversion, there may also be other issues and violations. Examples of abusive or improper activity could include: (i) backdating of notes or failure to provide the funding associated with the note; (ii) improper undisclosed affiliations between investors and the company or its officers and directors; (iii) manipulative trading practices; (iv) improper stock promotion (although a topic for another blog, stock promotion itself is not illegal as long as, among other things, the information disseminated is true and accurate, there is no pump-and-dump activity, and Securities Act Section 17(b) disclosures are used); or (v) trading on insider information.

During a conversion process, the number of issued and outstanding shares of common stock can increase dramatically, causing dilution to existing shareholders and a decrease in stock price from large selling pressure. In an action against Connexus Corporation, the SEC noted that the unreported issuances of securities increased the amount of common stock by more than 600% from the last reported number.

The ability of an investor to convert and trade responsibly makes the difference between a successful financing relationship with the investment community and one that can cause long-term damage to a company.

To be clear, I do not think there is anything inherently wrong, illegal or improper with these corporate finance transactions. The exact same structure is used for PIPE investments in companies big and small, whether traded on the OTC Markets, NASDAQ or NYSE. However, smaller companies often do not have the volume and liquidity to bear the effect of sudden enormous selling pressure. Larger companies are not immune to issues, though. Nuanced provisions negotiated in these convertible derivative instruments can be problematic as well, such as the recent use of the Black-Scholes put option in warrants (see Vapor Corp. as a prime example).

When considering a PIPE transaction, companies are often presented with numerous term sheets and investors to choose from. The terms will only vary slightly and many investors will match terms from a competitor. In choosing a transaction it is incumbent upon the company to conduct due diligence on the investor, including their reputation in the industry and trading history associated with other investments and conversions.

Form 8-K Filing Requirements Related to PIPE Transactions

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. For an overview of these reporting requirements, see my blog HERE. For a running update on the state of proposed changes to the specific reporting requirements in Regulations S-K and S-X, see my summary at the end of this blog.

Exchange Act Rule 13a-11 requires the filing of 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 and the issuance of unregistered securities. It is these two specific events that are implicated with the entry into corporate financing transactions, and subsequent conversions of convertible instruments such as convertible debt or preferred stock.

In particular, Item 1.01 of Form 8-K requires that a company report if it has entered into “a material definitive agreement not made in the ordinary course of business…” Under Item 1.01, the company must report: (a) the date of the agreement; (b) the parties to the agreement; (c) a description of any material relationship between the parties, other than the reported agreement; and (d) a brief description of the terms and conditions of the agreement.

Item 3.02 of Form 8-K requires that a company report the unregistered sale of securities. Under Item 3.02, the company must report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. The report must disclose: (a) the date, title and amount of securities sold; (b) the nature and amount of consideration paid; (c) the Securities Act exemption being relied upon and a brief explanation of the facts relied upon to support the exemption; and (d) where applicable, the terms of conversion or exercise.

The Item 3.02 filing requirement is triggered if the volume threshold of the underlying equity securities issuable upon conversion is exceeded, even if those issuances are structured as takedowns over time, such as where a convertible note is partially converted in multiple tranches. That is, if it is foreseeable that the total number of securities issued in a corporate finance transaction will exceed 5% of the current outstanding securities, an Item 3.02 8-K must be filed. Likewise, where the actual conversions and issuances of common stock exceed the 5% threshold in aggregate, an 8-K is required.

The Item 3.02 8-K must disclose all unregistered issuances that resulted in increasing the total outstanding securities by the 5% threshold. As a simple example, if a company reports 10,000,000 shares of outstanding common stock in its 10-Q and then proceeds to issue 100,000 shares each in a series of conversions, as soon as the total outstanding reaches 10,500,000, the 8-K filing requirement would be triggered and each of the conversions would need to be reported.

Form 8-K Filing Requirements: A Broad Overview

As mentioned above, any U.S. reporting company must file periodic reports on Form 8-K. A foreign issuer uses a Form 6-K, which has different requirements. The following is a brief description of each of the events that trigger an 8-K filing requirement. Many transactions will require the filing under multiple Item numbers, in which case the company can set forth all the material information and cross-reference the disclosure under each Item. Also, a Form 8-K can serve double duty and satisfy certain other filing requirements, such as those related to proxy proceedings or business combination transactions. The front page of the form 8-K provides check boxes to disclose such double use.

Section 1 – Registrant’s Business and Operations

Item 1.01 Entry into a Material Definitive Agreement – Material agreements are those that create material obligations that are enforceable by or against a company. As a rule of thumb, if an agreement is material enough to require separate board or shareholder consent, it requires an 8-K filing. Non-binding term sheets or letters of intent generally do not trigger a filing requirement, though material binding provisions contained therein may, such as significant breakup fees. A company is not required to file a copy of the agreement itself with the 8-K, but if it does not, the agreement must be filed with the next periodic report on either Form 10-Q or 10-K. As is encouraged by the SEC, I usually recommend that the agreement be filed with the 8-K. The determination of an 8-K filing requirement that is made at the time the agreement is entered into such that if the agreement becomes material through the passage of time or events, an 8-K filing is not later triggered.

Item 1.02 Termination of a Material Definitive Agreement – The termination of an agreement that is reported or reportable in Item 1.01, other than by its own terms, must be reported.

Item 1.03 Bankruptcy or Receivership – An 8-K must be filed for bankruptcy or receivership actions involving either the company or its parent (majority shareholder).

Item 1.04 Mine Safety – Reporting of Shutdowns and Patters of Violations – The requirement for an 8-K is triggered by the receipt of a notice under the Federal Mine Safety and Health Act of 1977 or from the Mine Safety and Health Administration.

Section 2 – Financial Information

Item 2.01 Completion of Acquisition or Disposition of Assets – In addition to reporting the particular acquisition or disposition transaction, this section triggers the requirement to provide financial statements and information under Regulation S-X, including historical and/or pro forma financial statements. If the report also involves a change of shell status, the financial statements must be included with the initial report under Item 2.01. If the company was not a shell, the financial statements may be filed by amendment within 71 days of the initial 8-K reporting the Item 2.01 event.

Item 2.02 Results of Operations and Financial Conditions – An Item 2.02 is triggered by the disclosure of any material non-public financial information about a completed quarter of fiscal year-end. An Item 2.02 disclosure is usually accompanied by a press release, which can be “furnished” and not “filed.” See below for a discussion on the difference. Also, an Item 2.02 filing must be made prior to any associated earnings call.

Item 2.03 Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement of a Registrant – An example of an off-balance sheet transaction would be one where the company guarantees or lease or other obligation of a third party.

Item 2.04 Triggering Events that Accelerate or Increase a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement – An example would be the default by the primary party to a guaranteed obligation.

Item 2.05 Costs Associated with Exit or Disposal Activities – An example would be the termination of a business division or manufacturing plant. Another example would be material write-offs or restructuring costs.

Item 2.06 Material Impairments – An example would be a material impairment to the value of assets such as goodwill or investment securities. Another example could be the loss of value to technology inventory due to obsolescence.

Section 3 – Securities and Trading Markets

Item 3.01 Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing – An example would be a notice of delinquency with the listing requirements of an exchange such as the NASDAQ or NYSE MKT. If such notice culminates in an actual delisting, another 8-K would need to be filed under this item. Likewise, a company’s decision to delist and move to the OTC Markets would be reportable.

Item 3.02 Unregistered Sales of Equity Securities – For a smaller reporting company, this Item requires that a company report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. For all other companies, the threshold is triggered at a 1% change.

Item 3.03 Material Modification to Rights of Security Holders – Examples would be amendments to preferred stock preferences or the issuance of senior securities.

Section 4 – Matters Related to Accountants and Financial Statements

Item 4.01 Changes in Registrant’s Certifying Accountant – An 8-K filing under this Item will always be reviewed by the SEC and must meet the exact particular disclosure requirements.

Item 4.02 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review – A filing on this Item is usually accompanied by or quickly followed by an amendment to the subject report and financial statements. Moreover, if the amended underlying report is not concurrently filed, an Item 4.02 filing in essence reports that the company is delinquent in its filing requirements, as an unreliable report is equivalent to no report. An Item 4.02 filing is due within 2 days of receipt of an auditor’s restatement letter.

Section 5 – Corporate Governance and Management

Item 5.01 Changes in Control of Registrant – Control includes changes in the board of directors, officers or control shareholders.

Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers – This Item includes any and all changes in officers or directors, whether by resignation, termination, refusal to stand for re-election or completion of a change of control transaction.

Item 5.03 Amendments to Articles of Incorporation or Bylaws; Changes in Fiscal Year – When completing a corporate action that is processed by FINRA, this item filing requirement is triggered when the amended articles are filed with the state, regardless of the timing of FINRA’s review and processing of the change with the markets. A restatement that does not make material changes does not trigger an 8-K filing, such as where a company is combining multiple amendments for ease of reference or cleaning up otherwise ambiguous language.

Item 5.04 Temporary Suspension of Trading Under Registrant’s Employee Benefits Plans – This item filing requirement is triggered by the receipt of a notice under the Employment Retirement Income Security Act of 1974 (ERISA).

Item 5.05 Amendments to the Registrant’s Code of Ethics, or Waiver of a Provision of the Code of Ethics – In addition to filing an 8-K, the company must carry through the change to the documents posted on its website.

Item 5.06 Change in Shell Company Status – An Item 5.06 filing is usually accompanied by an Item 2.02 disclosure and triggers the filing of Form 10 information, including financial statements.

Item 5.07 Submission of Matters to a Vote of Security Holders – This Item requires the reporting of voting results and is thus a retrospective report of a vote as opposed to a prospective notice of a matter to be submitted for vote. Item 5.07 also requires the disclosure of say-on-pay votes and the frequency on say-on-pay votes.

Item 5.08 Shareholder Director Nominations – This Item requires a company to inform shareholders of the date in which they must submit director nominations on Schedule 14N.

Section 6 – Asset-Backed Securities

Item 6.01 ABS Informational and Computational Materials

Item 6.02 Change of Servicer or Trustee – Requires a report of any changes, whether through resignation or termination.

Item 6.03 Change in Credit Enhancement or Other External Support – Requires a report of any material changes, whether through the loss, addition or change in support.

Item 6.04 Failure to Make a Required Distribution – Only requires the report of material failures to distribute in a timely manner.

Item 6.05 Securities Act Updating Disclosure – Includes material changes in an offering of AB securities.

Item 6.06 Static Pool – Alternative to filing a prospectus supplement required by Item 1105 of Regulation AB.

Section 7 – Regulation FD

Item 7.01 Regulation FD Disclosure – Information should be furnished and not filed. Where the information is material non-public information, such as in a press release, the filing must be made immediately prior to or simultaneously with the issuance of the release. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day. Regulation FD disclosures are an exception to the usual four-day filing rule.

Section 8 – Other Events

Item 8.01 – Other Events – This is a catch-all voluntary filing by companies that wish to report information that does not otherwise fit within an 8-K category. Because the information is voluntary and not otherwise required, there is no four-day filing rule.

Section 9 – Financial Statements and Exhibits

Item 9.01 Financial Statements and Exhibits – Requires the filing of all financial statements and exhibits required by other Items on Form 8-K and specifies such financial statement requirements. In addition, Item 9.01 sets forth the timing of filing of the financial statements for both shell and non-shell companies.

Penalties for Failure to File

Late or missed filings carry severe consequences to companies. To qualify to use Form S-3, a company must have filed all SEC reports in a timely manner, including Form 8-K, for the prior 12 months. Moreover, filing failures can result in enforcement proceedings and the conclusion of and disclosure related to inadequate controls and procedures.

Difference Between Filed and Furnished

Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The SEC allows certain information to be furnished as opposed to filed; however, it is incumbent upon the company to clearly disclose that it is avowing itself of the ability to furnish and not file. That is, unless otherwise specifically disclosed, information in a report made with the SEC will be deemed filed, not furnished. Note, however, that other liability provisions under the Exchange Act may apply that are not dependent on the filing of documents, such as the anti-fraud provisions under Rule 10b-5.

Further Reading

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. However, I note that with the recent election, and the GOP sweeping control of both the House and Senate, it is unclear what the future of these initiatives holds.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

The Author

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

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

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

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SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 2

Posted by Securities Attorney Laura Anthony | June 7, 2016 Tags: Non-GAAP, Non-GAAP Measures, Regulation G, SEC Issues New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

This is the second part in a two-part blog series on the use of non-GAAP financial information. In the first blog I summarized the new C&DI, and in this blog I am reviewing Regulation G and Item 10(e) of Regulation S-K. The first blog in the series can be read HERE.

Background

In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.

In recent years management has used MD&A and other areas of its disclosure to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.

However, where EBITDA may not be controversial, the SEC has seen a slippery slope in the use of these non-GAAP measures. The comments letters, and objections by the SEC, relate to failure to abide by Regulation G in providing non-GAAP information, disclosures related to why non-GAAP measures are useful, and cherry-picking of adjustments within a non-GAAP measure. Corp Fin has expressed a particular concern regarding “the use of individually tailored accounting principles to calculate non-GAAP earnings; providing per share data for non-GAAP performance measures that look like liquidity measures; and non-GAAP tax expense.”

The “non-GAAP earnings” issue is really revenue recognition. Public companies are under constant pressure to increase revenues and have become creative in figuring out ways that GAAP revenue recognition standards can be adjusted to increase revenues. Where the elimination of a non-cash GAAP expense item, such as depreciation or derivative liability, seems relatively harmless, and in fact is presented in the statement of cash flows, the inclusion of unearned revenue is much more questionable. Another controversial item affecting revenue is the couching of recurring cash expenses as non-recurring to justify eliminating that item in a non-GAAP presentation. Many of the new C&DI discussed in Part I of this blog series, focus on revenue recognition.

Although I understand the SEC concern, I wonder about the continued and increasing proliferation of non-GAAP measures precipitating the controversy. If 90% of companies use non-GAAP numbers to explain their financial operations, perhaps the GAAP rules themselves needs some adjustment. If, on the other hand, the increase is due to greater economic factors, such as the fact that the US economy has been stagnant for six straight years with zero or near-zero interest rates and no real “boom” following the recession “bust” of 2008, then the SEC may be right in its recent hard-line stance. The pressure on public companies to display consistent growth and improved performance continues regardless of the state of the economy. More on that topic another day.

Regulation G and Item 10(e) of Regulation S-K

Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K.

Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

Definition of non-GAAP financial measure and exclusions

A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) Ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

Regulation G and Item 10(e) requirements

Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in the new C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if it is misleading.

As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.

The Author

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

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

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

Download our mobile app at iTunes.

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SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1

Posted by Securities Attorney Laura Anthony | May 24, 2016 Tags: C&DI, Non-GAAP Measures, Regulation G, SEC Issues New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

The new C&DI follows a period of controversy, press and speeches on the subject. In the last couple of months SEC Chair Mary Jo White, SEC Deputy Chief Accountant Wesley Bricker, Chief Accountant James Schnurr and Corp Fin Director Keith Higgins have all given speeches at various venues across the company admonishing public companies for their increased use of non-GAAP financial measures. Mary Jo White suggested new rule making may be on the horizon, Corp Fin has been issuing a slew of comment letters, and there has even been word of enforcement proceedings on the matter.

In this two-part blog I will start with the new and circle back to the old. Part I will summarize the new C&DI, and Part II will review Regulation G and Item 10(e) of Regulation S-K.

New C&DI

On May 17, 2016, the SEC published 12 new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. Some of the C&DI are brand-new and some are revisions of existing guidance. Prior to this, the last published C&DI on non-GAAP financial measures was in July 2011.

Related to Revenue Recognition

The SEC issued four brand-new C&DI related to revenue recognition and, going directly to the issue of “misleading” information, the underpinning of fraud claims.

Question (100.01): Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.

Question (100.02): Can a non-GAAP measure be misleading if it is presented inconsistently between periods?

Answer: Yes. For example, a non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained. In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.

Question (100.03): Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?

Answer: Yes. For example, a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.

Question (100.04): A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.

To be sure the point is being made that adjustments may violate rules and be considered misleading and thus add risk of enforcement proceedings, the SEC has added a reference to new Question 100.01 to an existing C&DI allowing adjustments. In particular:

Question (102.03): Item 10(e) of Regulation S-K prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. Is this prohibition based on the description of the charge or gain, or is it based on the nature of the charge or gain?

Answer: The prohibition is based on the description of the charge or gain that is being adjusted. It would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria. The fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and the other requirements of Item 10(e) of Regulation S-K. See Question 100.01.

Three of the C&DI are amendments related to the use of “funds from operations” or “FFO” as defined by the National Association of Real Estate Investment Trusts (NAREIT). The SEC accepts the NAREIT’s definition of FFO and allows the presentation of FFO as a performance measure including FFO on a per share basis. However, the amended C&DI clarify that any adjustments to the standard FFO as defined by NAREIT must comply with Regulation G and that such adjustments “may trigger the prohibition on presenting this measure.” In other words, any adjustments will be scrutinized as possibly being misleading.

Related to earnings per share and liquidity measures

Further related to per share measures of performance, the SEC reiterates the rule that non-GAAP measures may not be used to present liquidity on a per share basis. In particular:

Question (102.05): While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?

Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission, consistent with Accounting Series Release No. 142. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.

Similarly, the SEC adds a clarification to an existing C&DI (Question 102.07) to confirm that “free cash flow” is a liquidity measure that must not be presented on a per share basis.

The SEC also confirms that the generally non-controversial EBITDA may not be presented on a per share basis (Question 103.02).

Related to presentation including reconciliation and prominence

The new C&DI add completely new language, amend prior guidance and eliminate and replace other prior guidance. The new guidance provides:

Question (102.10): Item 10(e)(1)(i)(A) of Regulation S-K requires that when a registrant presents a non-GAAP measure, it must present the most directly comparable GAAP measure with equal or greater prominence. This requirement applies to non-GAAP measures presented in documents filed with the Commission and also earnings releases furnished under Item 2.02 of Form 8-K. Are there examples of disclosures that would cause a non-GAAP measure to be more prominent?

Answer: Yes. Although whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made, the staff would consider the following examples of disclosure of non-GAAP measures as more prominent:

Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures;

Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures;

Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure;

A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption);

Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure;

Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table;

Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and

Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.

Question (102.11): How should income tax effects related to adjustments to arrive at a non-GAAP measure be calculated and presented?

Answer: A registrant should provide income tax effects on its non-GAAP measures depending on the nature of the measures. If a measure is a liquidity measure that includes income taxes, it might be acceptable to adjust GAAP taxes to show taxes paid in cash. If a measure is a performance measure, the registrant should include current and deferred income tax expense commensurate with the non-GAAP measure of profitability. In addition, adjustments to arrive at a non-GAAP measure should not be presented “net of tax.” Rather, income taxes should be shown as a separate adjustment and clearly explained.

The Author

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

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« SEC Issues Concept Release On Regulation S-K; Part 2 OTC Markets Amends IPO Listing Standards for OTCQX »

SEC Issues Concept Release On Regulation S-K; Part 2

Posted by Securities Attorney Laura Anthony | May 17, 2016 Tags: Form 8-K, MD&A, Regulation S-K, Regulation S-X, S-K Concept Release, SEC

On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). This blog is the second part discussing that concept release. In Part I, which can be read HERE, I discussed the background and general concepts for which the SEC provides discussion and seeks comment. In this Part II, I will discuss the rules and recommendations made by the SEC and, in particular, those related to the 100, 200, 300, 500 and 700 series of Regulation S-K.

Background

The fundamental tenet of the federal securities laws is defined by one word: disclosure. In fact, the SEC neither reviews nor opines on the merits of any company or transaction, but only upon the appropriate disclosure, including risks, made by that company. However, excessive rote immaterial disclosure can dilute the material important information regarding that particular company and have the unintended consequence of weakening necessary disclosure to potential investors and the public trading markets.

The SEC non-financial disclosure requirements for both registration statements and reports under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are found in Regulation S-K.

At the highest level, the purpose of disclosure is to provide investors and the marketplace with information needed to make informed investment and voting decisions. As discussed in the S-K Concept Release, proper disclosure “may lead to more accurate share prices, discourage fraud, heighten monitoring of the managers of companies, and increase liquidity.” Further, effective disclosure should “increase the integrity of securities markets, build investor confidence, and support the provision of capital to the market.”

The SEC seeks comment on hundreds of questions from broad conceptual points to specific rule changes. In many cases the SEC indicates that additional disclosure might be necessary on a particular topic. Although disclosure improvement is the goal, that does not necessarily mean less information and, in many cases, may actually mean more information.

Description of Business and Properties

The SEC believes that the information elicited under Item 101 regarding a description of the company’s business and Item 102 related to the company’s materially important physical properties, provides the necessary foundation needed by investors to make investing and voting decisions. This basic information assists in putting other disclosure items into context. The SEC seeks comment on whether Items 101 and 102 should be eliminated or modified and whether new or different disclosure requirements should be added to these Items.

The Concept Release contains detailed discussion of each of the requirements under Items 101 and 102, including prior comments received from the public and SEC views. Currently Item 101 requires a description of the general development of the company’s business over the past 3 years for smaller reporting companies and 5 years for other classes of company, or such shorter period as the company has been in business. Item 102 requires disclosure of the location and general character of plants, mines and other materially important physical properties.

Examples of information required include disclosure of the basic background of the business such as: (i) the year of formation; (ii) type of entity; (iii) nature and results of any bankruptcy, receivership or similar; (iv) nature and result of any material reclassification, merger or consolidation; (v) the acquisition or disposition of any material assets outside the ordinary course of business; and (vi) material changes to the business operations. In addition, Item 101 requires a narrative description of a company’s business, including 13 specific areas as follows: (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of business; (vi) working capital practices; (vii) dependence on certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) company sponsored research and development activities; (xii) compliance with environmental laws; and (xiii) number of employees.

Smaller reporting companies benefit from several other scaled disclosures from the standard requirements, including: (i) elimination of the requirement to discuss seasonality, working capital practices, backlog or government contracts; (ii) names of principal suppliers; (iii) royalty agreements or labor contracts; (iv) need for government approval for products or services; and (v) effects of existing or probable government regulations.

Emerging growth companies must meet all of the standard requirements. Moreover, keeping in line with the concept of materiality, where a smaller reporting company is in a business that makes any of the standard disclosures material to its business, it must include those discussions, even if not technically required. Accordingly, for example, a smaller reporting company in a cannabis-related industry would need to include a discussion on the need for government approval for products and services, and the effects of existing or probable government regulations on its business, even though the scaled disclosure requirements would not otherwise require such discussion.

As with other areas of discussion, the SEC requests comments on the scaled disclosure requirements and whether the current disparities between requirements related to smaller reporting companies and emerging growth companies should be eliminated.

The SEC discusses eliminating redundancies in the 101 and 102 disclosure requirements. In particular there are several categories in Form 8-K that request the same information elicited in Items 101 and 102 and included in all 10-Q’s and 10-K’s. Information on business background is included in the MD&A discussion and in footnotes to financial statements. Redundancies could be eliminated by allowing cross-referencing, including internal hyperlinks. Moreover, the SEC could, and should, distinguish between new registrants disclosing their business background for the first time, and those that are established reporting companies repeating information again and again.

Many of the detailed requirements may not be relevant in today’s business environment, which differs greatly from even twenty years ago. For instance, many businesses no longer have physical locations or corporate headquarters but rather run through virtual offices. For those businesses, providing a detailed discussion of each location (home office…) would not be relevant and rather could diminish the value of the business discussion. Likewise, businesses in today’s world often outsource or hire independent contractors. Consideration should be given to expanding the requirements to include such independent contractors, or eliminate this requirement altogether where it does not add value to the particular business. For example, it may be important to know that certain companies are scaling back on their workforce, while for others, the information is not relevant.

Likewise, Regulation S-K does not currently address the current reliance on web-based and intellectual property-based assets and as such, additional disclosure items may need to be included. Another area that may need increased disclosure relates to international business operations and reliance on non-U.S.-based assets.

Management Discussion and Analysis

Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis (“MD&A”) not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.

MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity for MD&A to use a principles/materiality approach and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.

In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. There has been a rise in recent controversy over the use of these non-GAAP numbers, an in-depth discussion of which will be the topic of a future blog.

However, the short version is that 90% of companies use non-GAAP numbers to explain their financial operations and the SEC is pushing back, making a review of the rules related to non-GAAP use a priority. There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves needs some adjustment.

Risk Factors

Risk-related disclosures need a thorough review and potential overhaul. Although the SEC has long stated that risk factors should not be boilerplate repetition of items applicable to the market as a whole and not necessarily applicable to a particular company, most companies use boilerplate language. I note that Item 503 contains examples of risks that a company can make related to its offerings, and so, of course, those risks, in boilerplate format, are always included in registration statements and reports.

Currently, risk-related disclosures are currently included in multiple items under Regulation S-K, including Item 503 related to investment risk and Item 305 related to market risk. The focus of the SEC discussion is on aggregating risk information in a more central readable format and improving the content to enhance investors’ ability to evaluate the particular risk factors.

Securities of the Company

Several Items in Regulation S-K address the securities of a company. For example, Item 202 requires a description of the terms and conditions of securities being registered; Item 201 requires disclosure of the number of holders of common securities; Item 701 requires disclosure of sales of unregistered securities and use of proceeds from offerings, and Item 703 requires disclosure of securities re-purchased by a company and its affiliates.

As with other areas, the SEC focuses on whether these disclosures should be modified, increased or eliminated and on the presentation of the information.

The Author

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

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

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« SEC Issues Final Rules Implementing The JOBS ACT And Rules On The FAST ACT SEC Issues New C&DI On Use Of Non-GAAP Measures; Regulation G – Part 1 »

Regulation SCI

Posted by Securities Attorney Laura Anthony | April 18, 2016 Tags: Regulation SCI

The SEC adopted Regulation Systems Compliance and Integrity (Regulation SCI) on November 3, 2015 to improve regulatory standards and processes related to technology in the securities business including by financial services firms. Regulation SCI was originally proposed in March 2013. Security and standards related to technological processes, data storage and systems has been a top priority of the SEC over the last few years and continues to be so this year.

Background

Technology has transformed the securities industry over the last years both in the area of regulatory oversight such as through algorithms to spot trading anomalies that could indicate manipulation and/or insider trading issues, and for market participants through enhanced speed, capacity, efficiency and sophistication of trading abilities. Enhanced technology carries the corresponding risk of failures, disruptions and of course hacking/intrusions. Moreover, as U.S. securities market systems are interconnected; an issue with one entity or system can have widespread consequences for all market participants.

Regulation SCI was proposed and adopted to require key market participants to have comprehensive written policies and procedures to ensure the security and resilience of their technological systems, to ensure systems operate in compliance with federal securities laws, to provide for review and testing of such systems and to provide for notices and reports to the SEC. Key market participants generally include national securities exchanges and associations, significant alternative trading systems (such as OTC Markets, which has confirmed is in compliance with the Regulation), clearing agencies, and plan processors.

Prior to enactment of Regulation SCI, there was no formal regulatory oversight of U.S. securities markets technological systems. Rather, oversight was historically through a voluntary Automation Review Policy (“ARP”). Under the ARP, the SEC created an ARP Inspection Program as well as policy statements and ongoing guidance. Compliance with ARP policies has been included in rules over the years, including Regulation ATS for high-volume automated trading systems. Although most major market participants, including SRO’s and national exchanges, participate in the ARP program, it remained voluntary and the SEChad no power to ensure compliance or enforce standards.

In recent years technology has outpaced the ARP program’s reach. Today the U.S. securities markets are almost entirely electronic and, as noted in the SEC rule release, “highly dependent on sophisticated trading and other technology, including complex and interconnected routing, market data, regulatory, surveillance and other systems.” The need for a codified regulatory system has been amplified by real-world issues such as, for example, the effects of hurricane Sandy on DTC and the markets in general; the multiple occasions of halting and delay of trading on exchanges due to systems issues; the highly publicized NYSE breakdown resulting in orders being booked at incorrect prices as well as multiple well known breaches in security. In fact, the SEC rule release contains multiple pages of examples of breakdowns and issues with technology in the markets.

Overview of Regulation SCI

Regulation SCI consists of 7 rules (Rules 1000 through 1007) as follows: (i) Rule 1000 contains definitions, including defining an SCI entity; (ii) Rule 1001 contains the policies and procedures requirements for SCI entities for operational capability, the maintenance of fair and orderly markets and systems compliance; (iii) Rule 1002 contains the obligations of SCI entities when there is an SCI defined event, including corrective measures, SEC notification and public notification; (iv) Rule 1003 contains requirements related to material changes and SCI reviews; (v) Rule 1004 contains requirements related to business continuity and disaster testing; (vi) Rule 1005 contains recordkeeping requirements; (vii) Rule 1006 contains requirements related to electronic filings and submissions; and (viii) Rule 1007 contains requirements for service bureaus.

SCI Entities

Regulation SCI broadly defines an SCI Entity as “an SCI self-regulatory organization, SCI alternative trading system, plan processor, or exempt clearing agency subject to ARP” and then contains drilled-down definitions within the broad categories. Regulation SCI is meant to encompass and include any entity that is significant in the operation and maintenance of fair and orderly markets.

SCI self-regulatory organizations include registered national securities associations (FINRA being the only one), all national securities exchanges, registered clearing agencies (DTC) and the Municipal Securities Rulemaking Board (MSRB). As a side note, there are currently 18 registered national securities exchanges including: (1) BATS Exchange, Inc. (“BATS”); (2) BATS Y-Exchange, Inc. (“BATS-Y”); (3) Boston Options Exchange LLC (“BOX”); (4) CBOE; (5) C2; (6) Chicago Stock Exchange, Inc. (“CHX”); (7) EDGA Exchange, Inc. (“EDGA”); (8) EDGX Exchange, Inc. (“EDGX”); (9) International Securities Exchange, LLC (“ISE”); (10) Miami International Securities Exchange, LLC (“MIAX”); (11) NASDAQ OMX BX, Inc. (“Nasdaq OMX BX”); (12) NASDAQ OMX PHLX LLC (“Nasdaq OMX Phlx”); (13) Nasdaq; (14) National Stock Exchange, Inc. (“NSX”); (15) NYSE; (16) NYSE MKT; (17) NYSE Arca; and (18) ISE Gemini, LLC (“ISE Gemini”).

An SCI Alternative Trading System is defined by volume broken down by NMS (National Market Systems) and non-NMS stocks and generally includes an Alternative Trading System with 1% or more of the NMS stocks volume or 5% or more of non-NMS stocks volume. Alternative Trading Systems which trade only municipal securities or corporate debt securities are excluded from the requirements. The OTC Markets is an SCI Entity and has confirmed that it is in compliance with Regulation SCI.

Interestingly, broker-dealers are not included as SCI Entities. The SEC reasoned that all broker-dealers are subject to Rule 15c3-5 and other FINRA rules which impose requirements related to the capacity, integrity and security of the broker-dealers’ systems and technology. However, the SEC did note that some broker-dealers are large enough that they could pose a real market risk if their systems were to break down or be infiltrated. The SEC may amend the rules in the future to include these firms.

An SCI “plan processor” includes “any self-regulatory organization or securities information processor acting as an exclusive processor in connection with the development, implementation and/or operation of any facility contemplated by an effective national market system plan.” There are currently four plan processors including the CTA Plan, CQS Plan, NASDAQ UTP Plan and OPRA Plan.

An “exempt clearing agency subject to ARP” includes “an entity that has received from the Commission an exemption from registration as a clearing agency under Section 17A of the Act, and whose exemption contains conditions that relate to the Commission’s Automation Review Policies, or any Commission regulation that supersedes or replaces such policies.” There is currently only one entity that meets this definition, Omgeo Matching Services – US, LLC.

In addition, Regulation SCI breaks systems down into three categories, including “SCI systems,” “critical SCI systems” and “indirect SCI systems,” meant to encompass systems and processes that are subject to heightened requirements, processes and procedures. “SCI Systems” include trading, clearance and settlement, order routing, market data, market regulation, and market surveillance. In particular, an “SCI System” is defined as “all computer, network, electronic, technical, automated, or similar systems of, or operated by or on behalf of, an SCI entity that, with respect to securities, directly support trading, clearance and settlement, order routing, market data, market regulation, or market surveillance.”

A “critical SCI system” is an SCI system that directly supports (i) clearance and settlement systems of clearing agencies; (ii) openings, reopenings, and closings on primary trading markets; (iii) trading halts; (iv) initial public offerings; (v) the provision of consolidated market data (i.e., SIPs); or (vi) exclusively listed securities. In addition, a “critical SCI system” is an SCI system that provides critical functionality to the market. An “indirect SCI system” is “any systems of, or operated by or on behalf of, an SCI entity that, if breached, would be reasonably likely to pose a security threat to SCI systems” and such systems only have to comply with the Regulation SCI provisions related to security and intrusions.

SCI Events

An SCI Event is defined as “an event at an SCI entity that constitutes: (1) a systems disruption; (2) a systems compliance issue; or (3) a systems intrusion.” A “systems disruption” is “an event in an SCI entity’s SCI systems that disrupts, or significantly degrades, the normal operation of an SCI system.” A “systems compliance issue” is defined as an “an event that has caused an SCI system to operate in a manner that does not comply with the [Securities Exchange] Act” and the rules and regulations thereunder and the entity’s rules and governing documents, as applicable. A “systems intrusion” is defined as “any unauthorized entry into the SCI systems or indirect SCI systems of an SCI entity.”

An SCI Event triggers certain obligations including taking corrective action, notifying the SEC and disseminating information. While the response to an SCI Event does not include a materiality analysis, it does include a risk-based analysis. Although the SEC provided for exceptions to the reporting and information requirements for events the de minimus or no impact on the SCI Entity’s operations or market participants, all disruptions require certain recordkeeping, assessment, and corrective measures regardless of how seemingly small they might be.

The SEC rightfully points out that outwardly inconsequential technological issues may later prove to have been a significant cause of larger issues. In addition, an SCI entity’s records of small events may prove useful to the SEC in identifying patterns, weaknesses or circumstances that result in significant issues. Along the same lines, the SEC requires recordkeeping and reporting related to both intentional and unintentional SCI Events.

Obligations of SCI Entities

Regulation SCI requires covered entities to establish written policies and procedures, with specific controls and systems that support trading, clearance and settlement, order routing, market data, market regulation and market surveillance. The written procedures must address levels of capacity, integrity, resiliency, availability and security. Such written policies must be designed to ensure that technological systems can maintain operations with minimal disruptions to the trading markets.

Regulation SCI also requires covered entities to comply with quarterly regulatory notification and reporting requirements and mandatory testing. Testing must include designated third parties and test business continuity and disaster recovery plans, including backup systems. SCI-covered entities must report any disruptions in their systems, compliance issues or system intrusions. The systems and technology of an SCI-covered entity must be reviewed annually by third-party qualified sources.

The specific systems obligations of SCI entities are laid out in Rules 1001-1004 of Regulation SCI. Rule 1001 contains the policy and procedure requirements with respect to operational capacity and maintenance of fair and orderly markets. Rule 1002 contains the obligations with respect to SCI events, including corrective action, SEC notification and information dissemination. Rule 1003 contains requirements related to material system changes, and SCI reviews. Finally, Rule 1004 contains requirements related to business continuity and disaster recovery plan testing.

Rule 1001 generally requires SCI entities to maintain reasonably designed policies and procedures to ensure the adequate capacity, integrity, resiliency, availability, and security of SCI systems (and security for indirect SCI systems) to maintain the SCI entity’s operational capability and promote the maintenance of fair and orderly markets. Guidance and discussion on the Rule indicate that the SEC has a risk-based approach requiring more robust policies and procedures for higher-risk systems. An SCI entity’s policies and procedures should ensure its own operational capability, including the ability to maintain effective operations, minimize or eliminate the effect of performance degradations, and have sufficient backup and recovery capabilities.

SCI policies and procedures must provide, at a minimum, (i) the establishment of reasonable current and future technology infrastructure capacity planning estimates; (ii) periodic capacity stress tests of systems to determine their ability to process transactions in an accurate, timely, and efficient manner; (iii) a program to review and keep current systems development and testing methodology; (iv) regular reviews and testing, as applicable including backup systems, to identify vulnerabilities pertaining to internal and external threats, physical hazards, and natural or man-made disasters.; (v) business continuity and disaster recovery plans that include maintaining backup and recovery capabilities sufficiently resilient and geographically diverse and are reasonably designed to achieve next-business-day resumption of trading and two-hour resumption of clearance and settlement services following a wide-scale disruption; (vi) standards that result in systems being designed, developed, tested, maintained, operated, and surveilled in a manner that facilitates the successful collection, processing, and dissemination of market data (in this regard, a sample of reasonable standards are provided in Table A); and (vii) standards for monitoring SCI systems and making prompt changes as necessary.

Rule 1001 requires that SCI entities establish written policies and procedures designed to ensure that the entity complies with the Securities Exchange Act and the rules and regulations thereunder as well as the entity’s own governing documents. The Rule provides a non-exhaustive list of minimum elements that must be included in such compliance policies and procedures. These elements include: “(i) testing of all SCI systems and any changes to SCI systems prior to implementation; (ii) a system of internal controls over changes to SCI systems; (iii) a plan for assessments of the functionality of SCI systems designed to detect systems compliance issues, including by responsible SCI personnel and by personnel familiar with applicable provisions of the Act and the rules and regulations thereunder and the SCI entity’s rules and governing documents; and (iv) a plan of coordination and communication between regulatory and other personnel of the SCI entity, including by responsible SCI personnel, regarding SCI systems design, changes, testing, and controls designed to detect and prevent systems compliance issues.”

Rule 1002 contains the obligations with respect to SCI events, including corrective action, SEC notification and information dissemination. Under the Rule an SCI-delineated person must take the required action upon reasonably confirming that an SCI event has occurred. As such, the SEC requires an SCI entity to have written policies and procedures that “include the criteria for identifying responsible SCI personnel, the designation and documentation of responsible SCI personnel, and escalation procedures to quickly inform responsible SCI personnel of potential SCI events.” Such “responsible SCI personnel” means “for a particular SCI system or indirect SCI system impacted by an SCI event, such senior manager(s) of the SCI entity having responsibility for such system, and their designee(s).”

The Rule contains in-depth and detailed discussion of corrective actions, notification requirements and information dissemination requirements. In essence, the SEC must be immediately notified of all SCI events other than de minimis events, although even de minimis events contain recordkeeping requirements and must be included In SCI reports. Until the SCI event is resolved, the SCI entity must keep the SEC regularly updated as to the progress of the investigation and resolution of the event, and must file a report with the SEC once the event is resolved. Subject to certain exceptions, the SCI entity must disseminate information to its members and participants regarding all SCI events.

Rule 1003 contains requirements related to material system changes, and SCI reviews. In particular, Rule 1003 requires quarterly reports to the SEC describing completed, ongoing, and planned material systems changes to its SCI systems and security of indirect SCI systems. Rule 1003 also requires a minimum of an annual review of an SCI entity’s compliance with Regulation SCI.

Rule 1004 contains requirements related to business continuity and disaster recovery plan testing. As with notification requirements, an SCI entity must designate certain personnel to complete business continuity and disaster recovery plan testing. In particular, the SCI entity must designate those members or participants “that the SCI entity reasonably determines are, taken as a whole, the minimum necessary for the maintenance of fair and orderly markets in the event of the activation of such plans.” Such testing must be completed at least once every 12 months.

The recordkeeping and electronic filing requirements of Regulation SCI are laid out in Rules 1005 through 1007.

The Author

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

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

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

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« Mergers And Acquisitions: Types Of Transactions The U.S. Capital Markets Clearance And Settlement Process »

House Passes More Securities Legislation

Posted by Securities Attorney Laura Anthony | March 15, 2016 Tags: House Passes More Securities Legislation

In what must be the most active period of securities legislation in recent history, the US House of Representatives has passed three more bills that would make changes to the federal securities laws. The three bills, which have not been passed into law as of yet, come in the wake of the Fixing American’s Surface Transportation Act (the “FAST Act”), which was signed into law on December 4, 2015.

The 3 bills include: (i) H.R. 1675 – the Capital Markets Improvement Act of 2016, which has 5 smaller acts imbedded therein; (ii) H.R. 3784, establishing the Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee within the SEC; and (iii) H.R. 2187, proposing an amendment to the definition of accredited investor. None of the bills have been passed by the Senate as of yet.

Meanwhile, the SEC continues to finalize rulemaking under both the JOBS Act, which was passed into law on April 5, 2012, and the Dodd-Frank Act, which was passed into law on July 21, 2010. The SEC provides comprehensive information on its progress under each of the Acts on its website. For Dodd-Frank see HERE and for the JOBS Act see HERE.

H.R. 1675 – Capital Markets Improvement Act of 2016

On February 3, 2016, the House passed H.R. 1675, the Capital Markets Improvement Act of 2016, comprising 5 titles including (i) Title I – Encouraging Employee Ownership Act of 2015; (ii) Title II – Fair Access to Investment Research; (iii) Title III – Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification; (iv) Title IV – Small Company Disclosure Simplification; and (v) Title V – Streamlining Excessive and Costly Regulations Review.

The Executive Office strongly opposes H.R. 1675 and has issued a Statement of Administration Policy voicing its objections. The Executive Office points out that the bill has many flaws, imposes risks to investors, is overly broad, allows financial institutions to avoid appropriate oversight and is duplicative of existing administration authorities. I will continue to monitor progress and provide updates.

Title I – Encouraging Employee Ownership Act of 2015

The bill requires the SEC to amend Securities Act Rule 701 to require an issuer to provide certain delineated disclosures to employee investors regarding compensatory benefit plans if the aggregate sales price or aggregate amount of securities sold in any 12-month period exceeds $10 million, indexed for inflation every 5 years. The current regulations have a threshold of $5 million.

The Executive Branch strongly opposes the bill and even issued an official Statement of Administration Policy expressing its opposition.

Brief Summary of Rule 701

Rule 701 provides an exemption from the registration requirements under Section 5 of the Securities Act for offers and sales of securities pursuant to certain compensatory benefit plans and contracts related to compensation. The exemption only applies to issuers that are not subject to the reporting requirements of the Securities Exchange Act and is generally used by private companies.

The aggregate amount of sales under Rule 701 is limited to the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer (or of the parent if the parent is a co-issuer or guarantor); or (iii) 15% of the total outstanding of the class of securities being offered. Rule 701 currently requires the delivery of the compensatory benefit plan or contract as applicable and additional disclosure if the aggregate sales exceed $5 million. Those additional disclosure include risk factors, a summary of the plan and financial statements prepared in accordance with U.S. GAAP.

Although securities issued under Rule 701 are restricted under Rule 144, they become freely tradable 90 days after the issuer becomes subject to the reporting requirements of the Securities Exchange Act without regard to the current information and holding period requirements under Rule 144 for non-affiliates and without regard to the holding period requirements for affiliates.

Like other exemptions, Rule 701 transactions are still subject to the anti-fraud provisions of the federal securities laws. Rule 701 does not pre-empt state law and accordingly, state securities laws must be complied with in any issuance under the Rule.

Title II – Fair Access to Investment Research

Title II requires the SEC to adopt rules providing that research issued by investment funds will not be deemed to be an offer for the sale of securities regardless of whether the report covers an issuer that is going to or has embarked on a registered offering and regardless of whether a broker-dealer associated with the fund will participate in the offering. The Act contains strong language, including prohibiting an SRO (FINRA) from maintaining or enforcing any rules conditioning the ability of a member to publish or distribute research on whether the member is participating in a registered offering.

Title III – Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification

Title III attempts to codify a broker-dealer registration exemption for mergers and acquisition brokers. The Executive Office Statement of Administration Policy points out that Title III as written is overly broad and would eliminate the registration requirements for M&A brokers engaged in a transaction for any privately held company with gross revenues up to $250 million. The Executive Office thinks this exemption amount is too high, among other issues. Moreover, the Executive Office notes that the SEC has already recognized an exemption for M&A brokers though a no action letter (see my blog HERE).

Title IV – Small Company Disclosure Simplification

Title IV creates an exemption from the XBRL requirements for small and emerging growth companies. The Executive Office also opposes this change on the grounds that “[o]pen data disclosure systems benefit investors, issuers, and the public, increasing transparency of publicly traded companies by making their filings more easily accessible. Impeding regulators’ ability to use 21^st century technological tools to regulate markets and protect investors is contrary to the SEC’s mission.”

I support Title IV and the exemption from the XBRL requirements.

Title V – Streamlining Excessive and Costly Regulations Review

Title V may be herculean in nature. Title V requires the SEC to review each significant regulation issued by the SEC to determine by vote of the SEC if such regulation is (i) outmoded, ineffective, insufficient or excessively burdensome; or (ii) is no longer necessary in the public interest or consistent with the SEC’s mandate to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. Title V requires the immediate review and a 10-year periodic review. The Executive Office statement of opposition states that “[T]hese requirements are unnecessarily duplicative, wasteful and costly. The SEC already complies with the Regulatory Flexibility Act and is encouraged, under Executive Order 13579, to review rules to assess whether they are outdated or excessively burdensome. Requiring a review and full Commission vote on every major rule every 10 years under full Administrative Procedure Act-style requirements would severely hinder the SEC’s ability to monitor markets and protect investors.”

H.R. 3784 – Establishing Advocate for Small Business Capital Formation and Small Business Capital Formation Advisory Committee

On February 1, 2016, the House passed H.R. 3784, the SEC Small Business Advocate Act. The Act proposes to amend the Securities Exchange Act to establish the Advocate for Small Business Capital Formation within the SEC. The office would be charged with (i) assisting small businesses and their investors in resolving significant problems with the SEC and other SROs; (ii) identifying areas where small businesses and their investors would benefit from changes in SEC and other SRO regulation; (iii) identifying problems small businesses have with security access to capital; (iv) analyzing the potential impact of proposed rules and regulations on small businesses; (v) conduct outreach programs with small businesses and their investors; and (vi) work to propose these changes to the SEC and Congress.

In addition, the Act would create the Small Business Capital Formation Advisory Committee. The committee would provide the SEC with advice on SEC rules, regulations, and policies relating to (i) capital raising by emerging, privately held small businesses and publicly traded companies with less than $250 million in public market capitalization through securities offerings; (i) trading in the securities of such businesses and companies; and (3) public reporting and corporate governance requirements of such businesses and companies.

The new proposed committee seems duplicative of the existing SEC Advisory Committee on Small and Emerging Companies, which 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.

H.R. 2187 – Amendment to the Definition of Accredited Investor

Also on February 1, 2016, the House passed H.R. 2187, the Fair Investment Opportunities for Professional Experts Act, proposing an amendment to the definition of accredited investor as to natural persons. In particular, the bill proposes to add provisions to the definition of accredited investor to include (i) any natural person who is currently licensed or registered as a broker or investment adviser by the SEC, FINRA or a state securities regulator and (ii) any natural person the SEC determines by regulation to have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA.

In addition, the bill tweaks other aspects of the definition related to natural persons. The bill proposes to adjust the current $1,000,000 net worth accredited investor eligibility standard every 5 years for inflation. The bill tweaks the exclusion of a person’s primary residence from the calculation such that any indebtedness secured by the residence (i.e., a mortgage) that is in excess of the fair market value of the home, will be included as a liability in determining net worth. I think this creates ongoing calculation issues as the value of homes can vary widely in a short period of time.

I doubt the bill in its current form will gain any traction or ultimately become law, but we will, no doubt, see changes to the accredited investor definition in the near future. For further discussion, 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.

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« SEC Gives Insight On 2016 Initiatives SEC Advisory Committee On Small And Emerging Companies Reviews Capital Formation »

SEC Gives Insight On 2016 Initiatives

Posted by Securities Attorney Laura Anthony | March 8, 2016 Tags: dodd-frank act, mary jo white, SEC, The Fast Act, the jobs act

SEC Chair Mary Jo White gave a speech at the annual mid-February SEC Speaks program and, as usual, gave some insight into the SEC’s focus in the coming year. This blog summarized Chair White’s speech and provides further insight and information on the topics she addresses.

Consistent with her prior messages, Chair White focuses on enforcement, stating that the SEC “needs to go beyond disclosure” in carrying out its mission. That mission, as articulated by Chair White, is the protection of investors, maintaining fair, orderly and efficient markets, and facilitating capital formation. In 2015 the SEC brought a record number of enforcement proceedings and secured an all-time high for penalty and disgorgement orders. The primary areas of focus included cybersecurity, market structure requirements, dark pools, microcap fraud, financial reporting failures, insider trading, disclosure deficiencies in municipal offerings and protection of retail investors and retiree savings. In 2016 the SEC intends to focus enforcement on financial reporting, market structure, and the structuring, disclosure and sales of complex financial instruments.

2016 Disclosure Agenda

Chair White hit on the tremendous volume of regulatory changes and congressional mandates. Since 2010 Congress has given the SEC nearly 100 statutory mandates covering a multitude of complex rule requirements, with the FAST Act, JOBS Act, and the Dodd-Frank Act just being 3 examples. White confirms that the amount of recent rulemaking is of historic proportions, completing or overhauling many regulatory areas and providing dramatic changes to others. Again, 3 small examples are the FAST Act, JOBS Act and the Dodd-Frank Act, with the multitude of regulatory changes flowing from these 3 statutory directives.

In 2016 the SEC will continue implementing rules as directed by Congress. In addition to finalizing the remaining security swap and security-based swap dealer requirements under the Dodd-Frank Act, the SEC hopes to continue rulemaking related to the asset management industry, the structure of the equity markets and disclosure requirements (under Regulation S-K and Regulation S-X).

Related to the asset management industry, in May 2015 the SEC proposed increased reporting for investment advisers and mutual funds, including a requirement that funds report risk metrics, the use of derivatives, securities lending and liquidity of holdings.

Related to the structure of equity markets, the SEC has increased oversight over proprietary traders (see my blog HERE) and has proposed major revisions to regulations for alternative trading systems (this will be the subject of a future blog). Also related to equity markets, Chair White referenced the recent ANPR on new transfer agent rules (see my blog HERE) and the Tick Size Pilot program (see my blog HERE). Moreover, Chair White revealed that the SEC intends to shorten the clearing settlement life cycle from T+3 to T+2.

Disclosure effectiveness has been an ongoing central topic since the JOBS Act required the SEC to launch its Disclosure Effectiveness Initiative. The SEC intends to continue its focus in this arena and expects both additional rulemaking and industry guidance in 2016.

I have written several times on the SEC initiative and the subject of improving the disclosure requirements for reporting companies. Recently the SEC sought comment on financial disclosure requirements for subsidiaries and affiliate entities (see my blog HERE). Moreover, 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.

Mission and Philosophy

Chair White made a point of conveying the message that the SEC is not just about disclosure. They have broad regulatory authority over trading markets, broker-dealers, SRO’s, the settlement and clearing process and the PCAOB. The SEC intends to continue to work in each of these areas, including additional regulations on the swaps markets, clearing agencies, transfer agents, and technology systems. In addition, the SEC has and will continue to seek public comment on proposed rules, ideas related to proposed rules, and concepts in general. As Chair White states, “[W]e are therefore increasingly considering using measures beyond disclosure to fulfill our mission of providing strong investor protection, safeguarding market integrity, and achieving other regulatory objectives.”

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.

« State Blue Sky Concerns; Florida and New York House Passes More Securities Legislation »

State Blue Sky Concerns; Florida and New York

Posted by Securities Attorney Laura Anthony | March 2, 2016 Tags: Blue Sky Laws, Florida Corporate Statutes

I have often written about state blue sky compliance and issues in completing offerings that do not pre-empt state law, including Tier 1 of Regulation A+ and initial or direct public offerings on Form S-1. I’ve also often expressed my opinion that the SEC, together with FINRA, is best suited to govern most securities-related registrations and exemptions, including both for offerings and broker-dealer matters, and that the states should be more focused on state-specific registrations and exemptions (such as intrastate offerings) and investigation and enforcement with respect to fraud or deceit, or unlawful conduct.

Despite the SEC support for the NASAA-coordinated review program to simplify the state blue sky process for securities offerings, such as under Tier 1 of Regulation A+, only 43 states participate. I say “only” in this context because the holdouts – including, for example, Florida, New York, Arizona and Georgia – are extremely active states for small business development and private capital formation. Moreover, even using the coordinated review program, the states have vastly different rules and interpretations of the same rules.

Blue sky compliance is tricky at best. In this blog I am discussing particular difficulties with the blue sky legislation in Florida and New York as an example of the types of traps an issuer can face without proper planning and, of course, competent legal counsel.

For a review of federal pre-emption of state securities laws, see my two-part blog on the National Markets Improvement Act of 1996 (NSMIA) HERE and HERE. For further information on the NASAA-coordinated review program, see my blog HERE for further discussion.

Florida

Florida does not have an issuer exemption from broker-dealer registration for public offerings, including offerings made under Regulation A/A+ or self-underwritten public offerings made using Form S-1. Put another way, an issuer must register as a broker-dealer with the state of Florida (the state has an issuer registration process) in order to complete a Regulation A or direct public offering, and sell securities to investors within the state of Florida. Tier 2 of Regulation A+ pre-empts state law and accordingly, Florida cannot impose issuer broker-dealer registration.

The sale of Securities in Florida is regulated by the Florida Office of Financial Regulation, Division of Securities and is generally found in Chapter 517 Florida Statutes and corresponding rules adopted under the Florida Administrative Code (F.A.C.), Chapter 517, Florida Statutes – Securities and Investor Protection Act and Chapter 69W-100 through 69W-1000, Florida Administrative Code.

All sales of securities in Florida must be made by a properly registered dealer (Chapter 517.12(1), Florida Statutes) or by someone utilizing an exemption provided by Chapter 517.12(3), Florida Statutes. However, the broker-dealer registration exemptions, including the issuer exemption, only apply to exempt offerings. Neither a Regulation A nor a direct public offering are exempt offerings. Accordingly, persons who sell securities in a Tier 1 Regulation A offering or direct public offerings, including issuers and their officers, directors and employees, must register as a broker-dealer in the state of Florida to sell to investors within the state of Florida.

In addition, Florida law has another trap where an issuer or finder could inadvertently violate the law. Florida Statute §475.41 specifically states that a contract by an unlicensed broker to sell or to negotiate the purchase or sale of a business for compensation is invalid and in particular:

No contract for a commission or compensation for any act or service enumerated in §475.01(3) is valid unless the broker or sales associate has complied with this chapter in regards to issuance and renewal of the license at the time the act or service was performed.

Fla. Stat. §475.01(3) defines “operating” as a broker as meaning “the commission of one or more acts described in this chapter as operating as a broker.” “Broker” is defined broadly in Fla. Stat. §475.01(1)(a) and includes, among other things:

… a person who, for another, and for compensation or valuable consideration directly or indirectly paid or promised, expressly or impliedly, or with an intent to collect or receive compensation or valuable consideration therefore… sells… or negotiate[s] the sale, exchange, purchase, or rental of business enterprises or business opportunities… or who advertises or holds out to the public by any oral or printed solicitation or representation that she or he is engaged in the business of appraising, auctioning, buying, selling, exchanging, leasing or renting business enterprises or business opportunities… or who directs or assists in the procuring of prospects or negotiation or closing of any transaction which does, or is calculated to, result in a sale, exchange, or leasing thereof, and who receives, expects, or is promised any compensation or valuable consideration, directly or indirectly… (emphasis added)

Relying on these provisions, Florida courts and arbitration panels have found consulting and finder arrangements related to mergers and acquisitions and other corporate finance transactions that would otherwise not require federal broker-dealer registration, to be unlawful.

In addition to the conflict with federal law, the Florida statute is particularly troubling for practitioners as it is not included in the Florida Securities and Investor Protection Act found in chapter 517 of Florida Statutes. Florida Statute §517.12 is the state equivalent to Section 15(a)(1) of the Exchange Act requiring broker-dealer registration. Like the Exchange Act, §517.12 requires registration as a broker or dealer for the sale or offer of any securities.

Section 475, on the other hand, is the Florida statute governing “Real Estate Brokers, Sales Associates, Schools and Appraisers.” Section 517 gives no reference to Section 475 and vice versa. Other than through research of case law, a practitioner would have no reason to research laws governing real estate transactions in association with business mergers and acquisitions and the payment of related finders’ fees.

Selling securities without a license can be a criminal matter under §517.302. Violation of §517.302 is a third-degree felony, punishable by up to five years in prison and is a strict liability offense. A separate violation of §517.12 occurs every time the defendant sells a security without the proper license. Thus, a defendant who sells a security to eight different victims would commit eight separate violations of §517.12. Neither ignorance of the license requirement nor the defendant’s good faith reliance on the advice of counsel is a recognized defense.

The Florida provisions remind us of the complexities associated with state blue sky compliance.

New York

New York State’s securities statute, Articles 23-A of the General Business Law, known as the Martin Act, is unique among state securities laws in two important respects. First, the Martin Act does not require the registration of securities, other than securities sold in real estate offerings, theatrical syndications or intra-state offerings. Instead, it requires that issuers register as dealers in their own securities. New York exempts issuers from registering as dealers when they complete a firm commitment underwritten offering but not in other circumstances, including a best efforts underwritten offering or where no underwriter or placement agent is utilized.

Second, the Martin Act does not differentiate between registered or exempt offerings or provide for exemptions for federally covered (state pre-empted) offerings. The Martin Act requires that any person “engaged in the business of buying and selling securities from or to the public” to register as a broker-dealer. Although the Martin Act does not offer any guidance, case law has interpreted the words “to the public” to exclude private offerings under Section 4(a)(2). However, despite requests, New York has failed to amend the Martin Act to make any differentiation, leaving practitioners not knowing what, if any, notice filings would be required for private offerings.

As a result of the controversy surrounding New York’s blue sky compliance, many practitioners simply do not file any notice documents or pay any fees where the offering pre-empts state law under the NSMIA. As a reminder, securities subject to the NSMIA are called “covered securities.”

Covered securities may still be, and generally are, subject to notice filing requirements by the individual states. The NSMIA specifically allows the states to require a copy of any document filed with the SEC, together with annual or periodic reports of the value of securities sold or offered to be sold to persons located in the state (if not already included in the SEC filing) as long as such filing is solely for notice purposes and for the assessment or calculation of a fee. States may also require the filing of consent to service of process.

States may also require the payment of a fee in connection with a notice filing except that fees are specifically prohibited in connection with securities that are listed or authorized for listing on a national securities exchange such as the NYSE or NASDAQ and securities in Title III crowdfunding transactions except where 50% or greater of the securities are sold in a single state. Although a state may not condition the federal pre-emption granted by the NSMIA upon the payment of a fee, it can suspend an otherwise covered offering in its state for the failure to file a notice filing and pay the fee.

The Committee on Securities Regulation of the New York State Bar Association submitted a position paper to the Office of the New York State Attorney General in August 2002 related to New York’s overreaching blue sky laws with respect to private offerings; however, the state of New York did not respond.

The Committee concluded that all offerings exempt under Section 4(a)(2) of the Securities Act and Rule 506 of Regulation D are exempt from the Martin Act and that New York cannot require issuers to register as broker-dealers for such federally pre-empted private offerings. The Committee goes further by stating that “[I]f New York State wishes to receive a notice and fee for Section 4(a)(2) and Rule 506 offerings, it must amend the Martin Act to require (or to permit the Attorney General to require) notice filings in non-public offerings.” Many practitioners rely on this position paper in support of the position that no filings must be made with New York when relying on Section 4(a)(2) of the Securities Act.

Conclusion

My consistent view is that the SEC, together with FINRA, is best suited to govern most securities-related registrations and exemptions, including both for offerings and broker-dealer matters, and that the states should be more focused on state-specific registrations and exemptions (such as intrastate offerings) and investigation and enforcement with respect to fraud or deceit, or unlawful conduct.

I am thrilled with the opportunity that Tier 2 of Regulation A+ offers for issuers in completing going public transactions that pre-empt state blue sky law and would like to see an expansion of the NSMIA for direct and initial public offerings using form S-1.

The Author

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

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

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

Download our mobile app at iTunes.

« SEC Proposes Transfer Agent Rules SEC Gives Insight On 2016 Initiatives »

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

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« 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.

The Author

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

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