SEC Denies Expert Market – For Now
Posted by Securities Attorney Laura Anthony | August 22, 2021 Tags: ,

As the compliance date for the new 15c2-11 rules looms near, on August 2, 2021, in a very short statement, the SEC shot down any near-term hope for an OTC Markets operated “expert market.”  The SEC short statement indicated that a review of the proposed exemptive order that would allow the expert market is not on its agenda in the short term.  The SEC continued that “[A]ccordingly, on September 28, 2021, the compliance date for the amendments to Rule 15c2-11, we expect that broker-dealers will no longer be able to publish proprietary quotations for the securities of any issuer for which there is no current and publicly available information, unless an existing exception to Rule 15c2-11 applies.”

The statement acts as a great segue for a review as to just what those exceptions may be.  In addition, this blog will discuss the OTC Markets proposed expert market and finish with a broader refresher on the new 211 rules including the current public information requirements for each class of issuer.  For an in-depth discussion of the amended rules, see HERE.

Also, importantly, even for companies that believe they are current in their OTC Markets Alternative Reporting requirements, OTC Markets requires that the company profile be verified through the OTCIQ system as part of the 211 compliance process.  OTC Markets has indicated that profiles must be updated by August 9 to ensure their compliance team has sufficient time to confirm the availability of current public information and update company information prior to the rule’s September effective date.

As more fully described below, current information works on a 180-day timeline from the date of the end of a reporting period.  Since most companies have a calendar year reporting period, the SEC picked September 28th as the compliance deadline because that is exactly 181 days from March 31st.  Assuming a report is filed for the March 31st quarter end, the company will remain piggyback qualified from April 1st through September 27th inclusive.  If the Company does not file its June 30th report, it will lose qualification on September 28th (the compliance date) because the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.

Adding pressure to the thousands of companies that will be impacted by the new rules, on July 20, TD Ameritrade published a 162-page list of over 6,000 companies that do not have current public information, for which it will accept liquidating orders only, beginning mid-August.  That list was reduced to 3,500 companies by August 2nd and as of today, TD Ameritrade has suspended its plans to cease trading for the time being as companies continue to get up.

15c2-11 Exceptions

  1. Piggyback Exception

Under the new rules, the SEC is requiring that a company’s current publicly available information be timely filed or filed within 180 calendar days from a specified date, depending on the category of company, for a broker-dealer to rely on the piggyback exemption to publish quotations.  The chart below summarizes the filing requirements.  The 180-day period begins on the date that a reporting period ends.  Accordingly, for example, if a SEC reporting issuer has a December 31 year-end and filed a report for that period, quotations for the period January 1 – June 29 inclusive, would be covered by the piggyback exception.  If the same issuer filed its quarterly reports for March 31, June 30 and September 30, the 180-day period would extend from each of those dates (until April 30 of the following year).  However, if the same issuer failed to file its September 30 10Q, it would no longer be able to rely on the piggyback exception beginning December 28 (180 days following June 30) because following that date, the company would not have current and publicly available information with respect to any reporting period that ended 180 calendar days before the publication or submission of the quotation.

In making the calculation for an alternative reporting (catch-all) company, a broker-dealer must ensure that current information is dated within 12 months of the publication of the quotation and that the balance sheet is less than 16 months old.  Accordingly, for example, if the alternative reporting company has a December 31 year-end, and filed its annual report for December 31, 2020 including all the required information (with a balance sheet dated after September 1, 2019 and a profit and loss for the 12 months preceding that period), a broker-dealer could continue to rely on the piggyback exception until December 31, 2021.

Of course, maintaining current information requires more than just financial statements.  As further discussed below, where SEC or other regulatory requirements prescribe the information that must be reported (such as for a foreign private issuer), Rule 15c2-11 does not require different information.  The Rule, however, does prescribe the information required by a catch-all company.  The OTC Markets has updated its current information reporting requirements to encompass all of the information and requirements in the new Rule.

The amended rule adds a 15-day conditional grace period from the date of a publicly available determination that a company no longer has current information within the 180-day specified period as set forth in the chart below, for a broker-dealer to continue to quote the particular security. The purpose of the grace period is to give the markets notice that the company is in danger of no longer being quoted and provide investors with an opportunity to liquidate positions.  In order to use the grace period, three conditions must be met: (i) OTC Markets or FINRA must make a public determination that current public information is no longer available within 4 business days of the information no longer being available (i.e., expiration of the time periods in the chart); this could be by, for example, a tag on the quote page or added letter to the ticker symbol; (ii) all other conditions for reliance on the piggyback exception must be effective (such as a one way quote); and (iii) the grace period ended on the earliest of the company once again making current information publicly available or the 14th calendar day after OTC Markets or FINRA makes the public determination in (i) above.  I note that once OTC Markets has made a publicly available determination that a broker-dealer may rely on the piggyback exception, it has an affirmative duty to make a publicly available determination that the same company no longer has publicly available current information as required by the rule.

The SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggyback exception; rather, the amended rule provides for a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations.  A broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period.  Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter-end.  Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility.  Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility.

To reduce some of the added burdens of the rule change, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the piggyback exception have been met.  To be able to properly keep track of piggyback exception eligibility, OTC Markets will need to establish, maintain, and enforce reasonably designed written policies and procedures to determine, on an ongoing basis, whether the documents and information are, depending on the type of company, filed within the prescribed time periods.

The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:

Category of Company 15c2-11 Current Information
Exchange Act reporting company Filed within 180 days following end of a reporting period.
Regulation A reporting company Filed within 120 days of fiscal year-end and 90 days of semi-annual period end
Regulation Crowdfunding filer Filed within 120 days of fiscal year-end.
Foreign Private Issuer Since first day of most recent completed fiscal year, has filed information required to be filed by the laws of home country or principal exchange traded on.
Catch-all company Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet.

Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e., approximately 2 years and 2 months).  A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date.


In addition to the current publicly available information requirement, to rely on the piggyback exception, the new rules require: (i) at least a one-way priced quotation at a specified price (either bid or ask); and (ii) that no more than 4 days in succession have elapsed without a quotation (frequency of quotation requirement).  Although the priced quotation must be at a specified price, there is no minimum threshold (for example, it does not have to be above $0.01).  For a broker-dealer to rely on the piggyback exception, a quoted OTC security of an issuer would need to be the subject of a bid or offer quotation, at a specified price, with no more than four business days in succession without such a quotation.

The initial rule proposal contained a provision that would have eliminated the piggyback exception altogether for shell companies.  This provision received significant pushback and would have had a huge chilling effect on reverse merger transactions in the OTC Markets.  In response to the pushback, the final rule allows for broker-dealers to rely on the piggyback exception to publish quotations for shell companies for a period of 18 months following the initial priced quotation on OTC Markets.  In essence, a shell company is being granted 18 months to complete a reverse merger with an operating business, or in the alternative, to organically begin operations itself.  The amended rules only allow the piggyback exception for a period of 18 months following the initial quotation.   The first 18-month period for a shell company will begin on September 18, the compliance date for the new rules.   If a company remains a shell at the end of the 18-month period, it will lose piggyback eligibility and a new 211 compliance review would be necessary.

The rule adopts a definition of shell company that tracks Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2, but also adds a “reasonable basis” qualifier to help broker-dealers and OTC Markets make determinations.  A shell company is defined as any issuer, other than a business combination related shell company as defined in Rule 405 or asset backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents.  A company will not be considered a shell simply because it is a start-up or has limited operating history.  To have a reasonable basis for its shell company determination, a broker-dealer or the OTC Markets can review public filings, financial statements, business descriptions, etc.

In addition, a broker-dealer may not rely on the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act.

Understanding the dramatic change and impact the new rules will have on the OTC Market place, the SEC will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule.  In a request for relief, the SEC will consider all facts and circumstances including whether based on information provided, the issuer or securities are less susceptible to fraud or manipulation.   The SEC may consider securities that have an established prior history of regular quoting and trading activity; companies that do not have an adverse regulatory history; companies that have complied with any applicable state or local disclosure regulations that require that the company provide its financial information to its shareholders on a regular basis, such as annually; companies that have complied with any tax obligations as of the most recent tax year; companies that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors.  At the time of the rule release, the SEC suggested that requests for relief be submitted as soon as possible to prevent a quotation interruption prior to the rule’s implementation.  At the time of publication of this blog, I am unsure if the SEC could entertain such a request prior to the September 28 deadline.

  1. Unsolicited Quotation Exception

Rule 15c2-11 has an unsolicited quotation exception.  That is, a broker-dealer may issue a quote where such quotation represents unsolicited customer orders.  The Rule requires a broker-dealer that is presented with an unsolicited quotation to determine whether there is current publicly available information.  If no current available information exists, the unsolicited quotation exception is not available for company insiders or affiliates.  The Rule defines “affiliate” using the same language as Rule 144 and in particular “[A]n affiliate of an issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer.”  This definition encompasses officers and directors and presumptively covers shareholders owning 10% or more of the outstanding securities.

A broker-dealer may rely on a written representation from a customer’s broker that such customer is not a company insider or an affiliate.  The written representation must be received before and on the day of a quotation.  Also, the broker-dealer must have a reasonable basis for believing the customer’s broker is a reliable source including, for example, obtaining information on what due diligence the broker conducted.  Like the piggyback exception, a broker-dealer will be able to rely on a qualified IDQS (OTC Markets) or a national securities association (FINRA) determination that there is current publicly available information.

  1. ADTV and Asset Test Exception

Rule 15c2-11 has an ADTV and asset test exception for securities that are considered lower-risk.  To rely on this exception, the security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”).

The ADTV test requires that the security have a worldwide reported ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation.  To satisfy the final ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade)

The asset test requires that the company have at least $50 million in total assets and stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end.  This would cover both domestic and foreign issuers.

The rule also creates an exception for a company who has another security concurrently being quoted on a national securities exchange.  For example, some companies quote their warrants or rights on OTC Markets following a unit IPO offering onto a national exchange.

Like the piggyback exception, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the ADTV and asset test or the exchange-traded security exception have been met.  Conversely, if OTC Markets or FINRA is publishing the availability of an exception, they will also need to publish when such exception is no longer available.

  1. Underwritten Offering Exception

The Rule has an exception to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This change may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.  This exception requires that the broker-dealer have the 211 current information in its possession and have a reasonable basis for believing the information is accurate and the sources of information are reliable.

OTC Markets Request for Exemptive Order for Expert Market

OTC Markets requested an exemptive order with the SEC to permit broker-dealers to publish or submit proprietary quotations for securities, on a continuous basis, in a market where the distribution of such quotations is restricted to sophisticated or professional investors, without complying with the information review and recordkeeping requirements of amended Rule 15c2-11.  The SEC published the proposed exemptive order and requested public comment.

OTC Markets currently maintains an expert market which allows broker-dealer subscribers to, among other things, find price transparency in certain securities that may not be eligible or suitable for retail investors.  The request for exemptive relief would modify that expert market to provide greater access to certain retail investors.  An expanded expert market is intended to provide a marketplace, limited to sophisticated or professional investors, for grey market securities or small companies seeking growth opportunities that might prefer to be quoted in a more limited market.

Under the proposed conditional exemptive order, OTC Markets Group would authorize market data distributors, including Subscribers, to be eligible to receive quotations published or submitted on the Expert Market and to distribute such data to Subscribers who comply with certain obligations and restrictions on data access set forth in a Market Data Distribution Agreement (“MDDA”).  The MDDA would, among other things, restrict end users and the distribution to any third parties that do not qualify as a permitted recipient, and would require that the distributor or subscriber report all end users to OTC Markets.

Permitted recipients (“Qualified Experts”) or expert market users would include: (i) any qualified institutional buyer as defined in Rule 144A (generally must own and invest $100 million in securities); (ii) any accredited investor as defined in Rule 501(a) (see HERE); and (iii) any qualified purchaser as defined in Section 2 of the Investment Company Act of 1940 (generally have $5 million or more in securities).

Qualified securities on the expert market would include: (i) companies that are currently quoted under the piggyback exception and lose qualification on the compliance date for the amended rules (September 28); (ii) companies that lose 211 compliance in the future due to a lack of current public information, shell status or failure to meet the frequency of quotation requirement; and (iii) any security that is issued in conjunction with a Chapter 11 bankruptcy plan under Section 1145 of the Bankruptcy Code.  Securities that had been subject to a registration revocation or defunct companies would not be able to be quoted.

In operating the expert market under the proposed exemptive relief, OTC Markets would establish, maintain, and enforce written policies and procedures that are reasonably designed to allow only permitted recipients to view, and to prevent the general public from viewing, quotations published or submitted on the expert market. OTC Markets would also establish procedures to surveil the use of the expert market to ensure compliance with the MDDA.

As noted at the beginning of this blog, the SEC has taken any action on this Order off the table, at least in the near term.

More on Amended Rule 15c2-11

Amended Rule 15c2-11: (i) requires that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limits certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduces regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allows OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamlines the rule and eliminate obsolete provisions.

The amended Rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security.  The rule release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout.  The only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.  However, if new IDQS platforms or national securities associations develop, they would also be covered by the Rule.

A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review.  Keeping the rule’s current 3-business-day requirement, a broker-dealer’s quotation must be published or submitted within 3 business days after the qualified IDQS (OTC Markets) makes a publicly available determination.

Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies to file Forms 211 with FINRA.  I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews.

Current Public Information Requirements

The amended Rule (i) requires that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permits additional market participants to perform the required review (i.e., OTC Markets); and (iii) expands some categories of information required to be reviewed.

To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation.  The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation.

The catch-all category encompasses companies that alternatively report on OTC Markets, as well as companies that are delinquent in their SEC reporting obligations – provided, however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggyback exception.

For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence.  The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet.

Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied.  In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension.  The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggyback exception, for continued quotations.

Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.  In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information.  Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.

The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available.  Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security.  The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.

Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present.  Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application.  I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements.

Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer.  The posted information must not be password-protected or otherwise user-restricted.  A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.

Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame as laid out in the chart above. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation.  A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.

The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category.  A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet.  However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.  A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet.

The categories of information required to be reviewed will also expand.  For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officers, and directors.  In addition, records must be reviewed, and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.  As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10%-or-greater shareholders unless the company has current publicly available information.

The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets.  In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system.  If OTC Markets completes the 211 review, the broker-dealer, upon confirming that the 211 information is current and publicly available, is excepted from performing a separate review and can proceed to quote that security.

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SEC Spring 2021 Regulatory Agenda
Posted by Securities Attorney Laura Anthony | July 30, 2021 Tags:

The first version of the SEC’s semiannual regulatory agenda and plans for rulemaking under the current administration has been published in the federal register.  The Spring 2021 Agenda (“Agenda”) is current through April 2021 and contains many notable pivots from the previous SEC regime’s focus.  The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.

The Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions.  The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that.  The number of items to be completed in a 12-month time frame jumped up to 45 items since Fall, which had only 32 items.  Some of the new items are a revisit of previously passed rule changes.  Although a big jump from Fall 2020, 45 is in line with prior years.  The Spring 2019 Agenda had 42 and the Fall 2019 had 47 on the list.

Items on the Agenda can move from one category to the next or be dropped off altogether.  New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.

Four items appear in the pre-rule stage including prohibition against fraud, manipulation, and deception in connection with security-based swaps which was also on the Fall Agenda.  Added to the list are exempt offerings, third-party service providers and gamification.    Third-party service providers refer to the asset management industry and includes services such as index and model providers.  Under the gamification category, the SEC is considering seeking public comment on potential rules gamification, behavioral prompts, predictive analytics, and differential marketing.  Gary Gensler talked about gamification issues in a recent speech – see HERE

Interestingly, the SEC HERE; offering communications (HERE); amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (HERE); Regulation A (HERE); and Regulation CF (HERE).

The Agenda indicates that the SEC is now planning on seeking public comment on ways to further updated the SEC rules for exempt offerings “to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.”  All of these were points of contention during the rule amendment process.  Also in August 2020, the SEC updated the definition of an accredited investor and specifically decided not to increase the financial thresholds (see HERE).  Seems we could be going back to the beginning in this whole process.  As a practitioner I am frustrated by the idea that the SEC’s rulemaking could be so partisan-driven.  Historically, that was not the case.  Certainly, we have seen a different focus with new administrations but not a seesaw of rulemaking.

Thirty-six items are included in the proposed rule stage, up from just 16 on the Fall 2020 list, and include plenty of brand-new interesting topics.  New to the proposed rule list are ESG related items including climate change and human capital disclosure.  In addition to many public announcements on the topic of climate change, in March, the SEC issued a statement requesting public input on climate change disclosure with a focus on enhancing and updating the prior 2010 guidance (see HERE), it is now considering rule amendments to further enhance the disclosure requirements. Further proposed items in the ESG category are rules related to investment companies and investments advisors addressing environmental, social and governance factors.

Also new to the list is special purpose acquisition companies (SPACs) which could include a plethora of potential rule changes such as specific exclusion from the protections of Private Securities Litigation Reform Act (PSLRA), enhanced disclosure requirements, amendments to Exchange listing requirements and changes to accounting treatment, among others (see HERE).  Rule 10b5-1 and in particular, a review of affirmative defenses available for insider trading cases, has been added to the proposed rule list.  This is a topic Gary Gensler and the current SEC top brass have been vocal about in public speeches.  Similarly, potential changes to Section 10 liability provisions surrounding loans or the borrowing of securities now appear on the proposed rule list.

Another hot topic amongst the SEC and marketplace has been share repurchase programs by public companies, including the potential they unfairly benefit insiders selling into the upmarket created by the repurchase programs.  Share repurchase disclosure modernization has been added to the proposed rule list. Likewise, market structure reform including related to payment for order flow, best execution and market concentration are new to the Agenda in the proposed rule category.  Gary Gensler gave a heads-up that this was a priority in his May 6, 2021 speech to the House Financial Services Committee (see HERE).  Keeping in the market structure category, the SEC is considering amending the rules to shorten the standard settlement cycle.  The historical t+3 was shortened to t+2 back in March 2017 (see HERE) and many believe that technology can currently handle t+1 with a goal of reaching simultaneous settlement (t+0).

Rounding out new items on the Agenda appearing on the proposed rule list include disclosure regarding beneficial ownership of swaps including interests in security-based swaps; cybersecurity risk governance which could enhance company disclosure requirements regarding cybersecurity risk; electronic submission of applicators for orders under the Advisors Act, confidential treatment requests for filings on Form 13F, and ADV-NR; open-end fund liquidity and dilution management; incentive-based compensation arrangements at certain financial institutions that have $1 billion or more in total assets; and portfolio margining of uncleared swaps and non-cleared security-based swaps.

Many items remain on the proposed list including mandated electronic filings increasing the number of filings that are required to be made electronically; potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and records to be preserved by certain exchange members, brokers and dealers.

Amendments to the transfer agent rules still remain on the proposed rule list although it has been four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE).  Former SEC top brass suggested that it would finally be pushed over the finish line last year, but so far it remains stalled (see, for example, HERE).

Another controversial item still appearing on the proposed rule stage list is enhanced listing standards for access to audit work papers and improvements to the rules related to access to audit work papers and co-audit standards.  In June 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market” (see HERE).

Bolstering Nasdaq’s position, the Division of Trading and Markets and the Office of the Chief Accountant are considering jointly recommending (i) amendments to Rule 2-01(a) of Regulation S-X to provide that only U.S. registered public accounting firms will be recognized by the SEC as a qualified auditor of an issuer incorporated or domiciled in non-cooperating jurisdictions for purposes of the federal securities laws, and (ii) rule amendments to enhance listing standards of U.S. national securities exchanges to prohibit the initial and continued listing of issuers that fail to timely file with the SEC all required reports and other documents, or file a report or document with a material deficiency, which includes financial statements not prepared by a U.S. registered public accounting firm recognized by the SEC as a qualified auditor.

It is not just the pre-rule stage that reflects a re-do of recently enacted rules.  The disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE and finalized in December 2020 (see HERE) is now on the proposed rule list to determine if additional amendments might be appropriate.  Keeping with a seeming willingness to subject the marketplace to continued regulatory uncertainty, back on the proposed list is amendments to the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8.  After years of discussion and debate, the SEC adopted much-needed rule changes in September 2020 (see HERE) which are now apparently back on the table. The complete proxy advisory rule changes (see HERE) are also back in play on the proposed rule list.  Finally, amendments to the whistleblower program which had dropped off the list as completed, are now back on for further review.

Several items have moved from long term actions to the proposed rule stage.  Executive compensation clawback (see HERE), which had been on the proposed rule list in Spring 2020 and then moved to long-term action, is back on the proposed list.  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.  This topic has been batting around since 2015.  Also, clawbacks of incentive compensation at financial institutions moved from long-term to proposed.

Also moved up from long-term action to proposed is corporate board diversity (although nothing has been proposed, it is a hot topic); reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); amendments to the custody rules for investment advisors (which was moved from proposed to long term and now back to proposed); money market fund reforms; registration and regulation of security-based swap execution facilities; prohibitions of conflicts of interest relating to certain securitizations; broker-dealer liquidity stress testing, early warning, and account transfer requirements; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and short sale disclosure reforms.

Bouncing back to the proposed list from the long-term list in Fall after spending one semi-annual period on the proposed rule list are amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons.

Nine items are included in the final rule stage, down from 14 on the Fall Agenda, none of which are new to the Agenda.  Implementation of Dodd-Frank’s pay for performance jumped from the long-term list where it had sat for years, to the final rule stage (see HERE).  Establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC also jumped from a long-term action item to the proposed rule list. Likewise, amendments to the NMS Plan for the consolidated audit trail data security have been added.

Investment company summary shareholder report and modernization of certain investment company disclosures moved from the proposed to final rule stage, as did amendments to Regulation ATS for the registration of and reporting by alternative trading systems (ATS) for government securities.

Moving quickly from the proposed rule stage to final rule stage are the controversial amendments to the Rule 144 holding period and Form 144 filings.  In December 2020, the SEC surprised the marketplace by proposing amendment to Rule 144, which would prohibit the tacking of a holding period upon the conversion of variably priced securities (see HERE.  The responsive comments have been overwhelmingly opposed to the change, with only a small few in support and those few work together in plaintiff’s litigation against many variably priced investors.  Many of the opposition comment letters are very well thought out and illustrate that the proposed change by the SEC may have been a knee-jerk reaction to a perceived problem in the penny stock marketplace.  I wholly oppose the rule change and hope the SEC does not move forward.  For more on my thoughts on the damage this change can cause, see HERE.

Still listed in the final rule stage is universal proxy process.  Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.  The SEC re-opened comments on the rule proposal in April 2021 (see HERE).  Although things can change, final action is currently slated for October 2021.

Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); and an amendment to the definition of clearing agency for certain activities of security-based swaps dealers.

Seventeen items are listed as long-term actions, down from the 32 that were on the Fall list, including many that have been sitting on the list for years and one that is new.  Although the already implemented amendments to the proxy process and rules are under new review as discussed above, additional proxy process amendments dropped from the proposed list to a long-term action item. New to the list in long-term action is investment company securities lending arrangements.

Continuing their tenure on the long-term list is conflict minerals amendments; stress testing for large asset managers; custody rules for investment companies; requests for comments on fund names; amendments to improve fund proxy systems; end user exception to mandatory clearing of security-based swaps; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.

Several items have dropped off the Agenda as they have now been implemented and completed, including amendments to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation; use of derivatives by registered investment companies and business development companies; market data infrastructure, including market data distribution and market access; and amendments to the SEC’s Rules of Practice.

Moved from the proposed rule stage to a long-term action item are proposed changes to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies).  In May 2018, SEC amended the rules and issued a concept release (see HERE and HERE).  In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy.  This no longer seems to be a priority.

Dropped from the Agenda are amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years.  Surprisingly, the proposal was met with overwhelming pushback from market participants.  There were 2,238 comment letters opposing the change and only 24 in support.  Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other, more pressing matters.

Other items dropped from the Agenda without action include amendments to asset-backed securities disclosures (last amended in 2014); earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020 back down to long-term in Fall 2020 and now has been dropped altogether.  The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority.

Also dropped without action is amendments to Guide 5 on real estate offerings and Form S-11 (though some changes were made in relation to the acquisition of businesses by blind pools); and amendments to the family office rule (though I expect this will be partly covered by the item on the proposed list related to disclosure regarding beneficial ownership of swaps including interests in security-based swaps).

Disappointingly still not on the Agenda is Regulation Finders.  Although the SEC proposed a conditional exemption for finders (see HERE), it does not go far enough, and again is not a priority.

The Author

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SEC Re-Opens Comments On The Use Of Universal Proxy Cards
Posted by Securities Attorney Laura Anthony | June 4, 2021 Tags: ,

On April 16, 2021, the SEC voted to reopen the comment period on the proposed rules for the use of Universal proxy cards in all non-exempt solicitations for contested director elections.  The original rules were proposed on October 16, 2016 (see HERE) with no activity since.  However, it is not surprising that the comment period re-opened, and it is not as a result of the new administration.  The SEC’s Spring and Fall 2020 semi-annual regulatory agendas and plans for rulemaking both included universal proxies as action items in the final rule stage.  Prior to that, the topic had sat in the long-term action category for years.

In light of the several years since the original proposing release, change in corporate governance environment, proliferation of virtual shareholder meetings, and rule amendments related to proxy advisory firms (see HERE) and shareholder proposals in the proxy process (see HERE), the SEC believed it prudent to re-open a public comment period.  In addition, the SEC including additional questions for public input in its re-opening release.


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.

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.

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. As a response, the SEC issued the rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.

SEC Proposed Rule

On October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors.  In particular, the proposed rule would:

  • Create new Rule 14a-19 to require the use of universal proxy cards in all non-exempt solicitations in connection with contested director elections. The universal proxy card would not be required where the election of directors is uncontested.  There may be cases where shareholder proposals are contested by a company, in which case a shareholder would still receive two proxy cards; however, in such case, all director nominees must be included in each groups proxy cards;
  • Revise the consent required of a bona fide director nominee such that a consent for nomination will include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
  • Eliminate the short slate rule;
  • Prescribe certain filing, notice, and solicitation requirements of companies and dissidents when using universal proxy cards;
  • Require dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
  • Require dissidents in a contested election subject to new Rule 14a-19 to solicit holders of at least a majority of the voting power of shares entitled to vote on the election of directors;
  • Provide for a filing deadline for the dissidents’ definitive proxy statement; and
  • Prescribe formatting and other requirements for the universal proxy cards.

The Proposed Rules also include other improvements to the proxy voting process, such as mandating that proxy cards include an “against” voting option when permitted under state laws and requiring disclosure about the effect of a “withhold” vote in an election.

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. [proposed Rule 14a-19(b)(1)] Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority 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. [proposed 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. [proposed Rule 14a-19(a)(2)] Dissident must file its definitive proxy statement with the Commission.


The proposed 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.

In its rule release, the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”

Companies have a concern that dissident board representation can be counterproductive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve.  The SEC rule release solicits comments on this point.

Moreover, 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.

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SEC Chair Gary Gensler Testifies To Congress
Posted by Securities Attorney Laura Anthony | May 28, 2021 Tags:

On May 6, 2021, new SEC Chair Gary Gensler made his debut, giving testimony to the House Financial Services Committee.  Although Mr. Gensler is not new to regulatory leadership – he was head of the Commodity Futures Trading Commission (CFTC) – and as such, his style is certainly not new to capital markets participants, the testimony was nonetheless very enlightening of the mindset of the new SEC regime.  The purpose of the testimony was particularly related to the market volatility in January, including GameStop and AMC, and reactions to that trading frenzy including Robinhood’s temporary trading restrictions, but over four hours, touched on much more.

From thirty thousand feet, Gensler attributes the January volatility to an intersection of finance and technology.  On a more granular level, he highlights: (i) gamification and user experience; (ii) payment for order flow; (iii) equity market structure; (iv) short selling and market transparency; (v) social media; (vi) market plumbing – i.e., clearance and settlement; and (vii) system-wide risks, giving us a first look at potential areas of regulatory change and focus in the coming year.

This is a first look into Gensler’s points of interest and regulatory focus.  Interestingly, Gensler’s SEC will obviously be much different than the agency under Clayton.  Jay Clayton’s first speech focused on the SEC’s mission to protect Main Street Investors (see HERE), a mantra he continued throughout his regime.  Although, I was (and am) a fan of Jay Clayton, I also believe that his policies had the unintended consequences of suppressing the under $300 million market cap class (see for example HERE and HERE regulator, his deep understanding of technology and focus on the bigger system could be a benefit to small and middle market enterprises.

Gamification and User Experience

As with all industries, mobile apps have expanded access to capital markets, making it easy and cost-effective to open accounts, trade, get wealth management advice and learn about investing.  Gensler considers gamification as the use of game-like features, such as points, rewards, leaderboards and competitions, to increase customer engagement. Similarly, many apps enhance user experience with push notifications and social media features.  Technology allows the designers and engineers to collect data that is used for predictive analytics and which then makes suggestions to users.

Although that technology exists across many platforms from shopping to fitness to entertainment suggestions, in the world of capital markets, the consequences can be more severe.  As Gensler puts it, “[A] big loss could have immediate implications for the app user’s ability to afford their rent or pay other important bills. A small loss now could compound into a significant loss at retirement.”  Moreover, the apps encourage users to trade more, which in and of itself increases risks and could lower long-term gains.

The SEC staff is in the process of preparing a request for public comment on the issues and the interface with current SEC regulations, including Regulation Best Interest.  Moreover, the SEC will be considering new or updated rules that take into account recent technologies and communication practices.

As an aside, Mr. Gensler is not incapable of constructing and implementing an entire new rule set where one did not exist previously.  While running the CFTC, Gensler directed the agency to create and then implement regulations for swaps.  His tough stance earned him a divisive following with both strong opponents and proponents.  I’m an advocate for clear rules and guidance as opposed to regulation through enforcement but as the saying goes, be careful what you wish for.  As much as I like guidance, I would hate to see rules that squelched liquidity and opportunity for any investor class, especially the younger, technologically-savvy generation.

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.

Gensler breaks down payment for order flow 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.  Putting aside other aspects of this process, the data alone that the wholesaler garners is extremely valuable and provides a market advantage.

Gensler raises several other concerns, including a conflict of interest by brokers and an incentive to churn accounts or encourage more frequent trading.  He points out that other countries, such as the UK and Canada, prohibit brokers from routing order to off-exchange market makers in return for payment.  However, I do not believe that payment for order flow would create any additional conflict, and probably less so, than when a brokerage firm charges a straight-up commission on each trade.  Rather, the issue becomes disclosure and ensuring best execution.

Case in point, in the recent settled SEC enforcement action against Robinhood, certain principal trading firms seeking to attract Robinhood’s order flow told them that there was a tradeoff between payment for order flow and price improvement for customers. Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself.

Although Gensler points to this flaw in the system, I believe that requiring a firm to choose best execution over higher payments for order flow can at least partially resolve the issue.  In my mind, the issue becomes, if a brokerage firm cannot charge for trades because of competition and cannot charge for order flow, they will be forced to find other income sources (such as selling data, advertising, increased proprietary trading, higher fees on managed accounts, etc.).  Hopefully, the SEC will have a clear picture of what those other sources may be, and the potential negative consequences, when considering future policies and rulemaking.

Equity Market Structure

Gensler breaks the equity markets down to three segments: the national exchanges; alternative trading systems (ATSs), also called dark pools); and off-exchange wholesalers.  In January, the national exchanges accounted for 53% of volume; ATS trading was 9% and wholesalers accounted for 38%.  Of that 38%, only seven wholesalers accounted for the vast majority of volume.  Citadel Securities alone represented 47% of all retail volume.

Gensler raises several concerns including potential fragility, lack of healthy competition, and limits on innovation.  He has asked the SEC staff to look closely at the matter to make policy recommendations.

Gensler is not the first SEC Chair to be concerned with the state of the equity market structure.  In March 2019, then Chair Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform (see HERE). As noted in the speech, in 2018, the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.

Clayton and Redfearn also talked about a need for an overhaul of Regulation NMS.  Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.

In December 2020, the SEC adopted some amendments to Regulation NMS, including the Market Data Rules (subject of a future blog).  Also, related to equity market structure, in September 2020 the SEC adopted new rules completely overhauling Rule 15c2-11 and its related processes (see HERE.  Those rules have a September 28, 2021 compliance date which is keeping firms like mine, and audit firms extremely busy in between the regular 10-Q and 10-K seasons.

Short Selling and Market Transparency

Although the Dodd-Frank Act directed the SEC to publish rules on monthly aggregate short sale disclosures and to increase transparency in the stock loan market, those rules are two of the 11 remaining rules required by Dodd-Frank that have not yet been completed. Gensler has directed the SEC staff to prepare recommendations for these rules.

In addition, turning to a topic he knows well, Gensler has asked the SEC staff to consider recommendations about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so, how.  He believes that the March 2021 failure of giant family office Archegos Capital Management was fueled, at least in part, by the use of total return swaps based on underlying stocks and the significant exposure that the prime brokers had to the family office as a result.  Archegos Capital Management imploded, losing its entire $20 billion in just 10 days.

Social Media

As we all know, social media has officially intersected with the capital markets.  On Reddit, individuals gather in online communities to discuss a variety of topics anonymously, including investing; the subreddit r/wallstreetbets has about 10 million members.  Outside of Reddit, social media aspects of trading apps, and all social media sites, now have various capital market centered communities.

Of course, the obvious concern is the use of social media to engage in pump-and-dump activities and other market manipulation schemes.  Allaying “big brother” feedback, Gensler specifically states, “[T]o be clear, I’m not concerned about regular investors exercising their free speech online. I am more concerned about bad actors potentially taking advantage of influential platforms.”

He also points out that institutional investors and their algorithms also follow these online conversations. Developments in machine learning, data analytics, and natural language processing have allowed sophisticated investors to monitor various forms of public communication to see relationships between words and prices – known as sentiment analysis.  At this point, the SEC is monitoring and learning more about these practices.

Market Plumbing – Clearance and Settlement

The clearing process is what makes the markets operate.  For more on the U.S. Capital Markets Clearance and Settlement Process, see HERE.  Currently the settlement process takes two days – i.e., T+2 – a trade entered on Monday, settles on Wednesday.  For more on the settlement cycle and T+2 rule, see HERE.

Clearinghouses have rules to cover the credit, market, and liquidity risk that is present during those two days. All members transacting with the clearinghouses need to post collateral, called margin, to cover potential losses. If the broker went bankrupt before the trade is settled, the clearinghouse would use such margin to back the deliveries and payments with the goal of not disrupting the broader financial system.  In January, the rapidly changing prices, high volatility, and significant trading volume of the meme stocks prompted larger-than-usual central clearing margin calls on broker-dealers. Some of those broker-dealers, such as Robinhood, scrambled to secure new funding to post the required margin. A number of brokers, including Robinhood, chose to restrict additional buying activity by their customers in a variety of the meme stocks.

Using this as a backdrop, Gensler questions whether broker-dealers are adequately disclosing their policies and procedures around potential trading restrictions, whether margin and payment requirements are sufficient, and whether the broker can manage its liquidity risk.

Gensler has asked the SEC staff to look into these disclosure requirements and practices.  He has also asked for recommendations regarding shortening the settlement cycle further.  As an aside, it is thought with current technology the settlement cycle could now be shortened to T+1 and that with further adoption of blockchain-based technologies, settlement could occur simultaneously with the trade.  Gensler is a proponent and he understands technology.  Time is risk, and he supports a move towards T-0.

System Wide Risks

In general, Gensler points out that the January liquidity explosion highlighted areas of concern.  Robinhood, for instance, didn’t have sufficient liquidity to meet margin calls and had to fundraise within hours to meet $1 billion-plus obligations, and several brokers chose to shut down customer access to trading.  Several hedge funds also lost significant money during these events.  He also points to the Archegos implosion and the losses incurred by its banking partners.  Finally, the concentration of trading activity with Citadel and a few other major players increases system-wide risks.

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ESG Disclosures – A Continued Discussion
Posted by Securities Attorney Laura Anthony | April 9, 2021 Tags:

In a series of blogs, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Former SEC Chair Jay Clayton did not support overarching ESG disclosure requirements.  However, new acting SEC Chair Allison Herron Lee has made a dramatic change in SEC policy, appointing a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly forthcoming.

New Corp Fin Director John Coates is fully on-board, making speeches and otherwise being vocal in his support of ESG centered disclosures.  On March 22, 2021, the SEC launched a new page on its website bringing together all things ESG including agency actions and the latest information on ESG investing.

Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE).  The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE) and this third in the series is centered on ESG disclosures other than climate change.

Non-U.S. countries have also been beating the ESG drum with Europe requiring increased disclosures and the International Organization of Securities Commissions or “IOSCO,” without the participation of the SEC, issued a statement “setting out the importance of considering the inclusion of environmental, social, and governance matters when disclosing information material to investors’ decisions.”  At the end of January 2021, 61 companies signed on to the World Economic Forum’s “Stakeholder Capitalism Metrics,” which is a set of ESG metrics and disclosures intended to serve as a “set of universal, comparable disclosures focused on people, planet, prosperity and governance that companies can report on, regardless of industry or region.”  A summary of the metrics is below.

Current ESG Disclosure Requirements

Although there is not an ESG facing Regulation S-K item, the current disclosure obligations certainly encompass many ESG topics.  For a discussion of the existing and proposed climate change disclosure obligations, see HERE.  From a thirty-thousand-foot view, any information that is material to a company’s financial position, regardless of whether it can be labeled under an ESG category, is disclosable.  Also, the Nasdaq stock market has published an ESG Reporting Guide, which is discussed below and has proposed a rule requiring listed companies to meet certain minimum board membership diversity targets (that rule proposal will be the subject of another blog).

Countless memorandums and publications have been written on ESG matters, including what in particular and how they should be reported (with countless differing opinions).  The recent changes to Regulation S-K added the topic of human capital as a disclosure item including any human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy) (see HERE).

Item 407 of Regulation S-K requires disclosure of “whether, and if so how, the nominating committee (or the board) considers diversity in identifying nominees for director” and “if the nominating committee (or board) has a policy with regard to the consideration of diversity in identifying director nominees, describe how the policy is implemented, as well as how the nominating committee (or the board) assess the effectiveness of its policy.”

Audit committees and auditors must also consider ESG.  The Center for Audit Quality has published a roadmap for auditors and separate memo directed at audit committees to help them understand the role of auditors in connection with company-prepared ESG information.  I’ll cover ESG audit committee and audit-related matters in a separate blog.

Current disclosure rules require a company to make disclosures as needed to prevent other disclosures from being materially misleading.  As ESG rises in importance, and impacts financial statements, additional disclosures should naturally be considered by company management today.

Potential ESG Disclosures

On March 11, 2021, Acting Corp Fin Director John Coates issued a statement on ESG Disclosure clearly supporting additional disclosure requirements while at the same time acknowledging the complexity of a standardized system.  To invoke more thought on the topic, Director Coates believes the SEC must consider: (i) what disclosures are useful; (ii) what is the right balance between principles and metrics (including mandatory vs. voluntary disclosure); (iii) standardization across industries; (iv) evolving standards; (v) verification of disclosures; (vi) global comparability; and (vi) alignment with current practices.

Of course, the costs of disclosure must be considered, but Coates puts more emphasis on the costs of not requiring ESG disclosure.  There is currently a lack of consistent, comparable, and reliable ESG information available for investors.  As I noted in the second blog in this series, companies face higher costs in responding to investor demand for ESG information because there is no consensus ESG disclosure system.  A unified system would reduce the redundant requests for information from multiple sources.

Coates is a proponent of adding more provisions like certain board audit committee disclosures which allows a company to explain why they make certain decisions (if a company does not have an audit committee financial expert, it can explain why).

Political Spending

Coming in second place behind climate change, political spending disclosures are a favorite topic at the SEC.  In her March 15 speech, which was mainly focused on climate change, Chair Allison Herron Lee stated, “[A]nother significant ESG issue that deserves attention is political spending disclosure.” And that “political spending disclosure is inextricably linked to ESG issues.”  One example raised is a company that makes carbon neutral pledges or other climate change friendly disclosures but donates heavily to a politician that consistently votes against these initiatives.  Commissioner Caroline A. Crenshaw has also been vocal in her support of political spending disclosures.

However, for now, any rule-making is on hold.  Although both a recent House and Senate bill have been introduced that would require additional political spending disclosures, the Consolidated Appropriates Act of 2021, which has already been passed into law, currently restricts the SEC from finalizing a rule requiring company political spending disclosures.

Gary Gensler, who will likely take over as SEC Chair in April, expressed support for the SEC to consider company political spending disclosures while testifying at his senate confirmation hearing in early March.  As an aside, Mr. Gensler is very knowledgeable about and supportive of cryptocurrencies.  Many are hopeful he will implement the regulatory clarity the industry needs and wants, and in any event, should provide lots of blog material on that topic.

General Topics – World Economic Forum’s “Stakeholder Capitalism Metrics”

As mentioned above, the World Economic Forum has put together Stakeholder Capitalism Metrics.  Although a complete summary of the publication is beyond the needed scope for this blog, the main topics include:

  • Governing Purpose – a statement by companies as to how they propose solutions to economic, environment and social issues;
  • Quality of governing body – qualifications, background and diversity information on board members and executives;
  • Stakeholder engagement – what topics are engaged on and how were they decided;
  • Ethical behavior – (a) anti-corruption – including training against and disclosure of incidences; and (b) ethics – including training and internal reporting mechanisms;
  • Risk and opportunity oversight – risk disclosures and a mandate that opportunities and risks should integrate material economic, environmental and social issues, including climate change and data stewardship;
  • Climate Change – including greenhouse gas emissions and implementation of the Task Force on Climate-related Financial Disclosures;
  • Nature Loss – land use and ecological sensitivity;
  • Freshwater availability – water consumption and withdrawal in water-stressed areas;
  • Dignity and equality – including diversity and inclusion; pay equality; wage levels and risks for incidents of child, forced or compulsory labor;
  • Health and well-being – work related injuries and fatalities;
  • Skills for the future – training provided;
  • Employment and wealth generations – absolute number and rate of employment; economic contribution; and financial investments;
  • Innovation of better products and services – R&D spending; and
  • Community and social vitality – total tax paid by category.

Many other articles and memos have been published recently containing similar lists of proposed and expected ESG reporting.

Nasdaq ESG Reporting Guide

Nasdaq has had a corporate sustainability program in place for six years and has a decidedly positive viewpoint on ESG, seeing these factors as beneficial to investors, “but also for public companies trying to increase operational efficiency, decrease resource dependency, and attract a new generation of empowered workers.”  Nasdaq states, “[E]ffective management of sustainability issues helps Nasdaq (and our listed companies) better understand operational performance, address resource inefficiencies, and forecast enterprise risk. In addition, there is a growing body of academic and analytic evidence suggesting that ESG excellence correlates with other benefits, such as lower costs of capital, reduced shareholder turnover, and enhanced talent recruitment and retention. With a renewed market emphasis on long-term value creation, we also believe that ESG is an effective and mutually beneficial communication channel between public companies and the investment community.”

With that said, the Nasdaq ESG Reporting Guide is merely a recommendation for the record keeping and reporting of material information on ESG matters.  In determining materiality, Nasdaq suggests that companies consider impacts to external stakeholders and ecosystems in addition to those directly affecting the company.  Nasdaq does not impose financial or legal reporting requirements beyond those required by Regulations S-K and S-X.  Many companies choose to report ESG matters in separate ESG reports made available to investors on their website, rather than in formal reports to the SEC.

The Nasdaq guide focuses on economic principles and specific data, rather than moral or ethical arguments.  The ESG topics that Nasdaq address include:

  1. Environmental – (i) GHG Emissions (i.e., greenhouse gas emissions); (ii) emissions intensity; (iii) energy usage; (iv) energy intensity; (v) energy mix; (vi) water usage; (vii) environmental operations; (viii) climate oversight/board; (ix) climate oversight/management; and (x) climate risk mitigation.
  2. Social – (i) CEO pay ratio; (ii) gender pay ratio; (iii) employee turnover; (iv) gender diversity; (v) temporary worker ratio; (vi) non-discrimination; (vii) injury rate; (viii) global health and safety; (ix) child and forced labor; and (x) human rights.
  3. Corporate Governance – (i) board diversity; (ii) board independence; (iii) incentivized pay; (iv) collective bargaining; (v) supplier code of conduct; (vi) ethics and anti-corruption; (vii) data privacy; (viii) ESG reporting; (ix) disclosure practices; and (x) external assurance.

For each topic, Nasdaq provides an explanation as to why such a measurement is important and a formula for completing the measurement or setting a policy addressing the topic.

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ESG Investing and Ratings
Posted by Securities Attorney Laura Anthony | April 2, 2021 Tags: ,

As I mentioned in the last blog in this series on ESG, back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s regulatory focus.

Enter Chair Allison Herron Lee and in a slew of activity over the past few months, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly in the works.

Investors are focused now more than ever on ESG matters.  The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions.  Heavyweight investors are also on board.  In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.

One thing has not changed and that is that the system of “rating” or “scoring” a company based on all things ESG is extremely over-inclusive and imprecise.  The Aggregate Confusion Project from Massachusetts Institute of Technology (MIT) found that “It is very likely…. that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”

In a series of blogs I am tackling the wide and popular current ESG conversation.  In the first blog, I focused on climate change initiatives (see HERE).  In this second blog I am discussing ESG investing, ratings and the role of a Chief Sustainability Officer, and the third blog will be on ESG disclosures in general.

Backing up – What is “Environmental, Social and Governance” or “ESG”

It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider.  It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).

In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America.  However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.

The G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people.  The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses.  The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.

However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information are much more nebulous.  Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors.  A number of self-identified ESG experts have developed and many groups produce ESG ratings.  The ratings are not standardized, and as such the analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.

ESG Investing and Ratings

It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters.  Investors are pouring billions into asset managers who proclaim ESG who are in turn pumping out new ESG products (I can’t help but think about the mortgage bundling and complicated hedging products created around it right before the housing bubble in 2007-2008).

However, just like with ratings organizations, ESG fund managers and ESG products are not standardized in their meaning.  As Commissioner Roisman said in a recent speech:

“When an asset manager markets a fund as having an ESG strategy, it has an obligation to disclose material information about that fund to investors and potential investors. Additionally, it would make sense to me that asset managers who want to use these terms to name their funds or advertise their products should be required to explain to investors what they mean. How do the terms “ESG,” “green,” and “sustainable” relate to a fund’s objectives, constraints, strategies, and the characteristics of its holdings? Are “E,” “S,” and “G” weighted the same when selecting portfolio companies? Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and if so, to what extent?”

Also, it would not make sense for ESG to mean the same thing for different funds.  That is, one investor may be much more interested in investing in a fund that is concerned with renewable resources while another wants one focused on social issues such as diversity.  I note that the same issue presents itself when talking about a standardized ESG disclosure regime, which I will talk further about in another blog in this series.

Irrespective of the difficulty in defining ESG, it is clear that index funds and long-term investors are interested in long-term value for their portfolios.  In order to preserve long-term value, a fund or investor must have a diverse portfolio that mitigates systematic risk including climate change risk, financial stability risk and social stability risk.  This long-term portfolio management means that not every investment will be a winner and not every investment will consider ESG, but a diverse portfolio definitely involves ESG considerations.

We also now have an ESG friendly administration, meaning that ESG issues could find more support by the SEC for inclusion in a company’s annual proxy statement.  Shareholder proposals such as demands for reporting of greenhouse gas emissions, gender and race issues in the workforce and of course more on climate change, have historically been blocked as involving ordinary management decisions or micromanagement of the corporate structure.  Under the new administration, these proposals may survive attack and appear on proxy statements for shareholder approval.

Likewise, the new administration is likely to support regulatory changes that will either directly or indirectly impact public companies.  For example, near the end of the Trump administration the Department of Labor (DOL) passed rules that would prohibit ERISA fund managers from considering factors, that were not directly cost benefit based, such as ESG, in making voting and investment decisions for retirement funds.  On March 10, 2021, the DOL announced that it will not enforce these new rules.  Rather the DOL recognizes the use of ESG considerations in improving investment value and long-term investment returns for retirement investors and as such fiduciaries will not be prohibited from using these factors in any voting or investment decision analysis.

Who is a Chief Sustainability Officer

The time and expense of covering ESG ratings and attracting ESG investors is substantial. Enter a Chief Sustainability Officer (CSO).  A CSO is now a common position in Fortune 500 companies and growing in all sectors.  In addition to fielding the numerous ratings organizations and assisting management with messaging on ESG matters, a CSO is generally responsible for reviewing and helping to formulate ESG policies.  These policies include both engaging in more socially responsible activities (investments in climate change initiatives) and reducing irresponsible activities (reducing pollution from corporate plants or changing materials to make products more sustainable).  A CSO will also be integral in assisting with compliance with the existing and new climate and ESG disclosures in general.

Importantly, a CSO has the potential to reduce the impact of third-party ratings organizations.  Until there are standardized rating systems in place, third-party ratings remain arbitrary and capricious.  A CSO can work on data and analytics that are presented to rating organizations and analysts that reduce the information gaps and analyst irregularities.  A CSO can also put programs and messaging in place for direct corporate engagement with the investment community related to ESG matters.

It is now commonplace for a company to issue sustainability reports and those reports, although not generally currently filed with the SEC, are made publicly available on a company’s website.  A CSO should likewise be integral in the reports contents and importantly communicating its meaning to the board of directors.

Regardless of the noise surrounding ESG, there is no doubt that ESG is an important factor in Enterprise Risk Management (ERM) and must be understood and considered by a board of directors in its duties for ERM oversight.  An effective CSO must be able to help the board unpack these issues as well.

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Finders – Part 3
Posted by Securities Attorney Laura Anthony | March 19, 2021 Tags:

Following the SEC’s proposed conditional exemption for finders (see HERE), I’ve been writing a series of blogs on the topic of finders.  New York recently proposed, then failed to adopt a new finder’s regulatory regime.  California and Texas remain the only two states with such allowing finders for intra-state offerings.   Also, a question that has arisen several times recently is whether an unregistered person can assist a U.S. company in capital raising transactions outside the U.S. under Regulation S, which I addressed in the second blog in this series (see HERE).  This blog will discuss the New York, California and Texas rules.

New York

On December 1, 2020, the state of New York adopted an overhaul to some of its securities laws including modernizing registration and filing requirements with the Investor Protection Bureau and the Office of the Attorney General.  Although the proposed rules would have adopted a new definition of “finder” and required licensing and examinations for such activity, the final rule release dropped the proposal without explanation.

Putting aside finders, an important aspect of the new rules is that companies conducting Rule 506 offering in New York will now need to file a completed Form D through the NASAA electronic filing depository.  Prior to the new rules, New York’s Martin Act was very unclear on filing requirements and as a result, most practitioners simply did not file any notice documents or pay any fees where the offering pre-empted state law under the NSMIA (see HERE).  This position was supported by an interpretive opinion published by the New York State Bar Association.  Under the new rules, it is clear that a Form D is required, aligning New York with federal and other state notice provisions.

Historically, the Martin Act has not required the registration of securities, other than securities sold in real estate offerings, theatrical syndications or intra-state offerings. Instead, it requires that issuers register as dealers.  In particular, the Martin Act requires that any person “engaged in the business of buying and selling securities from or to the public” register as a broker-dealer.  New York exempted issuers from registering as dealers when they complete a firm commitment underwritten offering but not in other circumstances, including a best efforts underwritten offering or where no underwriter or placement agent is utilized.

The amended rules maintain this regulatory framework while expanding the definition of dealer and attempting to align, at least somewhat, the Martin Act with the federal framework involving covered securities. In particular, the new rules separate out dealers, and thus the forms necessary to file, into (i) Federal Regulation D Covered Securities Dealers; (ii) Federal Tier 2 Dealers; (iii) Federal Covered Investment Company Dealers; (iv) real estate dealers; and (v) all others.

In essence, the amended rules separate “dealers” that participate in federally covered transactions from those that do not.  A Federal Regulation D Covered Securities Dealers must file a Form D.  The new rules specify that the information in the Form D is all the information necessary to be filed by this category of dealer.  A Federal Tier 2 Dealer must file a Uniform Notice Filing of Regulation A – Tier 2 Offering Form, which contains all the necessary information for that category of dealer.  Finally, a Federal Covered Investment Company Dealer must file a Form N.

The New York rules did not proceed to provide a definition for “finders” but still require that “broker-dealers” that are not associated with a broker-dealer registered with the SEC or a member of FINRA be registered in New York to engage in broker-dealer activity.  Of course, it still leaves the gaping question as to whether finder activity is broker-dealer activity requiring registration.


California Corporation’s Code Section 25206.1 permits the payment of a fee to finders for transactions involving intra-state offerings with California issuers subject to numerous conditions.  In particular, a finder may be paid direct or indirect compensation if:

  • The finder is a natural person;
  • The finder only introduces accredited investors as defined by Rule 501 of the Securities Act (see HERE);
  • The issuer and the transaction are in California exclusively (if an issuer is relying on a federal exemption other than one that nods to state law such as intra-state offering, the federal law would conflict);
  • The securities purchase price cannot exceed $15,000,000 in the aggregate;
  • The finder cannot participate in negotiating any of the terms of the offer or sale of securities;
  • The finder cannot advise any party to the transaction regarding the value of the securities or the advisability of investing in, purchasing, or selling the securities;
  • The finder cannot conduct any due diligence on the part of any party to the transaction;
  • The finder cannot offer for sale any securities in which they own, directly or indirectly;
  • The finder cannot receive, directly or indirectly, possession or custody of any funds;
  • The securities transaction must be qualified or exempt from qualification under California law;
  • The finder can only disclose (a) the name, address and contact information of the issuer; (b) the name, type, price, and aggregate amount of any securities being offered; and (c) the issuer’s industry, location and years in business;
  • The finder must file in advance of taking any finder’s fees, a statement of information with the finder’s name and address, together with a $300 filing fee, with the California Bureau of Business Oversight, and thereafter file annual renewal statements with a $275 filing fee and representations that the finder has complied with the exemption conditions;
  • Concurrently with each introduction, the finder shall obtain the informed, written consent of each person introduced or referred by the finder to an issuer, in a written agreement signed by the finder, the issuer, and the person introduced or referred, disclosing the following: (a) the type and amount of compensation that has been or will be paid to the finder; (b) the finder is not providing advice to the issuer or any person introduced or referred by the finder as to the value of the securities or as to the advisability of investing in, purchasing, or selling the securities; (c) whether the finder is also an owner, directly or indirectly, of the securities being offered or sold; (d) any actual or potential conflict of interest; (e) that the parties to the agreement have the right to pursue any available remedies for breach of the agreement; and (f) a representation that the person being introduced is accredited; and
  • The finder must keep all records related to the transaction for five years.


Texas has a state finder’s registration process which is less onerous than full broker-dealer registration.  A finder registers in Texas by filing a Form BD and Form U-4 with the state.  A finder must be a natural person and cannot have agents working on their behalf.

Like California, even if registered, a finder’s activities are limited are subject to numerous conditions.  Texas finders are strictly limited to dealing with accredited investors.  Further, like California, a Texas finder would only be able to be compensated or operate in regard to Texas-based intra-state offerings or the activity would run afoul of federal securities laws.

Rule 115 of the Texas State Securities Board defines a “finder” as “[A]n individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor solely for the purpose of a potential investment in the securities of the issuer, but does not participate in negotiating any of the terms of an investment and does not give advice to any such parties regarding the advantages or disadvantages of entering into an investment, and conducts this activity in accordance with §115.11 of this title (relating to Finder Registration and Activities). Note that an individual registered as a finder is not permitted to register in any other capacity; however, a registered general dealer is allowed to engage in finder activity without separate registration as a finder.”

in turn prohibits a finder from: (i) participating in negotiating any terms of an investment; (ii) giving advice to an accredited investor or an issuer regarding the advantages or disadvantages of entering into an investment; (iii) conducting due diligence on behalf of a potential issuer or investor; (iv) providing a valuation or other analysis to an issuer or investor; (v) advertising to seek investors or issuers; (vi) having custody of an investor’s funds or securities; (vii) serving as escrow agent for the parties; or (viii) disclosing information to an investor or issuer other than as specified in parts (b) and (c) of the rule.

Rule 115.11(b) in turn requires that a finder disclose the following to each accredited investor: (i) that compensation will be paid to the finder; (ii) that the finder can neither recommend nor advise the investor with respect to the offering; and (iii) any potential conflict of interest in connection with the finder’s activity.

Rule 115.11(c) enumerates permitted finders’ disclosures, including: (i) the name, address and telephone number of the issuer; (ii) the name and a brief description of the security to be issued; (iii) the price of the security; (iv) a brief description of the business of the issuer in 25 words or less; (v) the type, number and aggregate amount of securities being offered; and (vi) the name, address, and telephone number of the person to contact for additional information.

Rule 115.11(d) contains specific detailed record-keeping requirements for finders.  Records are required to be kept for five years and must be segregated from any other records the finder may maintain.

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SEC Final Rule Changes For Exempt Offerings – Part 4
Posted by Securities Attorney Laura Anthony | February 26, 2021 Tags: ,

On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework.  The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion.  As such, like the proposed rules, I am breaking it down over a series of blogs with this fourth blog discussing the changes to Regulation A.  The first blog in the series discussed the new integration rules (see HERE).  The second blog in the series covered offering communications (see HERE).  The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE.

Background; Current Exemption Framework

The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration.  Offering exemptions are found in Sections 3 and 4 of the Securities Act.  Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another).  Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A.  Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c).  The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required.  In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.

For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.

Regulation A

The current two-tier Regulation A offering process went into effect on June 19, 2015, as part of the JOBS Act.  Since its inception there has been one rule modification opening up the offering to SEC reporting companies (see HERE) and multiple SEC guidance publications including through C&DI on the Regulation A process.  For a recent summary of Regulation A, see HERE.  In reviewing the rules, the SEC found a few areas where compliance with Regulation A is more complex or difficult than for registered offerings, including the rules regarding the redaction of confidential information in material contracts, making draft offering statements public on EDGAR, incorporation by reference, and the abandonment of a post-qualification amendment.  The new rules address these points.

The SEC has simplified the requirements for Regulation A and established greater consistency between Regulation A and registered offerings by permitting Regulation A issuers to: (i) file certain redacted exhibits using the process previously adopted for registered offerings (see HERE); (ii) make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements (see HERE);  (iii) incorporate financial statement information by reference to other documents filed on EDGAR and generally allow incorporation by reference to the same degree as a registered offering (see HERE); and (iv) to have post-qualification amendments declared abandoned.

In addition, as has been discussed for several years now, the new rules increase the Tier 2 offering limit.  Moreover, the new rules add an eligibility standard such that an Exchange Act reporting company which is delinquent in such reports, will not qualify to rely on Regulation A.

Increase in Offering Limit

The new rules increase the maximum Regulation A Tier 2 offering from $50 Million to $75 million in any 12-month period.  As such, the 30% offering limit for secondary sales has increased from $15 million to $22.5 million.  Tier 1 offering limits remain unchanged.

Redaction of Confidential Information in Certain Exhibits

In March 2019, the SEC amended parts of Regulation S-K to allow companies to mark their exhibit index to indicate that portions of the exhibit or exhibits have been omitted.  Under the rules, a company must include a prominent statement on the first page of the redacted exhibit stating that certain identified information has been excluded from the exhibit because it is both not material and would be competitively harmful if publicly disclosed.  A company must also indicate with brackets where the information has been omitted from the filed version of the exhibit.  At the time the Regulation A rules were not changed such that Regulation A filers were still compelled to submit an application for confidential treatment in order to redact immaterial confidential information from material contracts and plans of acquisition, reorganization, arrangement, liquidation, or succession.

The new rules have aligned the Regulation A requirements with those for registered offerings.  The SEC has added a new instruction to the Form 1-A that allows companies to redact exhibits using the same procedure as for registered offerings.  SEC staff will continue to review Forms 1-A filed in connection with Regulation A offerings and selectively assess whether redactions from exhibits appear to be limited to information that meets the appropriate standard.   Upon request, companies are expected to promptly provide supplemental materials to the SEC similar to those currently required by Exchange Act reporting companies.  The information that the SEC could request includes an unredacted copy of the exhibit and an analysis of why the redacted information is both not material and the type of information that the company customarily and actually treats as private and confidential.  The new rules follow the updated definition of “confidential” which does not include the “competitive harm” factor in the analysis.  See HERE.

Regulation A Companies are also still able to request confidentiality under Rule 83.  For more on confidential treatment in SEC filings, see HERE.

Confidential Offering Statement

Companies that are conducting Regulation A offerings are permitted to submit non-public draft offering statements and amendments for review by the SEC if they have not previously sold securities pursuant to (i) a qualified offering statement under Regulation A or (ii) an effective Securities Act registration statement.  Prior to the rule amendments, confidential submittals had to be filed as an exhibit to a public filing at least 21 days prior to the qualification of the offering statement, which adds time and expense to the process.  Aligning with confidential treatment for registered offerings, the SEC has amended the rules to allow a company to make draft offering statements and related correspondence available to the public via EDGAR by changing the previous submission selection from “confidential” to “public.”

Incorporation by Reference

The ability to incorporate financial statements by reference to Exchange Act reports filed before the effective date of a registration statement is permitted on Form S-1, subject to certain conditions.  Aligning Regulation A with the S-1 provisions, the new rules will allow previously filed financial statements to be incorporated by reference into a Regulation A offering circular.  To avail itself of the ability to incorporate by reference companies that have a reporting obligation under Rule 257, or the Exchange Act must be current in their reporting obligations. In addition, companies must make incorporated financial statements readily available and accessible on a website maintained by or for the company and disclose in the offering statement that such financial statements will be provided upon request.  Companies conducting ongoing offerings still need to file an annual post-qualification amendment with updated financial statements.

Abandonment of an Offering

Prior to the rule amendment, Regulation A permitted the SEC to declare an offering statement abandoned but did not provide the same authority for post-qualification amendments.  The new rules now specifically allow for the SEC to declare a post-qualification filing abandoned.

Ineligibility for Delinquent Exchange Act Reporting Companies

Regulation A includes an eligibility requirement that company conducting a Regulation A offering must have filed all reports, with the SEC, required to be filed, if any, pursuant to Rule 257 during the two years before the filing of the offering statement (or for such shorter period that the issuer was required to file such reports).  When the SEC amended Regulation A to allow Exchange Act reporting companies to rely on the rule, it did not amend the provision related to delinquent filings.  Accordingly, since Exchange Act companies are not required to file reports pursuant to Rule 257, a company could technically be delinquent and eligible to use Regulation A.  In actuality, the SEC generally commented and pushed back on such companies, but the new rules close this loophole. In particular, companies that do not file all the reports required to have been filed by Sections 13 or 15(d) of the Exchange Act in the two-year period preceding the filing of an offering statement are ineligible to conduct a Regulation A offering.

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SEC Final Rule Changes For Exempt Offerings – Part 3
Posted by Securities Attorney Laura Anthony | February 19, 2021 Tags:

On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework.  The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion.  As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters.  The first blog in the series discussed the new integration rules (see HERE).  The second blog in the series covered offering communications (see HERE).  This third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D.


The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration.  The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.

Offering exemptions are found in Sections 3 and 4 of the Securities Act.  Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another).  Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A.  Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c).  The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required.  In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.

Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements.  Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest.  Rule 506 is “safe harbor” promulgated under Section 4(a)(2).  If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.

Rule 506 is bifurcated into two separate offering exemptions.  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, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering.

For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.

Rule 506(c) Verification Requirements

Rule 506(c) allows for general solicitation and advertising; however, all sales must be made to accredited investors and the company must take reasonable steps to verify that purchasers are accredited.  It is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering.  For more on Rules 506(b) and 506(c), see HERE.

Rule 506(c) provides for a principles-based approach to determine whether an investor is accredited as well as setting forth a non-exclusive list of methods to determine accreditation.  After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.

Examples of the type of information that companies can review and rely upon include: (i) publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages); (ii) third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and (iii) third-party accredited investor verification service providers.

The SEC has added a new item to the non-exclusive methods of verification.  In particular, where the company has previously gone through the steps to verify accredited status for an existing investor, it can rely on the written representation that the investor continues to qualify as an accredited investor as long as the company is not aware of information to the contrary.  With the rule change, the entire non-exclusive methods of verification included in the rule are:

  1. Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year.  If such forms and information are joint with a spouse, the written representation must be from both spouses.
  2. Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed.  For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
  3. Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
  4. A written certification verifying accredited investor status from existing accredited investors of the company that have previously invested in a 506(b) offering with the same issuer prior to the enactment of 506(c); and
  5. A written representation from a person at the time of sale that he or she qualifies as an accredited investor where the company previously took reasonable steps to verify such person as an accredited investor in accordance with the rules, and so long as the company is not aware of information to the contrary.  A written representation under this method of verification will satisfy the issuer’s obligation to verify the person’s accredited investor status for a period of five years from the date the person was previously verified as an accredited investor.

The SEC has provided guidance on the application of some of the non-exclusive methods of verifying accredited status.  To wit:  related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property.  Where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.  However, if the evidence is at all questionable, further inquiry should be made.

The new rule release reaffirms that the rule is meant to be principles-based and that by offering suggested methods of verification, the SEC is not discouraging any reasonable methods a company may deem appropriate.  Companies are encouraged to consider (i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (ii) the amount and type of information that the company has about the purchaser; and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

Rule 506(b); Harmonization of Disclosure Requirements

Rule 506(b) has scaled disclosure requirements based on the size of the offering, where unaccredited investors are included.  Prior to the amendments, the scaled requirements were broken into 4 categories.  The amended rules update the information requirements for investors under Rule 506(b) where any unaccredited investors are solicited to align with information required under Regulation A.  For Rule 506(b) offerings up to $20 million, the same financial information that is required for Tier 1 Regulation A offerings, is now required.  For offerings greater than $20 million, the same financial information that is required for Tier 2 Regulation A offerings is now required.

In standardizing the 506(b) and Regulation A disclosures, the SEC has eliminated the ability to only provide a balance sheet where a company has trouble getting financial statements when conducting a Rule 506(b) offering.  Foreign private issuers may provide the financial information in either U.S. GAAP or IFRS as would be permitted in a registration statement.

If the company is not subject to the Exchange Act reporting requirements, it must also furnish the non-financial statement information required by Part II of Form 1-A or Part I of a Securities Act registration statement on a form that the issuer would be eligible to use (usually Form S-1).  If the company is subject to the Exchange Act reporting requirements, it must provide its definitive proxy with annual report, or its most recent Form 10-K.  These information requirements only apply where non-accredited investors will be solicited to participate in the offering.

Finally, as mentioned in Part I of this blog series related to integration where an issuer conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other is limited to 35.

Rule 504

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to allow companies to continue to conduct intrastate offerings under Section 3(a)(11) of the Securities Act and created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions.  Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted.  At that time, the SEC also amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule.  For more on the 2016 rule amendments, see HERE.

Even with the increased offering limits, as of today only approximately 2% of all Regulation D offerings under $5 million, rely on Rule 504.  The amended rules hope to encourage the use of Rule 504 by raising the offering limits to $10 million in any 12-month period.

Rule 504 is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies.  Rule 504 does not have any specific investor qualification or limitations.  However, Rule 504 does not pre-empt state law and as such, the law of each state in which an offering will be conducted must be reviewed and complied with.

Bad-Actor Provisions

Rules 504, 506(b), 506(c), Regulation A and Regulation Crowdfunding all have bad-actor disqualification provisions.  While the disqualification provisions are substantially similar, the look-back period for determining whether a covered person is disqualified differed between Regulation D and the other exemptions.  The amended rules harmonize the bad-actor provisions among Regulations D, A and Crowdfunding by adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.

Under Regulation D, the disqualification event is measured as of the time of sale of the securities in the offering.  Prior to the amendment, the look-back period was measured from the time the company files an offering statement for both Regulation A and Regulation Crowdfunding.  However, the SEC believes that it is important to look to both the time of filing of the offering document and the time of the sale with respect to disqualifying bad actors from participating in an offering.  The amended rules add “or such sale” to any look back references in Regulation A and Regulation Crowdfunding.

As a refresher, the bad actor rules relate to certain activities or events involving covered persons.  Covered persons include:

  • The issuer and any predecessor of the issuer or affiliated issuer;
  • Any director, general partner or managing member of the issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);
  • Any beneficial owner of 20% or more of the outstanding equity securities of the issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting (for SEC guidance on voting control, see HERE;
  • Investment managers of issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering; general partners and managing members of such investment managers; the directors and executive officers of such general partners; and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);
  • Any promoter connected with the issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);
  • Any person who has been or will be paid, either directly or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
  • Any director, officer, general partner, or managing member of any such compensated solicitor.

Disqualifying events include:

  • Criminal convictions (felony or misdemeanor) within the last five years in the case of issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Final orders issued by a state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, or the National Credit Union Administration that, at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
  • Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203(e) or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
  • Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
  • Suspension or expulsion from membership in, or suspension or bar from association with, a member of an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
  • Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
  • U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.

For further reading on SEC guidance on the bad actor provisions, see HERE.

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SEC Amendments To Rules Governing Proxy Advisory Firms
Posted by Securities Attorney Laura Anthony | January 22, 2021 Tags: ,

In a year of numerous regulatory amendments and proposals, Covid, newsworthy capital markets events, and endless related topics, and with only one blog a week, this one is a little behind, but with proxy season looming, it is timely nonetheless.  In July 2020, the SEC adopted controversial final amendments to the rules governing proxy advisory firms.  The proposed rules were published in November 2019 (see HERE).  The final rules modified the proposed rules quite a bit to add more flexibility for proxy advisory businesses in complying with the underlying objectives of the rules.

The final rules, together with the amendments to Rule 14a-8 governing shareholder proposals in the proxy process, which were adopted in September 2020 (see HERE), will see a change in the landscape of this year’s proxy season for the first time in decades.  However, certain aspects of the new rules are not required to be complied with until December 1, 2021.

The SEC has been considering the need for rule changes related to proxy advisors for years as retail investors increasingly invest through funds and investment advisors, in which the asset managers rely on the advice, services and reports of proxy voting advice businesses.  It is estimated that between 70% and 80% of the market value of U.S. public companies is held by institutional investors, the majority of which use proxy advisory firms to manage the decision making and logistics of voting for thousands of proposals within a concentrated period of a few months.  Proxy voting advice businesses provide a variety of services including research and analysis on matters to be voted upon; general voting guidelines that clients can adopt; giving specific voting recommendations on specific matters subject to a shareholder vote; and handling the administrative process of returning proxies and casting votes.  The administrative tasks are usually electronic and, at times, can involve an automated completion of a ballot based on programed voting instructions.

The final vote was divided with the SEC Commissioners voting 3-1 in favor of the new rules.  On the same day the SEC Commissioners, also in a 3-1 divided vote, endorsed guidance to investment advisors related to the new rules.  The guidance updates the prior guidance issued in August 2019 – see HERE.

In essence, the amendments condition the availability of two exemptions from the information and filing requirements of the federal proxy rules, which are often used by proxy voting advice businesses, on compliance with tailored and comprehensive conflicts of interest disclosure requirements.  In addition, the exemptions are conditioned on the requirements that (i) companies that are the subject of proxy voting advice have that advice made available to them in a timely manner; and (ii) clients of proxy advice businesses are made aware of a company’s response to the advice in a timely manner.

The amendments codify the SEC’s longstanding view that proxy advice constitutes a solicitation under the proxy rules and is thus subject to the anti-fraud provisions.  In particular, the amendment changes the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provides additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amends rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.

Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”

The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder.  The rules apply to any company which has securities registered under Section 12 of the Act.  Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures.  Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy.  The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.

The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules.  In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.“

The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor.  This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.

By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions.  In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice.  Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.

On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request.  For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.

In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”

Rule 14a-2(b) – Exemptions from the Filing and Information Requirements

Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders.  Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule.  Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.”  The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.

Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts.  The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).

The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.

The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9).  A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions.  In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters).  The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.

New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021.  Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.

Conflicts of Interest

The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while at the same time working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.

The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure.  The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship.  The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.

Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects.  The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended.  Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended.  Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible.  This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.

Review and Feedback on Proxy Advisory Materials

Although some of the largest proxy advisory firms such as ISS and Glass Lewis voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients.  Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice.  The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.

The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses.  The time for review was set as a number of days based on the date of filing of the definitive proxy statement.  However, commenters pushed back and the SEC listened.

The final rules allow proxy advisory businesses to take matters into their own hands.  In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).

As adopted the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures.  Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible.  Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.

New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule.  In particular:

(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients.  The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.

(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).

The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company.  Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice.  Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.

It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.

Rule 14a-9 – the Anti-Fraud Provisions

All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.  The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.

The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading.  Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.

The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest.  The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule.  The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does in fact meet those legal requirements.

Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.

Supplemental Guidance for Investment Advisors

On the same day as enacting the amended rules the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules.  The guidance updates the prior guidance issued in August 2019 – see HERE.  The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.

The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline.  The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.

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