SEC Proposes Amendments To Rule 10b5-1 Insider Trading Plans
As expected from the Spring 2021 Regulatory Agenda, on December 15, 2021, the SEC proposed amendments to Rule 10b5-1 under the Securities Exchange Act of 1934 (“Exchange Act”) to enhance disclosure requirements and investor protections against insider trading. Although there is a statutory framework, the laws surrounding insider trading are largely based on judicial precedence and are difficult to navigate. I last wrote about insider trading in 2014 (see HERE) but there have been many curves in the road since that time.
Since the adoption of Rule 10b5-1, courts, commentators, and members of Congress have expressed concern that the affirmative defense under Rule 10b5-1(c)(1)(i) has allowed traders to take advantage of the liability protections provided by the rule to opportunistically trade securities on the basis of material nonpublic information. Furthermore, some academic studies of Rule 10b5-1 trading arrangements have shown that corporate insiders trading pursuant to Rule 10b5-1 consistently outperform trading of executives and directors not conducted under a Rule 10b5-1 trading arrangement. The purpose of the new proposed rules is to prevent these perceived abuses of the existing structure.
Background
Insider trading is prohibited by the general anti-fraud provisions and in particular Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Section 10(b) of the Exchange Act makes it unlawful for any person, directly or indirectly, to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.
Rule 10b-5 provides that it shall be unlawful for any person, directly or indirectly to: (i) employ any device, scheme, or artifice to defraud; (ii) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (iii) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
As mentioned, the law of insider trading is otherwise defined by judicial opinions. There are three main theories on which insider trading is based: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory. Rule 10b5-1(b) defines “on the basis of” for trading on insider information as “[S]ubject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is ‘on the basis of’ material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.”
Rule 10b5-1(c) provides an affirmative defense to insider trading including for parties that frequently have access to material nonpublic information, including corporate officers, directors and issuers. Currently, Rule 10b5-1(c) provides that a person’s purchase or sale is not on the basis of material non-public information if:
- Before becoming aware of the information, the person had: (a) entered into a binding contract to purchase or sell the security; (b) instructed another person to purchase or sell the security for the instructing person’s account, or (c) adopted a written plan for trading securities;
- The contract, instruction or plan described in (i) above: (a) must have specified the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold; (b) must have included a written formula or algorithm, or computer program, for determining the amount of and price at which the securities will be purchased or sold; or (c) did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; provided, in addition, that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when doing so; and
- The purchase or sale that occurred was pursuant to the contract, instruction, or plan. A purchase or sale is not “pursuant to a contract, instruction, or plan” if, among other things, the person who entered into the contract, instruction, or plan altered or deviated from the contract, instruction, or plan to purchase or sell securities (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction or position with respect to those securities.
As is common with many federal securities laws and rules, Rule 10b5-1 also includes a provision that the affirmative defenses in (c) are only available when the contract, instruction, or plan to purchase or sell securities was given or entered in good faith and not as part of a plan or scheme to evade the prohibitions of the law.
Proposed Rule Changes
The proposed amendments to Rule 10b5-1 would update the requirements for the affirmative defense, including imposing a cooling off period before trading could commence under a plan, prohibiting overlapping trading plans, and limiting single-trade plans to one trading plan per twelve-month period. In addition, the proposed rules would require directors and officers to furnish written certifications that they are not aware of any material nonpublic information when they enter into the plans and expand the existing good faith requirement for trading under Rule 10b5-1 plans.
In addition, the proposed amendments require more comprehensive disclosure about a company’s policies and procedures related to insider trading and its practices around the timing of options grants and the release of material nonpublic information. A new table would be required to report any options granted within 14 days of the release of material nonpublic information and the market price of the underlying securities the trading day before and the trading day after the disclosure of the material non-public information. Moreover, Forms 4 and 5 would be amended to add a new checkbox to disclose whether a transaction was made pursuant to a Rule 10b5-1(c) or other trading plan. Also, gifts of securities would have to be reported on Form 4 instead of being exempt and allowed to be reported on a yearly Form 5.
Insider Trading Affirmative Defenses
The proposed amendments to Rule 10b5-1 would add new conditions to the affirmative defense to insider trading liability found in Rule 10b5-1(c)(1), including:
- 10b5-1 trading plans entered into by corporate officers and directors must include a 120-day cooling off period before any trading can commence under the trading plan after its adoption, including adoption of a modified trading plan;
- 10b5-1 trading plans entered into by companies must include a 30-day cooling off period before any trading can commence under the trading plan after its adoption, including adoption of a modified trading plan;
- Officers and directors must certify that they are not aware of material nonpublic information about the company or the security when adopting a new or modified trading plan;
- The affirmative defense under Rule 10b5-1(c)(1) does not apply to multiple overlapping Rule 10b5-1 trading plans for open market trades in the same class of securities;
- 10b5-1 trading plans to execute a single trade are limited to one plan per 12-month period; and
- 10b5-1 trading arrangements must be entered into and operated in good faith.
New Disclosure Obligations
The proposed amendments require more comprehensive disclosure regarding Rule 10b5-1 trading plans, option grants, and issuer insider trading policies and procedures, including:
- A requirement for a company to disclose in its annual reports whether or not (and if not, why not) the company has adopted insider trading policies and procedures. Additionally, companies would be required to disclose their insider trading policies and procedures, if they have adopted such policies and procedures;
- A requirement for a company to disclose in its annual reports its option grant policies and practices, and to provide tabular disclosure showing grants made within 14 days of the release of material nonpublic information and the market price of the underlying securities on the trading day before and after the release of such information;
- A requirement for a company to disclose in its quarterly reports the adoption and termination of Rule 10b5‑1 trading plans and other trading arrangements by directors, officers, and issuers, and the terms of such trading arrangements;
- A requirement that Section 16 officers and directors disclose by checking a box on Forms 4 and 5 whether a reported transaction was made pursuant to a 10b5-1(c) trading arrangement; and
- A requirement that Section 16 officers and directors disclose bona gifts of securities on Form 4.
« SEC Issues Guidance On Spring-Loaded Compensation Awards
SEC Issues Guidance On Spring-Loaded Compensation Awards
On November 29, 2021, the SEC issued accounting guidance on the recognition and disclosure of “spring-loaded awards” made to executives. A spring-loaded award is a share-based compensation arrangement where a company grants stock options or other awards shortly before it announces market-moving information such as an earnings release with better-than-expected results or the disclosure of a significant transaction. The SEC new guidance and scrutiny is not unexpected following the re-opening of the comment period on proposed rules on listing standards for the recovery of erroneously awarded executive compensation (“Clawback Rules”) (see HERE) and proposed new rules on share repurchase programs and stock trading plans (blogs coming soon on each of these).
According to the new SEC accounting bulletin prepared by the SEC’s Office of the Chief Accountant and the Division of Corporation Finance, non-routine spring-loaded grants merit particular scrutiny by those responsible for compensation and financial reporting governance at public companies. In particular, it is the SEC’s view that a company should not grant spring-loaded awards under the mistaken belief that the accounting for the award, including compensation cost, does not have to include the additional value conveyed to the recipient from the anticipated announcement of material information.
SEC Accounting Bulletin No. 120
As an attorney, I do delve into the technicalities of accounting standards but rather keep my information high level. The new SEC Accounting Bulletin No. 120 is meant to align guidance related to the accounting treatment of spring-loaded compensation awards with existing GAAP principals, including those reflected in FASB Topic 718. FASB ASC Topic 718 is based on the underlying accounting principle that compensation cost resulting from share-based payment transactions be recognized in financial statements at fair value. Topic 718 addresses a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans.
In presenting the new guidance, the SEC noted that it is observed numerous instances where companies have granted share-based compensation while in possession of positive material non-public information. When companies are in possession of positive material non-public information, the staff believes these companies should consider whether adjustments to the current price of the underlying share or the expected volatility of the price of the underlying share for the expected term of the share-based payment award are appropriate when applying a fair-value-based measurement method to estimate the cost of its share-based payment transactions.
The bulletin includes interpretive guidance related to the transition from nonpublic to public status, valuation methods (including assumptions such as expected volatility, expected term, and current price of the underlying share, particularly when valuing spring-loaded awards), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, and capitalization of compensation cost related to share-based payment arrangements. The guidance includes specific examples, and as usual, reminds companies of their corporate governance and disclosure obligations, as well as the need to maintain effective internal controls.
The new guidance applies to all share based compensation, whether granted to employees or non-employees.
Transition from Nonpublic to Public Status
The SEC bulletin sets forth a set of facts and then four sample questions and interpretations based on those facts. The fact scenario involves a private company that files a registration statement with the SEC and which had been issuing stock compensation based on intrinsic value. The SEC considers the company to be public upon first filing a registration statement as opposed to upon the closing of the public offering.
The first question focuses on accounting for share options that were granted, while private, but for which services (vesting) will not occur until the company is public. In that case, the company could continue to value the options as it did as a non-public company unless the options are subsequently modified, repurchased or cancelled.
The second question focuses on the accounting of fully vested awards that have not been settled. In that case, the company would increase its liability for the award for the difference between the previous intrinsic value and the new fair value as accounted for as a public company. The third question confirms that a company may not retrospectively apply the fair value-based method to an award granted before becoming public. Finally, the fourth question reminds the company that it should clearly describe in MD&A the change in accounting policy that will be required by Topic 718 in subsequent periods and the reasonably likely material future effects.
Valuation Methods
Again, the SEC bulletin sets forth a set of facts and then four sample questions and interpretations based on those facts. Topic 718 indicates that the measurement objective for equity instruments awarded to grantees is to estimate the fair value at the grant date the company is obligated to issue the award when the grantees have delivered the good or rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments. Observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, should be used as the basis for the measurement for equity and liability instruments awarded in a share-based transaction. If observable market prices of identical or similar equity or liability instruments are not available, Topic 718 provides various valuation options.
This section is especially interesting because it considers when a valuation estimate can be considered misleading when the fair value does not correspond to the value ultimately realized by the grantees who received the share options. Although estimates by nature are difficult, the estimate of fair value should reflect the assumptions marketplace participants would use in determining how much to pay for an instrument on the fair value measurement date. As long as the original valuation is made in good faith, based on reasonable market information, later changes would not call into question the original valuation.
As long as all the principals in Topic 718 are applied, the SEC will decide which of those allowed valuations are better or worse than another. Here, the emphasis is on all the principles which includes that a valuation technique or model (i) is applied in a manner consistent with the fair value measurement objective and other requirements Topic 718, (ii) is based on established principles of financial economic theory and generally applied in that field and (iii) reflects all substantive characteristics of the instrument (except for those explicitly excluded by Topic 718). Moreover, valuation techniques can change over time as long as they continue to comply with all the rules.
Although valuations do not have to be completed by outside third parties, they must be completed by a person with the requisite expertise.
Assumptions in Valuation Methods
Fair value determinations must consider (i) the expected volatility of its company’s share price; (ii) the expected term of the option, taking into account both the contractual term of the option and the effects of grantees’ expected exercise and post-vesting termination behavior; and (iii) the determination of the current price of the underlying share. The Black-Scholes-Merton framework is often used to determine fair value.
Volatility is a measure of the amount by which a financial variable, such as share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Option-pricing models require an estimate of expected volatility as an assumption because an option’s value is dependent on potential share returns over the option’s term. The higher the volatility, the more the returns on the share can be expected to vary — up or down. Because an option’s value is unaffected by expected negative returns on the shares, other things being equal, an option on a share with higher volatility is worth more than an option on a share with lower volatility.
Topic 718 does not specify a particular method of estimating expected volatility, but it does provide a list of factors entities should consider in estimating expected volatility. Factors consider both historical volatility and expected or implied future volatility. Companies that have appropriate traded financial instruments from which they can derive an implied volatility should generally consider this measure and may even consider it exclusively.
In computing historical volatility, companies should consider the length of the option. Longer term options are less likely to have the same volatility as longer historical periods. Companies should use consistent regular intervals for price observations, which could include daily, weekly or monthly reviews, based on reasonable facts and circumstances. The SEC bulletin lists certain circumstances in which it believes it would be acceptable for a company to rely exclusively on historical volatility.
In computing expected future volatility, the objective is to ascertain the assumptions that marketplace participants would likely use in determining an exchange price for an option. Future events could range widely but may include mergers and acquisitions, material transactions, changes in business models or changes in key executives.
In computing implied volatility, a company should consider: (i) the volume of market activity of the underlying shares and traded options; (ii) the ability to synchronize the variables used to derive implied volatility (i.e., trading prices measured at the same point in time and if no active trading market, at the point in time closest to the grant date); (iii) the similarity of the exercise prices of the traded options to the exercise price of the newly-granted share options (at or near the money options); (iv) the similarity of the length of the term of the traded and newly-granted share options; and (v) consideration of material non-public information. The SEC bulletin lists certain circumstances in which it believes it would be acceptable for a company to rely exclusively on implied volatility.
Where a company has recently gone public and does not a trading history upon which it can base estimates, it can base its estimates on similar entities. Similar entities would be those in the same industry, stage of life cycle, size and financial leverage. A company can look to industry sector indexes to find comparables but should not use the index itself.
Regardless of methods used, a company must disclose the expected volatility and method used to estimate it. Disclosure would be appropriate in the financial statement footnotes and under critical accounting estimates in its MD&A. Moreover, if the volatility could have a material impact on the future business of the company, additional disclosure may be required in the general MD&A discussion.
As mentioned, in determining fair value, a company must also consider the expected term of the option. Generally, if an option is tradeable, it is sold rather than exercised. Likewise, if it is not tradeable, it must be exercised or allowed to expire. Tradeable options have a higher fair value. The new SEC bulletin provides guidance on determining expected term of an option which includes a consideration of the contractual term, but also tradeability (and therefore hedgeability) and likelihood of early exercise. Expected term can never be shorter than the vesting period of an option. Also, Topic 718 requires that a company aggregate individual awards into groups with respect to exercise and post-vesting employment termination behaviors for the purpose of determining expected term.
Current Price and Spring-Loaded Grants
Assumptions used to estimate the fair value of equity and liability instruments granted in share-based payment transactions shall be determined in a consistent manner from period to period. For example, an entity might use the closing share price or the share price at another specified time as the current share price on the grant date in estimating fair value, but whichever method is selected, it shall be used consistently.
A consistently applied method to determine the current price of the underlying share should include consideration of whether adjustments to observable market prices (e.g., the closing share price or the share price at another specified time) are required such as for material non-public information. Determining whether an adjustment to the observable market price is necessary, and if so, the magnitude of any adjustment, requires significant judgment. Companies should carefully consider whether an adjustment to the observable market price is required, for example, when share-based payments arrangements are entered into in contemplation of or shortly before a planned release of material non-public information, and such information is expected to result in a material increase in share price. Non-routine spring-loaded grants merit particular scrutiny by those charged with compensation and financial reporting governance.
The Author
« Update On Nasdaq And NYSE Direct Listings SEC Proposes Amendments To Rule 10b5-1 Insider Trading Plans »
Update On Nasdaq And NYSE Direct Listings
The rules related to direct listings continue to evolve as this method of going public continues to gain in popularity. The last time I wrote about direct listings was in September 2020, shortly after the SEC approved, then stayed its approval, of the NYSE’s direct listing rules that allow companies to sell newly issued primary shares on its own behalf into the opening trade in a direct listing process (see HERE). Since that time, both the NYSE and Nasdaq proposed rules to allow for a direct listing with a capital raise have been approved by the SEC.
The Nasdaq Stock Market has three tiers of listed companies: (1) The Nasdaq Global Select Market, (2) The Nasdaq Global Market, and (3) The Nasdaq Capital Market. Each tier has increasingly higher listing standards, with the Nasdaq Global Select Market having the highest initial listing standards and the Nasdaq Capital Markets being the entry-level tier for most micro- and small-cap issuers. For a review of listing standards, see HERE.
On December 3, 2019, the SEC approved amendments to the Nasdaq rules related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market (see HERE). As previously reported, on February 15, 2019, Nasdaq amended its direct listing process rules for listing on the Market Global Select Market (see HERE). In May 2021, the SEC finally approved Nasdaq’s proposed rules to allow for a concurrent IPO and direct listing without the use of an underwriter (previously direct listings were only available for secondary offerings by existing shareholders). The very handy Nasdaq Initial Listing Guide now also includes the direct listing financial and liquidity requirements for the Nasdaq Global Market and Nasdaq Capital Market.
Direct Listings in General
Traditionally, in a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC. For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.
A direct listing could also be associated with a spin-off of a subsidiary or division of a listed company, such as the current planned spin-off of Johnson & Johnson’s consumer health division and the spin-off by GE into three separate public companies.
Most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering. For more on Rule 506, see HERE.
Early investors take a greater risk because there is no established secondary market or clear exit from the investment. Even where an investment is made in close proximity to an intended going public transaction, due to the higher risk, the private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.
Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk. For more on the accredited investor definition including the SEC’s last amendments, see HERE and HERE.
The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.
In a direct listing, there is a chance for an initial dip in trading price, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved, at least partially, by using an overallotment or greenshoe option. An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position.
A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).
The NYSE and Nasdaq rules now allow a company to sell shares directly into the trading market and thus complete a capital raise at the same time as its going public transaction. In essence, this direct listing hybrid is an IPO without an underwriter.
Nasdaq Direct Listing Process with Capital Raise
On May 19, 2021, the SEC approved Nasdaq’s proposed rule change to permit direct listings with a concurrent capital raise without an underwriter. Nasdaq calls the process a “Direct Listing with a Capital Raise.” Soon after the SEC’s approval, Nasdaq proposed an amendment to the rule to revise the pricing parameters for new direct listings with a capital raise. As of the time of this writing, the SEC has issued an order seeking comments on the modifications in which order it raises several issues with the proposed rule change.
A company seeking to list securities on Nasdaq must meet minimum listing requirements, including specified financial, liquidity and corporate governance criteria. Nasdaq listing Rules IM-5315-1, IM-5405-1 and IM-5505-1 set forth the direct listing requirements for the Nasdaq’s Global Select, Global Market and Capital Market respectively. The Rules describe how the Exchange will calculate compliance with the initial listing standards related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
New Listing Rule IM-5315-2 has been added to permit a company to list in connection with a primary offering in which the company will sell shares itself in the opening auction on the first of trading. A Direct Listing with a Capital Raise can only be accomplished in connection with a listing on Nasdaq’s Global Select market. The Direct Listing with a Capital Raise process also amended Rule 4702 to add a new order type – i.e., the Company Direct Listing Order, which will be used during the Nasdaq Halt Cross for the shares offered by the company in a Direct Listing with a Capital Raise. Finally, Rules 4120(c)(9), 4753(a)(3) and 4753(b)(2) were amended to establish requirements for disseminating information, establishing the opening price and initiating trading through the Nasdaq Halt Cross in a Direct Listing with a Capital Raise.
To qualify for a Direct Listing with a Capital Raise, the company’s unrestricted publicly held shares before the offering, plus the market value of the shares to be sold by the company in the direct listing must be at least $110 million (or $100 million, if the company has stockholders’ equity of at least $110 million) (as opposed to the IPO value of $45 million), with the value of the unrestricted publicly held shares and the market value being calculated using a price per share equal to the lowest price of the price range established by the company in its S-1 registration statement. As discussed further below, it is this pricing provision that Nasdaq is now seeking to amend.
Officers, directors or owners of more than 10% of the company’s common stock prior to the opening auction may purchase shares sold by the company in the opening auction, provided that such purchases are not inconsistent with general anti-manipulation provisions, Regulation M, and other applicable securities laws. However, shares held by these insiders are not included in calculations of publicly held shares for purposes of exchange listing rules except that, with respect to a Direct Listing with a Capital Raise, all shares sold by the company in the offering and all shares held by public holders prior to the offering will be included in the calculation of publicly held shares, even if some of these shares are purchased by inside investors.
Of course, any company seeking to complete a Direct Listing with a Capital Raise must satisfy all other requirements for a listing on the Nasdaq Global Select market, including having 450 unrestricted round lot stockholders (stockholders that hold more than 100 shares) with at least 50% of such round lot holders each holding unrestricted securities with a market value of at least $2,500 and 1.25 million unrestricted publicly held shares outstanding at the time of listing. In a Direct Listing with a Capital Raise process, the requirements must be fully satisfied on the first day of trading. That is, there is no grace period as is the case in a traditional IPO process. For a review of the Global Select Market direct listing requirements, including related to direct listings, see HERE.
In considering the initial listing of a company in connection with a direct listing in general, Nasdaq will determine that such company has met the applicable Market Value of Unrestricted Publicly Held Shares requirements based on the lesser of: (i) an independent third-party valuation of the and (ii) the most recent trading price for the company’s common stock in a Private Placement Market where there has been sustained recent trading. For a security that has not had sustained recent trading in a Private Placement Market prior to listing, Nasdaq will determine that such Company has met the Market Value of Unrestricted Publicly Held Shares requirement if the Company satisfies the applicable Market Value of Unrestricted Publicly Held Shares requirement and provides a Valuation evidencing a Market Value of Publicly Held Shares of at least $250,000,000.
In a Direct Listing with a Capital Raise, the market is informed of the minimum price at which the company can sell shares as it is included in the company’s registration statement. Accordingly, in a Direct Listing with a Capital Raise, Nasdaq will calculate the value of shares, including those being sold by the company and those held by public shareholders immediately prior to the listing, using a price per share equal to the lowest price in the price range disclosed by the issuer in its registration statement. Nasdaq will use the same price per share in determining whether the company has met the applicable bid price and market capitalization requirements based on the same per share price.
As noted above, a Direct Listing with a Capital Raise would allow the company to sell shares in the opening auction on the first day of trading on the exchange. To effectuate this, Nasdaq amended Rule 4702 to create a new order type called a Company Direct Listing Order (CDL Order). While there are many granular details about the CDL Order in the final rules, the most important concept is that the CDL Order is a market order which is entered without a price so the price will be determined by the Nasdaq Halt Cross, or the opening auction. Also, (i) the price must be at or above the lowest price and at or below the highest price of the price range set forth in the company’s S-1 registration statement; and (ii) the full quantity of the order (i.e., the total number of shares that the company seeks to sell in the Direct Listing with a Capital Raise) must be sold within that price range. If there is insufficient buying interest and Nasdaq is not able to price the auction to satisfy the CDL Order, the shares would not begin trading.
As noted above, in late June 2021, shortly after the SEC finally approved Nasdaq’s new Direct Listing with a Capital Raise, Nasdaq proposed a rule change to the price range limitations. In particular, Nasdaq has proposed to modify the pricing range limitation such that a Direct Listing with a Capital Raise can be executed in the Cross at a price that is at or above the price that is 20% below the lowest price and at or below the price that is 20% above the highest price of the price range established by the company in its effective registration statement. Nasdaq also proposes to modify the Pricing Range Limitation such that a Direct Listing with a Capital Raise can be executed in the Cross at a price above the price that is 20% above the highest price of such price range, provided that the company has certified to Nasdaq that such price would not materially change the company’s previous disclosure in its effective registration statement. The SEC has not approved the proposed change and has pointed out many issues with the proposal. I suspect Nasdaq will continue to tweak the request to the SEC’s satisfaction.
NYSE Direct Listing Process with Capital Raise
A company that seeks to list on the NYSE must meet all of the minimum initial listing requirements, including specified financial, liquidity and corporate governance criteria, a minimum of 400 round lot shareholders, 1.1 million publicly held outstanding shares and a $4.00 share price. Direct listings are subject to all initial listing requirements applicable to equity securities and as such, in a direct listing process, the rules must specify how the exchange will calculate compliance with the initial listing standards including related to the price of a security, comprising the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
In order to qualify for the NYSE big board in a direct listing process, a company must have a minimum of $100 million aggregate market value of publicly held shares. In contrast, in an IPO, a company is only required to have a market value of publicly held shares of $40 million. The reason for the much higher standard in a direct listing process is a concern related to the liquidity and market support in an opening auction process without attached underwriters.
The NYSE rules allow a company to sell shares directly into the market, without an underwriter, as part of a direct listing process. In order to accomplish this, the NYSE created a new process dubbed an Issuer Direct Offering (IDO). To get the process across the finish line, the last amendment to the proposed rule (i) deleted a provision that would provide additional time for companies completing a direct listing to meet the initial listing distribution standards; (ii) added specific provisions related to the concurrent selling security holder and IDO process; (iii) added provisions related to participation in the direct listing auction when completing an IDO; and (iv) removed references to direct listing auctions in the rule related to Exchange-Facilitated Auctions.
The material aspects of the final NYSE direct listing rule (i) modifies the provisions relating to direct listings to permit a primary offering in connection with a direct listing and to specify how a direct listing qualifies for initial listing if it includes both sales of securities by the company and possible sales by selling shareholders; (ii) modifies the definition of “direct listing”; and (iii) adds a definition of “Issuer Direct Offering (IDO)” and describes how it participates in a direct listing auction.
To clarify the difference between an IDO and selling security holder process, the NYSE has defined a shareholder-resale process as a “Selling Shareholder Direct Floor Listing.” A pure Selling Shareholder Direct Floor Listing occurs where a company is listing without a related underwritten offering upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements.
The Selling Shareholder Direct Floor Listing process retains the existing standards for direct listing and how the NYSE determines company eligibility, including the market value of publicly held shares. In particular, a company can meet the $100 million market value of publicly held shares requirement using the lesser of (i) an independent third-party valuation; and (ii) the most recent trading price of the company’s common stock in a trading system for unregistered securities that is operated by a national securities exchange or a registered broker-dealer (“Private Placement Market”). In order to satisfy the $100 million valuation, the NYSE requires that the independent valuation comes in at a market value of at least $250 million. In addition, the NYSE will only consider the Private Placement Market price if the equity trades on a consistent basis with a sustained history of several months, in excess of the market value requirement. Shares held by directors, officers or 10% or greater shareholders are excluded from the calculation.
An IDO listing is one in which a company that has not previously had its common equity securities registered under the Exchange Act, lists its common equity securities on the NYSE at the time of effectiveness of a registration statement pursuant to which the company would sell shares itself in the opening auction on the first day of trading on the Exchange in addition to, or instead of, facilitating sales by selling shareholders. This process is being called a “Primary Direct Floor Listing.” In a Primary Direct Floor Listing, a company can meet the $100 million market value of publicly held shares listing requirement if it sells at least $100 million in market value of shares in the NYSE’s opening auction on the first day of trading. Alternatively, where a company will sell less than $100 million of shares in the opening auction, the NYSE will determine that the company has met its market value of publicly held shares requirement if the aggregate market value of the shares the company will sell in the opening auction on the first day of trading and the shares that are publicly held immediately prior to the listing is at least $250 million. In that case, the market value is calculated using a price per share equal to the lowest price of the price range established by the company in its registration statement.
In order to facilitate the direct sales by the company, the NYSE has created a new type of buy-sell order called an “Issuer Direct Offering Order (IDO Order)” which would be a limit order to sell that is to be traded only in a Direct Listing Auction for a Primary Direct Floor Listing. An IDO Order is subject to the following: (i) only one IDO Order may be entered on behalf of the company and only by one member organization; (ii) the limit price of the IDO Order must be equal to the lowest price of the price range in the effective registration statement; (iii) the IDO Order must be for the quantity of shares offered by the company as disclosed in the effective registration statement prospectus; (iv) an IDO Order may not be canceled or modified; and (v) an IDO Order must be executed in full in the Direct Listing Auction.
A designated market maker effectuates the Direct Listing Auction manually and is responsible for setting the price (which involves many factors including working with the valuation financial advisor and the price set in the registration statement). The Direct Listing Auction and thus Primary Direct Floor Listing would not be completed if (i) the price is below the minimum or above the highest price in the range in the effective registration statement or (ii) there is not enough interest to fill both the IDO Order and all better priced sell orders in full. In other words, a Primary Direct Floor Listing can fail at the finish line. To provide a little help in this regard, the NYSE has provided that an IDO Order that is equal to the auction price, will receive priority over other buy (sell) orders.
The NYSE has also added provisions regarding the interaction with a company’s valuation or other financial advisors and the designated market maker to ensure compliance with all federal securities laws and regulations, including Regulation M. To provide an additional level of investor protection, and to satisfy the SEC, the NYSE retained FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of the federal securities laws and NYSE rules. Finally, the NYSE made several changes to align definitions and rule cross-references with the new provisions and direct listing process.
In passing the rule, the SEC noted that after its several modifications, they were satisfied that the final rule helped ensure that the listed companies would have a sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly markets.
« SEC Adopts The Use Of Universal Proxy Cards SEC Issues Guidance On Spring-Loaded Compensation Awards »
SEC Adopts The Use Of Universal Proxy Cards
On November 17, 2021, the SEC adopted final rules requiring parties in a contested election to use universal proxy cards that include all director nominees presented for election at a shareholder meeting. The original rules were proposed on October 16, 2016 (see HERE) with no activity until April, 2021, when the SEC re-opened a comment period (see HERE). The rule adoption comes with a flurry of rule amendments, proposals and guidance related to the proxy process, some of which reverses recent rules on the same subject.
The final rules will require dissident shareholders and registrants to provide shareholders with a proxy card that includes the names of all registrant and dissident nominees. The rules will apply to all non-exempt solicitations for contested elections other than those involving registered investment companies and business development companies. The rules will require registrants and dissidents to provide each other with notice of the names of their nominees, establish a filing deadline and a minimum solicitation requirement for dissidents, and prescribe presentation and formatting requirements for universal proxy cards. The SEC also adopted amendments to the proxy rules to ensure that proxy cards clearly specify the applicable shareholder voting options in all director elections and to require proxy statements to disclose the effect of a shareholder’s election to withhold its vote.
Background
Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Companies subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”) must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies.
When a shareholder votes by proxy, they execute a written directive instructing the entity to whom the proxy is granted how to vote on the shareholder’s behalf. Protecting the ability of shareholders to vote, including their right to elect directors through the proxy process, has been the focus of numerous SEC rulemakings and other efforts over the years. In addition to regulating the form, content and timing of proxy solicitation materials, the SEC regulates proxy advisory firms (some rules for which are in flux – see HERE) and shareholder proposals (see HERE).
Currently where there is a contested election of directors, shareholders are likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e., all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned, the second would cancel out and replace the first under state corporate law.
Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally, in a contested election the opposing candidates will not agree, presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.
Shareholders can always appear in person – or in today’s world, virtually in person – and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. Besides other impediments, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years, some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition. To provide the same voting rights to shareholders utilizing a proxy card as they would have in person, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.
To address some aspects of the problem, in 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First, it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e., those prepared by the company) to get those names.
In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card, and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. After a stall in the rulemaking process, the SEC has now adopted the use of a “universal proxy” card that includes the names of all nominated director candidates.
The final rule amendments regarding universal proxy will apply to all shareholder meetings involving contested director elections held after August 31, 2022. The rule amendments regarding voting options will be applicable to all shareholder meetings involving director elections held after August 31, 2022.
Universal Proxy Rules
On November 17, 2021, the SEC adopted new Rule 14a-19 under the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. Under new Rule 14a-19, the universal proxy card must include all director nominees presented by management and shareholders for election at the upcoming shareholder meeting. To facilitate the use of universal proxy cards, the SEC amended the current proxy rules so each side can list the other side’s director candidates on its universal proxy card. The new rules also establish new notice and filing requirements for all soliciting parties, as well as formatting and presentation requirements for universal proxy cards. In addition, the final rules require shareholders presenting their own director candidates in the contest to solicit holders of a minimum of 67% of the voting power of shares entitled to vote in the election.
The final rules also establish new requirements for all director elections, including uncontested elections. The rules mandate that “against” and “abstain” voting options be provided on a proxy card where such options have legal effect under state law. The rules also require disclosure in the proxy statement about the effect of all voting options provided.
In summary, the final rules:
- Create new Rule 14a-19 to require the use of universal proxy cards by all participants in all non-exempt solicitations in connection with contested director elections. The universal proxy card must include the names of both registrant and dissident nominees, along with certain other shareholder nominees included as a result of proxy access;
- Expand the determination of a “bona fide nominee” to include a person who consents to being named in any proxy statement for a registrant’s next shareholder meeting for the election of directors;
- Require dissidents to provide registrants with notice of their intent to solicit proxies and to provide the names of their nominees no later than 60 calendar days before the anniversary of the previous year’s annual meeting;
- Require registrants to notify dissidents of the names of the registrants’ nominees no later than 50 calendar days before the anniversary of the previous year’s annual meeting;
- Require dissidents to file their definitive proxy statement by the later of 25 calendar days before the shareholder meeting or five calendar days after the registrant files its definitive proxy statement;
- Require each side in a proxy contest to refer shareholders to the other party’s proxy statement for information about the other party’s nominees and refer shareholders to the SEC’s website to access the other side’s proxy statement free of charge;
- Require that dissidents solicit the holders of shares representing at least 67% of the voting power of the shares entitled to vote at the meeting; and
- Establish presentation and formatting requirements for universal proxy cards that ensure that each party’s nominees are presented in a clear, neutral manner.
The new rules also implement changes to the form of proxy and proxy statement disclosure requirements applicable to all director elections. These amendments:
- Require proxy cards to include an “against” voting option in director elections, when there is a legal effect to a vote against a director nominee;
- Require that the proxy card provide shareholders with the ability to “abstain” in a director election where a majority voting standard applies; and
- Require proxy statement disclosure about the effect of a “withhold” vote in an election of directors.
The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:
Due Date | Action Required |
No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [new Rule 14a-19(b)(1)] | Dissident must provide notice to the registrant of its intent to solicit the holders of at least 67% of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees. |
No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [new Rule 14a-19(d)] | Registrant must notify the dissident of the names of the registrant’s nominees. |
No later than 20 business days before the record date for the meeting. [current Rule 14a-13] | Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners. |
By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [New Rule 14a-19(a)(2)] | Dissident must file its definitive proxy statement with the Commission. |
The new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.
There is a concern that shareholders could be confused as to which candidates are endorsed by whom, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.
« Nasdaq Updated LAS Form Update On Nasdaq And NYSE Direct Listings »
Nasdaq Updated LAS Form
Effective September 17, 2021, Nasdaq updated its Listing of Additional Shares (LAS) Form and the process for the review of such forms.
Background
Nasdaq Rule 5250 sets forth certain obligations for companies listed on Nasdaq including related to requirements to provide certain information and notifications to Nasdaq, make public disclosures, file periodic reports with the SEC, and distribution of annual and interim reports. Rule 5250(e) specifies the triggering events that require a listed company to submit certain forms to Nasdaq.
Rule 5250(e) requires the submittal of specific forms related to the following triggering events:
- Change in Number of Shares Outstanding – Each listed company must file a form with Nasdaq no later than 10 days after the occurrence of any aggregate increase or decrease of any class of securities listed on Nasdaq that exceeds 5% of the amount of securities outstanding of that class.
- Listing of Additional Shares – As further detailed below, a listed company must give Nasdaq 15 calendar days advance notice before issuing additional securities in specified circumstances.
- Record Keeping Change – Each listed company must give Nasdaq notice of (a) a change in its name, par value or title of its security, trading symbol or similar change within 10 days following the change; (b) promptly following a change in the general character or nature of its business or any change in the address of its principal executive offices; and (c) at least 10 calendar days advance notice of certain corporate actions relating to non-convertible bonds listed on the Nasdaq Bond Exchange, including redemptions (full or partial calls), tender offers, changes in par value, and changes in identifier (e.g., CUSIP number or symbol).
- Substitution Listing – Each listed company must give Nasdaq 15 calendar days advance notice of a substitution listing event (other than a re-incorporation or a change in place of domicile). For a reincorporation or change in domicile, a company must notify Nasdaq as soon as practicable after such event.
- Transfer Agent, Registrar, ADR Bank Changes – Each listed company shall notify Nasdaq promptly following a change in transfer agent, registrar or ADR bank.
- Dividend or Stock Distribution – Each listed company shall notify Nasdaq, no later than 10 calendar days prior to the record date of any dividend or stock distribution.
I’ve included a full chart of all Nasdaq notification form requirements at the end of this blog.
Listing of Additional Shares (LAS)
All listed companies, other than foreign companies that only list an ADR or ADS, must give Nasdaq 15 calendar days advance notice before issuing additional securities in specified circumstances. In particular, a LAS form must be filed when a listed company:
- Establishes or materially amends a stock option plan, purchase plan or other equity compensation arrangement pursuant to which stock may be acquired by officers, directors, employees, or consultants without shareholder approval. However, Nasdaq recognizes that when a grant is given as a material inducement to employment, it may not be practical to provide the 15 days advance notice. Accordingly in such a case it is sufficient to notify Nasdaq about the grant no later than the earlier of: (x) five calendar days after entering into the agreement to issue the securities; or (y) the date of the public announcement of the award required. For more on the issuance of equity based compensation, see HERE
- Issues securities that may potentially result in a change of control of the Company (see HERE).
- Issues any common stock or security convertible into common stock in connection with the acquisition of the stock or assets of another company, if any officer or director or Substantial Shareholder of the Company has a 5% or greater interest (or if such persons collectively have a 10% or greater interest) in the Company to be acquired or in the consideration to be paid (see HERE).
- Issuing any common stock, or any security convertible into common stock in a transaction that may result in the potential issuance of common stock (or securities convertible into common stock) greater than 10% of either the total shares outstanding or the voting power outstanding on a pre-transaction basis (including through a rights offering or adoption of a poison pill).
Rule 5250(e) warns that Nasdaq reviews these forms to determine compliance with applicable Nasdaq rules, including the shareholder approval requirements. As such, if a Company fails to file timely the form required by this paragraph, Nasdaq may issue either a public reprimand letter or a delisting determination.
Previously an incomplete LAS form could be submitted to Nasdaq starting a review process. However, listed companies often believed that submittal of an incomplete form satisfied the notice requirement and would not provide updated information until well past the 15-day limit. In order to facilitate the intent of the Rule, effective September 17, 2021, Nasdaq updated the LAS form. The new notification form will require basic information about the transaction and cannot be submitted unless this information is included. Once submitted, the form cannot be amended or changed. If the terms of a transaction change after submittal of the form, the listed company must notify Nasdaq either by calling the listing qualifications staff or via email.
Upon submission of the new form, Nasdaq will promptly notify the company that the obligation to notify Nasdaq is completed. In many cases, this will happen the next day. Although the new form will satisfy the notification requirement, Nasdaq can continue to review the transaction and require additional information from the listed company.
The form is submitted through the Nasdaq listing center and does not require any supporting documentation. Rather, the form is designed to illicit the necessary information for Nasdaq to determine compliance with its rules.
Nasdaq Notification Requirements
The following is a chart of required Nasdaq notifications, form type and due dates.
Company Action | Notification Form | Due Date |
Apply to transfer between Nasdaq Market Tiers | Listing Application Market Transfer | Upon company request |
Cash Dividends and Other Cash Distributions
Forward Stock Splits, Stock Dividends and Rights Offerings Interest Payments |
Dividend/Distribution/Interest Payment Form | As soon as possible after declaration, and, in any event, no later than simultaneously with the public disclosure and no later than 10 calendar days prior to record date |
Change in Company Name
Change in Security Title or Par Value |
Company Event Notification | No later than 10 calendar days after the change |
Change in State of Incorporation or Place of Organization
Change Requiring Updated Corporate Governance Certification or Listing Agreement |
Company Event Notification | As soon as practicable after change |
Change in Trading Symbol | Company Event Notification | No later than two business days prior to desired change |
Change in Transfer Agent or Registrar
Noncompliance with Corporate Governance Rules |
Email notification to continuedlisting@nasdaq.com | At time of occurrence |
Check Payments | Check Payment Form | At time of occurrence |
Formation of a Holding Company that Replaces a Listed Company or Listing a New Class of Securities in Substitution for a Previously Listed Class of Securities
Reverse Stock Split |
Company Event Notification | No later than 15 calendar days prior to effective date
|
Hearing Request | Hearing Request Form | No later than 7 calendar days following Staff Determination |
Increase or Decrease of 5% or More in the Number of Shares Outstanding | Change in Shares Outstanding | No later than 10 calendar days after occurrence |
Investment Management Entity and Portfolio Company Certification | Certification Form | No later than December 31 of current year |
Listing of Additional Shares | Listing of Additional Shares | No later than 15 calendar days prior to the share issuance |
Listing a New Class of Securities | Listing Application Seeking to List a New Class of Securities | No later than 30 calendar days prior to the anticipated first trade date |
Mergers | Email notification to nasdaqreorgs@nasdaq.com | Prior to declaring the shareholder meeting date |
Redemptions/Extensions of Derivative Securities | Email notification to nasdaqreorgs@nasdaq.com | Prior to declaring the shareholder meeting date |
Request Rule Interpretation | Rule Interpretation Request | Upon company request |
Tender Offers | Email notification to nasdaqreorgs@nasdaq.com | As soon as practicable |
« SEC Updates Filing Fees And Payment Methods SEC Adopts The Use Of Universal Proxy Cards »
SEC Updates Filing Fees And Payment Methods
During the busiest capital markets boom most practitioners, including myself, have ever experienced, on October 13, 2021, in a whopping 432-page release, the SEC amended and modernized the filing fee payment methods and disclosure requirements. The amendments revise most fee-bearing forms, including Securities Act registration statements, schedules, and related rules to require companies and funds to include all required information for filing fee calculation in a structured format. The amendments also add new payment methods including ACH and debit and credit card options while eliminating the antiquated paper checks and money orders as a payment option.
The amendments are generally effective January 31, 2022. The changes in payment type options will be effective May 31, 2022. Pursuant to the transition provision, large-accelerated filers will become subject to the structuring requirements for filings they submit on or after 30 months after the January 31, 2022, effective date. Accelerated filers, certain investment companies that file registration statements on Forms N-2 and N-14, and all other filers will become subject to the structuring requirements for filings they submit on or after 42 months after the January 31, 2022 effective date. Compliance with the amended disclosure requirements other than the structuring requirements will be mandatory on the January 31, 2022 effective date.
Separately, effective October 1, 2021, the SEC lowered its filing fees from $109.10 per million dollars registered to $92.70 per million dollars.
Background
The SEC assesses filing fees on operating companies and investment companies (Funds) that engage in certain transactions involving publicly offered securities, including registered securities offerings, tender offers, and mergers and acquisitions. In addition, Funds are assessed fees on an annual basis for open-end Funds and unit investment trusts. The current methods to process and validate filing fee information are highly manual. The information generally is not machine-readable, and filers are not always required to report the underlying components of the fee calculation. Accordingly, calculations can be difficult and prone to error adding burdens on both the filer and SEC staff.
Currently the SEC staff conducts a manual review of the filing fee information for every fee-bearing filing that is filed with the SEC. The amendments are intended to improve filing fee preparation and payment processing by facilitating both enhanced validation through filing fee structuring and lower-cost, easily routable payments through the ACH payment option.
Structured Reporting Format
The amendments create a structured reporting format for all filers across all fee-bearing forms. In addition, the explanatory notes will now be required to include all information data points for the filing fee calculation. The structured data will be required to use Inline XBRL (for more on Inline XBRL, see https://securities-law-blog.com/2018/08/21/sec-adopts-inline-xbrl/?hilite=%27inline%27%2C%27xbrl%27 ). The new format is designed to allow the SEC staff to quickly identify and correct errors, and also adds a technological component such that the EDGAR system will automatically check the filing-fee-related information for internal consistency. The new format also eliminates the filer’s need to enter duplicate filing fee information in the header and the body of the filing, thereby avoiding the possibility of entering inconsistent data.
The amendments streamline the presentation of filing fee-related information and potentially facilitate any future changes in the structuring technology applied to it, the amendments move the filing fee-related information to a separate exhibit document (“filing fee exhibit”) rather than requiring it on the filing’s cover page. The majority of information must be presented in tabular format, including any offsets claimed by the registrant and explanations where one prospectus covers two or more registration statements.
The new required information includes, among other things, the type of security being newly registered or carried forward, the registration form type, file number, amount of securities being registered, proposed maximum aggregate offering price per unit, proposed maximum aggregate offering price, initial effective date of one or more previously filed registration statements associated with any unsold securities that the registrant is carrying forward; fees paid in connection with amendments; and entries for total offering amounts, the total amount of fee offsets and the total fee due net of fee offsets and any previously paid amounts. The new disclosures also add a fee rate column.
Related to Forms S-3 and F-3 the filing fee information must appear in a prospectus filed under Rule 424(b) or post-effective amendment rather than a periodic report that is incorporated by reference into the registration statement to avoid extending the filing fee structured information requirements to periodic and current reports. Moreover, each post-effective amendment or final prospectus filed pursuant to Rule 424(b) must provide required information about a specific transaction that includes the maximum aggregate amount or maximum aggregate offering price of the securities to which the post-effective amendment or prospectus relates. Further, each such prospectus must indicate that it is a final prospectus for the related offering to assist in calculation of the amount of securities sold.
Likewise, each post-effective amendment or final prospectus to Forms S-4 and F-4 must provide required information about a specific transaction and particular company being acquired that must include the maximum aggregate amount or maximum aggregate offering price of the securities to which the post-effective amendment or prospectus relates. Each such prospectus must indicate that it is a final prospectus for the related offering to assist in calculation of the amount of securities sol
As the form is rarely used, the amendments do not modify Form N-5, which is a Securities Act registration used by small business investment companies.
Filing Fee Payment Methods
Currently, filers may pay filing fees by wire transfer, paper check, or money order. Under the final amendments, filers will have four payment options including wire transfer, ACH, debit cards, and credit cards. ACH payments will not be subject to a processing fee, unless imposed by the filer’s financial institution, and therefore typically will provide a lower cost alternative to wire transfer. ACH payments also will require fields—including the Central Index Key (CIK) field used to identify EDGAR filers—that will reduce the need for manual re-routing of filing fee payments.
« SEC Affirms PCAOB Rules Implementing The Holding Foreign Companies Accountable Act Nasdaq Updated LAS Form »
SEC Affirms PCAOB Rules Implementing The Holding Foreign Companies Accountable Act
On November 5, 2021, as part of the implementation of the Holding Foreign Companies Accountable Act (“HFCA”), the SEC approved PCAOB Rule 6100. Rule 6100 establishes a framework for the PCAOB’s determination that it is unable to inspect or investigate completely registered public accounting firms located in foreign jurisdictions because of a position taken by an authority in that jurisdiction. The HFCA was adopted on December 18, 2020 and requires foreign-owned issuers to certify that the PCAOB has been able to audit specified reports and inspect their audit firm within the last three years. If the PCAOB is unable to inspect the company’s public accounting firm for three consecutive years, the company’s securities are banned from trading on a national exchange.
The Sarbanes-Oxley Act of 2002 (“SOX”) mandates that the PCAOB inspect registered public accounting firms in both the United States and in foreign jurisdictions and investigate potential statutory, rule, and professional standards violations committed by such firms and their associated persons. The HFCA requires that the SEC identify each “covered issuer” that has retained a registered public accounting firm to issue an audit report where that firm has a branch or office located in a foreign jurisdiction. Further, as to a covered issuer, the PCAOB must determine that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.
To implement compliance with the requirements of the HFCA, the SEC adopted final interim rules on July 30, 2021 (see HERE). The rules apply to covered companies that the SEC identifies as having filed an annual report on Forms 10-K, 20-F, 40-F or N-CSR with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the PCAOB has determined it is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction.
The SEC rules require identified companies to submit documentation to the SEC, on or before its annual report due date, establishing that it is not owned or controlled by a governmental entity in that foreign jurisdiction. The company will also be required to include disclosure in its annual report regarding the audit arrangements of, and governmental influence on the company. If the company is identified by the SEC (“Commission-Identified Issuers”) for three consecutive years, the SEC will prohibit trading of the company’s securities. The SEC is still considering how to implement the trading prohibition requirement.
Also, Commission-Identified Issuers must include disclosure for each non-inspection year:
- Identifying the registered accounting firm that prepared an audit report;
- the percentage of shares owned by governmental entities where the issuer is incorporated;
- whether these governmental entities have a controlling financial interest;
- information related to any board members who are officials of the Chinese Communist Party; and
- whether the articles of incorporation of the issuer contain any charter of the Chinese Communist Party.
Rule 6100
As mentioned, SOX mandates that the PCAOB inspect registered public accounting firms in both the United States and in foreign jurisdictions and investigate potential statutory, rule, and professional standards violations committed by such firms and their associated persons. The PCAOB realized early on that certain aspects of these mandates raised concerns for non-U.S. firms, including potential conflicts with local laws. To address these concerns, the PCAOB worked with international counterparts to develop arrangements and working practices to allow the PCAOB and foreign regulators to achieve their respective requirements.
To ensure that cooperation with foreign regulators maintained the spirit and requirements imposed by SOX, any arrangement with a foreign regulator must allow the PCAOB to: (i) conduct inspections and investigations in accordance with SOX; (ii) select the audit work and potential violations to be examined; and (iii) access firm personnel, audit work papers and other information and documents deemed relevant by the PCAOB.
Although most companies cooperate, not all regulators have despite repeated efforts. Over the years, the PCAOB has maintained a “Denied Access List” which identifies the jurisdictions where the PCAOB cannot conduct inspections because foreign authorities have denied access, and the auditors from those jurisdictions issue audit reports filed with the SEC for U.S.-listed foreign public companies. As of today, the PCAOB can conduct inspections everywhere it needs to do so except in mainland China and Hong Kong. Against this backdrop, Congress enacted the HFCA requiring the PCAOB to determine whether it is unable to inspect or investigate completely a registered public accounting firm that is located in a foreign jurisdiction because it is denied access by one or more authorities in that jurisdiction.
PCAOB Rule 6100 establishes the process for the PCAOB’s determinations under the HFCA; the factors the PCAOB will evaluate and the documents and information the PCAOB will consider when assessing whether a determination is warranted; the form, public availability, effective date, and duration of such determinations; and the process by which the Board will reaffirm, modify, or vacate any such determinations.
Determinations as to Registered Firms Headquartered in a Particular Jurisdiction
A determination by the PCAOB that it is denied access to a firm headquartered in a foreign jurisdiction because of a position taken by one or more authorities in that jurisdiction, applies to all firms headquartered in that jurisdiction. A jurisdiction-wide determination not only assists in the administrative efficiency of the statute, but is also consistent with the HFCA’s language that access must be denied due to a position taken by an authority (regulator/government) in that jurisdiction. Moreover, a jurisdiction wide assessment will allow for consistency.
Rule 6100 provides for jurisdiction wide determinations related to firms headquartered in that jurisdiction. “Headquarters” are defined as where the firm has its principal place of business, including where the firm’s management directs, controls and coordinates the firm’s activities. The PCAOB will make a rebuttable presumption that a firm is headquartered at the physical address reported by the firm as its headquarters to the PCAOB in the firm’s required filings. Where a firm is not headquartered but merely has a presence in the jurisdiction, the PCAOB will consider the extent of the firm’s presence and the nature of the audit work performed. However, based on experience, the PCAOB believes that most determinations will be jurisdiction-wide.
In making a jurisdiction-wide determination, the board will consider laws that restrict access, not whether the accounting firms are abiding by or availing themselves of those laws. For example, foreign laws may only deny access for certain business sectors or companies with specific business models. Even if only a few registered firms in that jurisdiction presently are auditing issuers in that sector or with that business model, the PCAOB would assess whether its access would be equally impaired should any registered firm in the jurisdiction perform the restricted engagements. Moreover, the PCAOB will consider restrictions by any regulator or governmental authority in that jurisdiction.
Determinations as to a Particular Firm with an Office in a Foreign Jurisdiction
Although as of now the PCAOB believes all determinations with be jurisdiction-wide, to account for unforeseen circumstances, Rule 6100 provides for a scenario in which the problem is with a particular firm and allows the PCAOB to make a determination of denied access on a firm-by-firm basis. For example, although it is not the case today, a foreign jurisdiction could impose rules that apply to registered accounting firms headquartered in its jurisdiction but not to firm’s that merely have an office there.
Apart from the determination being directed to a firm as opposed to a jurisdiction, the standards for making a determination are exactly the same under the Rule. Also, if a firm is a member of an international network but a separate legal entity, the other member firms will not be effected by a PCAOB determination of denied access.
Factors for Board Determinations
In determining whether it can inspect or investigate completely in a particular jurisdiction or as to a particular firm, the PCAOB will assess whether “the position taken by the authority (or authorities)” in the jurisdiction “impairs the PCAOB’s ability to execute its statutory mandate with respect to inspections or investigations.” The HFCA does not define “inspect or investigate completely.” The PCAOB defines the term broadly and includes when it is not able to commence an inspection or investigation or when, based on the PCAOB’s knowledge and experience, it has concluded that commencing an inspection or investigation would be futile as a result of the position taken by a foreign authority.
Rule 6100 ties the PCAOB’s ability to “inspect or investigate completely” to three core principles that guide the PCAOB’s framework for international cooperation. Specifically, the PCAOB will consider whether it: (i) can select the audits and audit areas it will review during inspections and the potential violations it will investigate; (ii) has timely access to firm personnel, audit work papers, and other documents and information relevant to its inspections and investigations, and the ability to retain and use such documents and information; and (iii) can otherwise conduct its inspections and investigations in a manner consistent with SOX and the PCAOB’s rules.
In making a determination, the PCAOB does not have to find that all three considerations are present. Impairment in any one respect may be sufficient under the circumstances to support a PCAOB determination. Similarly, the PCAOB does not need to conclude that it has been impaired as to both its inspections and its investigations.
Timing of Board Determinations
To begin, the PCAOB will make any determinations promptly upon the Rule’s effectiveness. Thereafter, the PCAOB will make an annual review of its findings to see if any changes in facts and circumstances warrant an adjustment to a determination, or if new jurisdictions or firms should be added. In addition, the Rule allows the PCAOB to make interim determination whenever it deems appropriate.
Basis for Determinations
Rule 6100 provides that when assessing whether its ability to execute its mandate has been impaired, the PCAOB may consider “any documents or information it deems relevant.” From there, the rule specifies three non-exclusive categories of documents and information that the PCAOB can rely upon when making a determination, but stresses that the PCAOB can consider anything it deems relevant.
The three non-exclusive categories include: (i) a foreign jurisdiction’s laws, statutes, regulations, rules, and other legal authorities as well as relevant interpretations of those laws; (ii) the entirety of the PCAOB’s efforts to reach and secure compliance with agreements with foreign authorities in the jurisdiction, including whether an agreement was reached, the terms of the agreement, interpretation and performance under the agreement; and (iii) the PCAOB’s experience with foreign authorities’ other conduct and positions relative to PCAOB’s inspections or investigations.
Form and Publication of Board Determinations
When the PCAOB makes a determination, it will issue a report to the SEC. The PCAOB’s report will describe its assessment of whether the position taken by the foreign authority (or authorities) impairs the PCAOB’s ability to execute its mandate with respect to inspections or investigations. The report will analyze the relevant factor(s) and describe the basis for the PCAOB’s conclusions. The PCAOB will identify the firm(s) subject to the PCAOB’s determination by the name under which the firm is registered with the PCAOB, and by the firm’s identification number with the PCAOB.
Promptly upon furnishing the report to the SEC, the report will be published on the PCAOB website. If necessary, the report will be redacted if it contacts private personal information that is confidential as a matter of law. A copy of the report will also be sent to the effected firm(s) by email.
Effective Date and Duration of Board Determinations
A determination becomes effective upon the PCAOB’s delivery of a report to the SEC and will be re-assessed at least annually.
Reassessment of Determination
The PCAOB will consider whether changes in facts and circumstances warrant a reassessment of a determination that is in effect. If the PCAOB concludes that a reassessment is warranted, the PCAOB will analyze the same factors as when making an initial determination and decide whether to leave its determination undisturbed or issue a new report modifying or vacating the determination. Apart from that annual process, the PCAOB also can reassess a determination on its own initiative or at the SEC’s request at any time.
« SEC Re-Visits Executive Compensation Clawback Rules SEC Updates Filing Fees And Payment Methods »
SEC Re-Visits Executive Compensation Clawback Rules
As expected, on October 14, 2021, the SEC re-opened the comment period on proposed rules on listing standards for the recovery of erroneously awarded executive compensation (“Clawback Rules”). The Clawback Rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification. The proposed rules were first published in July 2015 (see HERE) and have moved around on the SEC semiannual regulatory agenda from proposed to long-term and back again for years, but finally seem to be moving forward. Although the proposed rule remains unchanged from the July 2015 version, the SEC has added a few questions for comment in its re-opening release.
Background
There are currently existing rules which require the recovery of executive compensation and disclosure of such policies. In particular, Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) requires the CEO and CFO to reimburse the company for any bonus or other incentive-based or equity compensation for the prior 12 months, and any profits received from the sale of securities in that time period, if a company is required to prepare a restatement as a result of the misconduct related to financial reporting. In February 2021, the SEC invoked the rule in an enforcement action which it had rarely, if ever, had done before.
There are also rules which require disclosure related to executive compensation, including Clawback provisions. The Compensation Discussion and Analysis (CD&A) required by Item 402(b) requires an explanation of “all material elements of the registrant’s compensation of the named executive officers” and requires general discussions of performance including disclosure of any bonus structures and performance-based compensation and company policies and decisions regarding the adjustment or recovery of awards and payments to such named executive officers.
The proposed Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement would be prohibited. In addition to requiring companies to adopt written policies and procedures and to disclose same, the proposed Clawback Rules remove fault from the consideration of recovery, broaden the effected executives to include all named executive officers and extend the existing look-back period.
Proposed Rule
Section 954 of the Dodd-Frank Act added Section 10D to the Exchange Act, which provides that the SEC require national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not develop and implement a policy providing for the recovery of erroneously awarded compensation and for disclosure of that policy. A company would be subject to delisting if it does not adopt a compensation recovery policy that complies with the applicable listing standard, disclose the policy in accordance with SEC rules, and comply with the policy’s recovery provisions.
Specifically, the Proposed Rules would:
- Require national securities exchanges and associations to establish listing standards that require listed companies to adopt and comply with a compensation recovery policy in which recovery is required from current and former executive officers who received incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement to correct a material error. The recovery must be on a “no fault” basis without regard to whether any misconduct occurred, or the executive officer had responsibility for the misstated financial statements.
- Require that the amount of incentive-based compensation to be recovered be the amount the executive received over what they would have received based on the restated financial statement.
- Require a company to seek recovery except to the extent it would be impracticable to do so, such as where the recovery cost would exceed the amount to be recovered, or for foreign issuers, where recovery would violate home country laws.
- Prohibit companies from indemnifying current and former executive officers against the loss of recoverable incentive-based compensation.
- Require the filing of the compensation recovery policy as an exhibit to the company’s Exchange Act annual report.
- Require specific disclosure in the executive compensation disclosure section of annual reports and proxy statements, with XBRL tagging, if the company completed a restatement that required recovery in the past fiscal year or there is any recoverable amounts outstanding from any prior year.
The implementation and impact of the rule will rest on the definitions of incentive-based compensation and executive officers. The proposed rule defines “incentive-based compensation” as any compensation that is granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure, and further defining “financial reporting measure” as a measure that is determined and presented in accordance with the accounting principles used in preparing the issuer’s financial statements, any measure derived wholly or in part from such financial information, and stock price and total shareholder return. For incentive-based compensation based on stock price or total shareholder return, issuers would be permitted to use a reasonable estimate of the effect of the restatement on the applicable measure to determine the amount to be recovered.
The proposed rule defines an “executive officer” to include the company’s president, principal financial officer, principal accounting officer, any vice-president in charge of a principal business unit, division or function, and any other person who performs policy-making functions for the company and otherwise conforms to the full scope of the Exchange Act Section 16 definition.
The proposed Clawback Rules apply to all listed issuers and all securities, with limited exceptions. The proposed rules’ limited exemptions include security future products, standardized options and the securities of certain registered investment companies.
Restatements Triggering Application of Recovery Policy
The Clawback Rules require issuers to adopt and comply with policies that require recovery “in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.” The SEC includes any error that is material to the financial statements as “material noncompliance.” Accordingly, the Clawback Rules provide that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy.
The SEC clarifies that the following changes to financial statements would not trigger the recovery policy: (i) the retrospective application of a change in accounting policy; (ii) retrospective revision to a reportable division due to a company’s internal reorganization; (iii) retrospective reclassification due to a discontinued operation; (iv) retrospective application of a change in reporting entity such as from a reorganization or change in control; (v) retrospective adjustment to provisional amounts in connection with a prior business combination; or (vi) retrospective revision for stock splits.
Applicable Date and Time Period
The Clawback Rules would require the recovery of incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The date on which the company is required to prepare an accounting restatement is the earlier of (i) the date the board of directors or officers of the company, if board authorization is not required, conclude that the company’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.
Compliance with Recovery Policy
Under the proposed Clawback Rules, a company would be subject to delisting if it does not (i) adopt a compensation recovery policy that complies with the rules; (ii) disclose the policy in accordance with the rules, including XBRL tagging; and (iii) comply with its written compensation recovery policy.
Transition and Timing
The Clawback Rules would require that each national exchange propose new listing standards implementing the rules no later than 90 days following SEC publication of final rules; that such standards take effect no later than one year following SEC publication of final rules; and that each company adopt the recovery policy required by the rules no later than 60 days following the date on which the exchanges’ rules become effective.
« SEC Report On Meme Stocks SEC Affirms PCAOB Rules Implementing The Holding Foreign Companies Accountable Act »
SEC Report On Meme Stocks
On October 18, 2021, the SEC released a report on the meme stock craze that caused the securities of companies like GameStop Corp. to soar to unprecedented high trading prices and volume. Commissioners Hester Peirce and Elad Roisman criticized the report as being used as an excuse to add or consider adding additional regulations in the areas of conflicts of interest, payment for order flow, off-exchange trading, and wholesale market making when, however, no causal connection between the meme stock trading and these other factors has been established. I found the report interesting for the background and discussion on the U.S. trading markets.
Market Structure
From the perspective of individual investors, the lifecycle of a stock trade starts with an investor placing an order through an account they establish with a broker-dealer. The broker-dealer then routes the order for execution to a trading center, such as a national securities exchange, an alternative trading system (“ATS”), or an off-exchange market maker. Once a trading center executes the order, the customer receives a confirmation, the trade is reported to a securities information processor that collects, consolidates, and publishes the price and volume data to market data vendors and others. The trade details are also sent to the clearing broker, who affirms the trade by verifying the trade details. The clearing broker must “settle” an equity trade within two days of the trade date (called “T+2”) by officially moving the stock from the seller’s brokerage firm’s account to the buyer’s brokerage firm’s account and moving the money from the buyer’s brokerage firm to the seller’s brokerage firm, a process facilitated by clearing agencies. For an in-depth discussion of the U.S. capital markets clearance and settlement process, see HERE as updated HERE.
The market system and individual participants are regulated by the SEC, and under the SEC, various self-regulatory organizations (SROs, including national security exchanges, clearing agencies and FINRA). The Exchange Act includes various rules, requirements, and principles, such as those that prohibit exchanges from engaging in unfair discrimination and require them to promote the protection of investors and the public interest, as well as those that require SROs to file all proposed rule changes with the SEC. Broker-dealers register with the SEC and also become members of FINRA and, as such, are regulated by both.
Broker-dealers are subject to a multitude of rules and regulations related to trading, account opening obligations, custody of funds and securities, net capital requirements, sales practices, regulation best interest and a duty of “best execution.” Best execution requires a broker-dealer to execute customer orders at the most favorable terms reasonably available under the circumstances, generally, the best reasonably available price. In addition, FINRA rules prohibit a broker-dealer from trading ahead of customer orders – i.e., receiving a customer’s order to buy and then buying for its own account first at a price that would satisfy the customer’s order, without providing the customer with that price or better. Various rules also require disclosure of order flow and data on executions.
As mentioned, individual investors access the markets through opening accounts with a broker-dealer. Broker-dealer customers can open “cash” accounts or “margin” accounts. With a cash account, the customer must pay the full amount for securities purchased. With a margin account, the broker-dealer loans the investor money with the securities in the investor’s account serving as collateral. Individual investors in a margin account can use this money to purchase securities, sell securities short, or cover transactions in case their available cash falls below zero (i.e., overdraft). Option trading is even more sophisticated and as such a broker-dealer has increased obligations to ensure the customer is suitable for such trading.
The broker-dealer business has changed over the years with increased technology and competition resulting in very low and no commissions on a trade. To attract clients broker-dealers have become creative offering all kinds of incentives such as free stock for opening an account, no minimum account opening requirement, referral programs, celebrity and influencer marketing, social aspects in trading apps and gamification. The SEC is concerned about how these features affect investor behavior and is considering rulemaking in that regard.
Although no one is completely sure, it is thought the meme stock craze resulted from the perfect storm of (i) a huge increase in accounts opened using trading apps during the Covid lockdown; (ii) large price movements; (iii) large volume changes; (iv) an increasing short squeeze; (v) frequent Reddit mentions, including in WallStreetBets; and (vi) significant coverage in the mainstream media.
Some broker-dealers offer the ability for customers to buy fractional shares. Stocks do not trade in fractions and trades are only reported in multiples of one share. A broker-dealer fractional share program typically involves the dealer maintaining a separate account in which it either aggregates customers together for a full share or uses its own capital to purchase or sell a full share and then gives the customer a fraction of such share. These programs vary by broker-dealer, and voting or proxy rights depend on the broker-dealer’s policies.
Though retail broker-dealers have reduced commissions, some have maintained or increased other sources of revenue, such as: (i) payment for order flow; (ii) advisory services or managed accounts from broker-dealers that are dually registered as investment advisers or from affiliated investment advisers; (iii) interest earned on margin loans and cash deposits; (iv) income generated from securities lending; and (v) fees from additional services.
Payment for Order Flow
In the past few years, most broker-dealers have stopped charging fees for processing trades. To make up for this lost income, they make money by charging market makers for funneling order flow through them. The process is called payment for order flow. Robinhood reported $331 million of revenue for Q1 this year in payment for order flow – it is a big business. Also, most exchanges offer a form of payment for order flow wherein they compensate firms that provide liquidity with rebates and charge firms that take liquidity
Payment for order flow can be broken down into two categories: payment from wholesalers to brokers, and payment from exchanges to market makers and brokers. In a payment from wholesalers to brokers process, retail broker-dealers enter into agreements with wholesalers to purchase their order flow. Unlike public exchanges that must offer fair access to their publicly displayed quotes, these wholesalers can decide whether to execute these orders directly or to pass them along to be executed by the exchanges or other trading venues. The SEC is concerned that payment for order flow creates a conflict of interest by brokers to create more trading so they can charge a market maker for funneling those trades through them.
Order Execution, Clearance and Settlement
When an order is received, the broker-dealer routes the order for execution to a trading center, such as a national securities exchange, an alternative trading system (“ATS”), or an off-exchange market maker. Even if an order is executed off-exchange, the price is that quoted on the exchange. More than 40% of trades are executed off-exchange. Off-exchange market makers have more flexibility compared to on-exchange participants because they are not subject to the rules of the exchanges on which they quote. For example, exchanges require quotes in penny increments whereas wholesalers can execute in sub-pennies.
In January 2021, when the meme stocks were trading in unprecedented volumes, some retail broker-dealers restricted buying in certain stocks. Clearing agencies act as the central counterparty for almost all equities and options trades in the U.S. markets by functionally serving as the buyer to every seller and the seller to every buyer to lessen the risks associated with one counterparty to the trade failing to perform (i.e., deliver the securities or the money to pay for them). The NSCC, which is part of the DTCC system, maintains a “Clearing Fund” into which its member broker-dealers contribute margin to protect NSCC from potential losses arising from a defaulted member’s portfolio until it is able to close out that member’s positions.
The amount any member has to maintain in the Clearing Fund is based on complicated algorithmic calculations that include trading price, daily activity and risk assessments. On January 27, 2021, in response to market activity during the trading session, NSCC made intraday margin calls from 36 clearing members totaling $6.9 billion, bringing the total required margin across all members to $25.5 billion. In short, the amount that was required to be deposited with the clearing agency, by members as a result of the huge volatility in stocks such as GameStop caused some broker-dealers to restrict buying.
There are no rules that prevent a broker-dealer from restricting trading in any of its customer accounts. The impact on these broker-dealers raises question about the possible effects of acute margin calls on more thinly capitalized broker-dealers and other means of reducing their risks. One method to mitigate the systemic risk posed by such entities to the clearinghouse and other participants is to shorten the settlement cycle.
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Public Market Listing Standards
One of the bankers that I work with often once asked me if I had written a blog with a side-by-side comparison of listing on Nasdaq vs. the OTC Markets and I realized I had not, so it went on the list and with the implementation of the new 15c2-11 rules, now seems a very good time to tackle the project. I’ve added NYSE American to the list as well.
Quantitative and Liquidity Listing Standards
Nasdaq Capital Markets
To list its securities on Nasdaq Capital Markets, a company is required to meet: (a) certain initial quantitative and qualitative requirements and (b) certain continuing quantitative and qualitative requirements. The quantitative listing thresholds for initial listing are generally higher than for continued listing, thus helping to ensure that companies have reached a sufficient level of maturity prior to listing. NASDAQ also requires listed companies to meet stringent corporate governance standards.
Requirements | Equity Standard | Market Value ofListed Securities
Standard |
Net IncomeStandard |
Listing Rules | 5505(a) and5505(b)(1) | 5505(a) and5505(b)(2) | 5505(a) and5505(b)(3) |
Stockholders’ equity | $5 million | $4 million | $4 million |
Market value of unrestricted publicly held shares | $15 million | $15 million | $5 million |
Operating history | 2 years | N/A | N/A |
Market value of listed securities | N/A | $50 million* | N/A |
Net income from continuing operations (in the latest fiscal year or in two of the last three fiscal years) | N/A | N/A | $750,000 |
Unrestricted publicly held shares | 1 million | 1 million | 1 million |
Bid price orClosing Price** | $4$3 | $4$2 | $4$3 |
Corporate governance | Yes | Yes | Yes |
Unrestricted round lot shareholders*** | 300 | 300 | 300 |
Market Makers | 3 | 3 | 3 |
Listing Fee | Application fee – $5,000 first year annual fee depends on listed shares and ranges from $50,000 – $75,000 | Application fee – $5,000 first year annual fee depends on listed shares and ranges from $50,000 – $75,000 | Application fee – $5,000 first year annual fee depends on listed shares and ranges from $50,000 – $75,000 |
Total IPO Expenses**** | Approximately $750,000 | Approximately $750,000 | Approximately $750,000 |
* Currently traded companies qualifying solely under the Market Value Standard must meet the $50 million market value of listed securities and the applicable bid price requirement for 90 consecutive trading days before applying.
** To qualify under the closing price alternative, a company must have: (i) average annual revenues of $6 million for three years, or (ii) net tangible assets of $5 million, or (iii) net tangible assets of $2 million and a 3-year operating history, in addition to satisfying the other financial and liquidity requirements listed above.
*** Securities subject to resale restrictions for any reason are excluded from the calculation of publicly held shares, market value of publicly held shares and round lot shareholders. In addition, except for SPACs listing under IM-5101-2, at least half of the minimum required number of round lot holders must each hold unrestricted securities with a minimum value of $2,500.
**** Includes legal, accounting, audit, underwriter expense reimbursement, SEC filing fee, road show expenses, EDGAR fees, Nasdaq listing fee, FINRA filing fee and DTC eligibility. Does not include underwriter commission/discount.
In addition to the above requirements, if the security is trading in the U.S. over-the-counter market as of the date of application, the security must have a minimum average daily trading volume of 2,000 shares (including trading volume of the underlying security on the primary market with respect to an ADR), over the 30-trading-day period prior to listing, with trading occurring on more than half of those 30 days, unless such security is listed on the Exchange in connection with a firm commitment underwritten public offering of at least $4 million.
Companies seeking listing in connection with a Regulation A offering must, at the time of approval of the listing, have a minimum operating history of two years.
A company that principally administers its business in a Restrictive Market, and is conducting an initial public offering, must offer a minimum amount of securities in a firm commitment underwritten public offering in the U.S. to public holders that (i) will result in gross proceeds to the company of at least $25 million or (ii) will represent at least 25% of the company’s post-offering Market Value of Listed Securities, whichever is lower. A company that is conducting a business combination with an entity that principally administers its business in a Restrictive Market must have a minimum market value of unrestricted publicly held shares following the business combination equal to the lesser of (i) $25 million or (ii) 25% of the post-business combination entity’s market value of listed securities. A “Restrictive Market” is one in which Nasdaq determines to have secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction. In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s: (i) principal business segments, operations or assets; (ii) board and shareholders’ meetings; (iii) headquarters or principal executive offices; (iv) senior management and employees; and (v) books and records.
NYSE American (MKT)
Like Nasdaq, to list its securities on the NYSE MKT, a company is required to meet: (a) certain initial quantitative and qualitative requirements and (b) certain continuing quantitative and qualitative requirements. Unlike Nasdaq, the NYSE MKT does not exclude restricted securities from its liquidity standards, including round lot shareholders, market value of publicly held shares or total shares outstanding.
Criteria | Standard 1 | Standard 2 | Standard 3 | Standard 4a | Standard 4b |
Pre-tax Income(1) | $750,00 | N/A | N/A | N/A | N/A |
Market capitalization | N/A | N/A | $50 million | $75 million | N/A |
Total assets and total revenues | N/A | N/A | N/A | N/A | $75 million in total assetsand $75 million in revenues(1) |
Market value of public float(2) | $3 million | $15 million | $15 million | $20 million | $20 million |
Minimum Price | $3 | $3 | $2 | $3 | $3 |
Operating History | N/A | 2 years | N/A | N/A | N/A |
Shareholders’ Equity | $4 million | $4 million | $4 million | N/A | N/A |
Public shareholders/Public float (shares)(2) | Option 1: 800/500,000 Option 2: 400/1,000,000 Option 3: 400/500,000(3) |
||||
Listing Fee | $5,000 application fee and annual fee of either $50,000 or $75,000 depending on number of shares | ||||
Total IPO Expense | Approximately $750,000 – Includes legal, accounting, audit, underwriter expense reimbursement, SEC filing fee, road show expenses, EDGAR fees, NYSE listing fee, FINRA filing fee and DTC eligibility. Does not include underwriter commission/discount. |
(1) Required in the latest fiscal year, or two of the three most recent fiscal years.
(2) Public shareholders and public float do not include shareholders or shares held directly or indirectly by any officer, director, controlling shareholder or other concentrated (i.e., 10 percent or greater), affiliated or family holdings.
(3) Option 3 requires a daily trading volume of at least 2,000 shares during the six months prior to listing.
OTCQX AND OTCQB
OTC Markets also has qualitative and quantitative listing standards which increase based on the tier being quoted on and whether a company reports to the SEC or alternatively to OTC Markets. Note I did not include the listing qualifications for the OTCQX Premier, which have increased qualitative standards across the board.
Criteria | OTCQB U.S. | OTCQB International | OTCQX U.S. | OTCQX International |
Audit Requirements | Audited Financials in accordance with U.S. GAAP by PCAOB auditor.
One year only for Alternative Reporting |
Audited under qualified foreign exchange requirements which must be either IFRS, home country GAAP or U.S. GAAP | Audited Financials in accordance with U.S. GAAP by PCAOB auditor
One year only for Alternative Reporting |
Audited under qualified foreign exchange requirements which must be either IFRS, home country GAAP or U.S. GAAP |
Reporting and Disclosure | SEC reporting, Regulation A reporting, Bank Reporting or Alternative Reporting | Listed on a qualified foreign exchange and compliant with Exchange Act Rule 12g3-2(b) or be SEC reporting
If foreign exchange, must post reports on OTC Markets through the OTCIQ System. |
SEC reporting, Regulation A reporting, Bank Reporting or Alternative Reporting | Listed on a qualified foreign exchange and compliant with Exchange Act Rule 12g3-2(b) or be SEC reporting
If foreign exchange, must post reports on OTC Markets through the OTCIQ System. |
Minimum Bid Price* | $.01 | $.01 | $.25 | $.25 |
Round Lot Shareholders | 50 | 50 | 50 | 50 |
Freely tradeable Public Float** | 10% of the total issued and outstanding trading security | 10% of the total issued and outstanding trading security | 10% of the total issued and outstanding trading security | 10% of the total issued and outstanding trading security |
Transfer Agent | Must participate in Transfer Agent Verified Share Company | Must be SEC registered | Must participate in Transfer Agent Verified Share Company | Must be SEC registered |
OTC Sponsor | N/A | Must have letter of introduction from qualified OTC Markets Sponsor | Must have letter of introduction from qualified OTC Markets Sponsor | Must have letter of introduction from qualified OTC Markets Sponsor |
Company Profile | Submit verified company profile through OTCIQ | Submit verified company profile through OTCIQ | Submit verified company profile through OTCIQ | Submit verified company profile through OTCIQ |
Certification | Post certification signed by CEO/CFO verifying officers, directors, affiliates and advisors | Post certification signed by CEO/CFO verifying officers, directors, affiliates and advisors | Post certification signed by CEO/CFO verifying officers, directors, affiliates and advisors | Post certification signed by CEO/CFO verifying officers, directors, affiliates and advisors |
Penny Stock Rule*** | N/A | N/A | Must not be a penny stock | Must not be a penny stock |
Market Capitalization | N/A | N/A | $10 million | $10 million |
Market Makers | N/A | N/A | N/A | 1 |
Dilution Risk (for more on this, see HERE) | A key consideration in the application process | A key consideration in the application process | A key consideration in the application process | A key consideration in the application process |
Listing Fee | $5,000 application fee; $14,000 a year; beginning Jan 1, 2022 – $14,220 a year | $5,000 application fee; $14,000 a year; beginning Jan 1, 2022 – $14,220 a year | $5,000 application fee; $23,000 a year; beginning Jan 1, 2022 – $23,400 a year | $5,000 application fee; $23,000 a year; beginning Jan 1, 2022 – $23,400 a year |
IPO Expenses**** | Approximately $400,000 | Approximately $60,000 | Approximately $400,000 | Approximately $75,000 |
* Must meet the minimum closing bid price for each of the 30 consecutive days immediately preceding the company’s application. If listing in conjunction with an IPO, OTC Markets may exempt this requirement but the company must have a market maker meet the minimum closing bid price quote within 3 days of confirmation of quotation eligibility under Rule 15c2-11.
** OTC Markets may grant an exemption to this requirement if (i) at least 5% of the public float is freely tradeable and has a market value of $2 million or more; or (ii) the company has a separate class of securities traded on a national exchange.
*** Company must be penny stock exempt based on audited financials dated within 15 months of the listing. Must meet one of the following penny stock exemptions: (i) Net tangible assets – at least $5 million if less than 3 years of operations or at least $2 million if 3+ years of operations; (ii) Revenue – $6 million average for last 3 years; or (iii) Bid price of $5 or more and one of the following (a) net income of $500,000; (b) net tangible assets of $1 million; (c) revenue of $2 million or (d) total assets of $10 million.
**** Includes legal, accounting, audit, underwriter expense reimbursement, SEC filing fee, road show expenses, EDGAR fees, listing fee, FINRA filing fee and DTC eligibility. Does not include underwriter commission/discount. For international companies, presumes no concurrent capital raise.
Qualitative and Governance Standards
Nasdaq and NYSE MKT
Companies must meet the following corporate governance standards:
Corporate Governance Requirement | Description |
Distribution of Annual or Interim Reports | The company must make its annual and interim reports available to shareholders, either by mail or electronically through the company’s website. |
Independent Directors | The Exchange has various requirements regarding a company’s independent directors and audit committee. Although generally the company’s board of directors is required to have a majority of independent directors, there are several exceptions, such as for a controlled company or foreign private issuers.
For a review of the new Nasdaq board diversity rules, see HERE.
For a review of Nasdaq board independence standards, see – HERE.
For a review of the NYSE MKT board independence standards, see – HERE |
Audit Committee |
The company is required to have an audit committee consisting solely of independent directors who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements. The audit committee must have at least three members. One member of the audit committee must have experience that results in the individual’s financial sophistication.
For a drill down on Nasdaq audit committee requirements, see – HERE..
For a drill down on NYSE MKT audit committee requirements, see – HERE. |
Compensation of Executive Officers |
The company is required to have a compensation committee consisting solely of independent directors and having at least two members. The compensation committee must determine, or recommend to the full board for determination, the compensation of the chief executive officer and all other executive officers. Controlled companies and foreign private issuers are exempt from this requirement. |
Nomination of Directors | Independent directors must select or recommend nominees for directors. Controlled companies and foreign private issuers are exempt from this requirement. |
Code of Conduct | The company must adopt a code of conduct applicable to all directors, officers and employees. |
Annual Meetings |
The company is required to hold an annual meeting of shareholders no later than one year after the end of its fiscal year. |
Solicitation of Proxies |
The company is required to solicit proxies for all shareholder meetings. |
Quorum |
The company must provide for a quorum of not less than 33 1/3% of the outstanding shares of it voting stock for any meeting of the holders of its common stock. |
Conflict of Interest |
The company must conduct appropriate review and oversight of all related party transactions for potential conflict of interest situations. |
Shareholder Approval | The company is required to obtain shareholder approval of certain issuances of securities, including:· Acquisitions where the issuance equals 20% or more of the pre-transaction outstanding shares, or 5% or more of the pre-transaction outstanding shares whena related party has a 5% or greater interest in the acquisition target (see HERE)
· Issuances resulting in a change of control (see HERE) · Equity compensation (see HERE) · Private placements where the issuance equals 20% or more of the pre-transaction outstanding shares at a price less than the greater of book or market value (see HERE) |
Voting Rights | Corporate actions or issuances cannot disparately reduce or restrict the voting rights of existing shareholders.
For a review of the voting rights rules, see – HERE. |
OTC Markets
Requirement | OTCQB U.S. | OTCQB International | OTCQX U.S. | OTCQX International |
Bankruptcy or Reorganization Proceedings | Company does not qualify | Company does not qualify | Company does not qualify | Company does not qualify |
Independent Directors | If Alternative Reporting must have at least 2 independent directors | N/A | 2 independent directors | N/A |
Audit Committee | If Alternative Reporting must have a audit committee with a majority of independent directors | N/A | Audit committee with a majority of independent directors | N/A |
Shell Company or Blank Check Company | N/A | N/A | Company does not qualify | N/A |
Shareholder Meetings | N/A | N/A | Must conduct annual shareholder meeting and make financial reports available to its shareholders at least 15 calendar days prior to such meeting | N/A |
Application Process
Regardless of whether you are applying to list on the OTC Markets or a national securities exchange, the process is similar. All venues conduct background checks on officers/directors/significant shareholders, conduct thorough due diligence on the applicant company and engage in a comment and response process. In addition, both the Nasdaq and NYSE MKT consider the companies ability to maintain the continued listing requirements in the future, generally for a minimum period of 18 months (6 quarters) considering assets, cash flows, burn rates, and reductions in shareholder’s equity.
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