SEC Cracking Down on The Crypto Wild West and Other Digital Asset Updates
After a few years of relative dormancy, the SEC is once again targeting the flourishing cryptocurrency market. On August 3, 2021, SEC Chair Gary Gensler gave a speech to the Aspen Security Forum in which he referred to the cryptocurrency marketplace as the Wild West. Days later, the SEC filed its first case involving securities using DeFi technology and then a few days after that, reached a $10 million settlement with Poloniex for operating an unregistered digital asset exchange. Shortly after that, the SEC took aim at Coinbase’s planned crypto lending program causing the crypto giant to shelf the business model for the time being. SEC Commissioners are joining in, giving speeches in various forums focused on crypto and the regulatory environment.
Background
In July 2017, the world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector, when the SEC issued its Section 21(a) Report on the DAO investigation finding that a cryptocurrency is, in most cases, a security (see HERE). Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
The SEC’s Section 21(a) Report relied on the analysis in SEC v. W.J. Howey Co. to determine when a crypto is a security, building the guardrails to conclude that all, or almost all, cryptocurrencies at that time were/are indeed a security. For more on the Howey analysis, see HERE. Later in June 2018, the SEC gave some relief to the crypto world by announcing that Bitcoin and Ether were likely decentralized enough as to no longer be considered a security, hedging on the conclusion as to whether they were once considered such.
Using the same analysis as a backdrop, in March 2018, the SEC issued a public statement directed specifically to online platforms for the trading of digital assets/cryptocurrencies. The statement served as a dual caution to investors and warning to platforms. In essence, if a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration (see HERE).
In April 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a no-action letter to Turnkey Jet, Inc. and made a statement on both. Although the guidance was appreciated, it really offered nothing new or different about the analysis, which was firmly based on SEC v. W.J. Howey Co. (the “Howey Test”) (see HERE). Other than the Section 21(a) Report and this guidance, the world of crypto regulation has been enforcement-driven.
Even accepting that a cryptocurrency is a security and trying to comply with the federal securities laws has been a difficult task. Since the issuance of cryptocurrencies, by nature and function, would involve general information and gun-jumping, a traditional IPO with S-1 would not work, not to mention the plethora of custody issues for any broker-dealer willing to act as an underwriter. See here for more information on broker-dealer custody issues related to digital assets – HERE. Traditional exempt offerings would also not work – a distribution of cryptocurrencies is never limited to accredited investors.
That leaves Regulation A; however, the process of completing the offering circular with the SEC is a monumental task. Blockstack was the first back in 2019 to qualify an offering circular for the issuance of a full token with properties of what could be a utility token. Others have not followed. A few companies have tokenized their equity and several have completed offerings that operate in the cryptocurrency space, but the world has not seen the U.S. registration or qualification of an offering issuing a cryptocurrency.
Fast-forward to today and a new SEC Chair and administration. At the same time as decrying the world of cryptocurrency as out of control, the SEC is doing what we all want – asking Congress to enact legislation that provides legal boundaries and technologically appropriate guidelines – and what we don’t necessarily want – asking that the SEC be formally put in charge of regulating the marketplace.
Gary Gensler’s Speech to the Aspen Security Forum
In early August, SEC Chair Gary Gensler gave a speech to the Aspen Security Forum on the topic of cryptocurrency regulation. Beginning with a little history, and in particular, the publication of a white paper by Satoshi Nakamoto (whose identity remains a mystery) on Halloween night in 2008, solving two riddles that cryptographers and other technology experts had worked on for years. That is, the white paper provided a working method to move something of value over the internet without an intermediary, and to prevent the double spending of that digital token. Today, the crypto asset class is worth approximately $1.6 trillion with 77 tokens worth over $1 billion and 1,600 others with a value of at least $1 million.
Gary Gensler understands the technology behind digital assets having taught classes at MIT and regulated, at least in part, digital currency while running the CFTC. While fiat money is simply a store of value, unit of account and medium of exchange, Gensler sees cryptocurrency as only a highly speculative store of value and investment source. He does not believe crypto fulfills the functions of a unit of account or medium of exchange, other than by those looking to avoid, or worse, break the law. At this time, Gensler sees the crypto world as the Wild West lacking tangible investor protections.
Gensler continues that the digital asset class is rife with fraud, scams, and abuse. Moreover, he believes that many (MANY) cryptocurrencies that currently trade in the marketplace are securities firmly fitting within the Howey definition of an investment contract. As such, the purchase and sale of these digital assets must comply with the federal securities laws and the SEC has jurisdiction to enforce such compliance. Gensler is clear, stating, “[I]t doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime.”
It isn’t just digital assets and cryptocurrencies that Gensler believes are out of control, but also crypto trading platforms, lending platforms, and other “decentralized finance” (DeFi) platforms. DeFi software applications generally allow users to borrow, lend, earn interest and trade assets and derivatives. Some DeFi developers say the technology shouldn’t face federal oversight because the automated programs aren’t controlled by people or companies and don’t hold traders’ assets. The services are often used by people seeking to borrow against their cryptocurrency holdings to place larger bets.
Gensler believes that platforms where people can trade tokens and venues where people can lend tokens both implicate the securities laws as well as the commodities and banking laws. Giving a heads-up to enforcement proceedings to come, he believes that even some platforms that purport to operate outside of the United States and prohibit investment or trading by U.S. investors, are facilitating U.S. investors through private networks.
Turning to stablecoins (cryptocurrencies pegged or linked to the value of fiat currencies), Gensler is concerned that these stablecoins are circumventing traditional banking regulations and in some cases securities regulations, such as the Investment Company Act of 1940. I’ll talk more about stablecoins in a future blog.
Gensler rounds out his speech by suggesting that crypto ETF’s may see approval from the SEC after years of trying (he likes the idea that they will be regulated) and touches on the SEC’s recent request for comment on crypto custody arrangements by broker-dealers. Confirming that the SEC will continue to regulate cryptocurrency markets to the greatest extent of its ability, Gensler calls upon Congress to fill regulatory gaps, provide increased budgetary resources to regulation the marketplace and, of course, empower the SEC to oversee this trillion-dollar marketplace.
Recent Enforcement Proceedings
In the weeks following Chair Gensler’s speech in Aspen, there were a slew of enforcement-related proceedings targeting the cryptocurrency/digital asset space. On August 6, 2021, the SEC filed its first ever case involving securities using DeFi technology. The SEC charged a Cayman Island company for the unregistered sale of more than $30 million of securities using smart contracts and DeFi technology. The SEC claims that the company used smart contracts to sell mTokens and DMG governance tokens. The mTokens claimed to pay 6.25% interest and the DMG tokens gave voting rights, profit participation and an anticipated secondary trading market. Both could be purchased with digital assets.
Although the headlines caught the attention of anyone operating in the DeFi space, in reality the case involved standard fraud claims. The company ran into roadblocks in their planned business model and then lied to investors to cover up the shortcomings. Also, the fact that the SEC found both the mTokens and DMG tokens to be securities was not surprising. The token offerings were intended to raise capital for business operations and hit squarely on the well-published SEC Howey analysis related to digital assets.
Even though the SEC action was a standard unregistered sale of securities and fraud claim, the DeFi industry is clearly in the crosshairs of world regulators. Generally, DeFi businesses (think payment processing like Zelle or Venmo over the blockchain and peer-to-peer lending) are currently unregulated in the U.S., it isn’t likely to stay that way. In an August interview, Chair Gensler stated that where DeFi platforms reward participants with valuable digital tokens or similar incentives their activities should be regulated, even if the management claims to be decentralized.
On October 28, 2021, the Financial Action Task Force (FATF) published guidance stating that DeFi apps and services supporting peer-to-peer transactions over the blockchain should keep tabs on their users’ identities and funds as a way of preventing money laundering and terrorism financing. The Task Force generally publishes anti-money laundering (AML) rules that governments follow worldwide, including the U.S. Treasury, which is expected to issue its own guidance in the short term. I will go over the FATF guidance in an upcoming blog.
On August 9, the SEC reached a $10 million+ settlement with Poloniex for operating an unregistered online digital asset exchange in connection with its trading platform. Poloniex operated a web-based trading platform that facilitated buying and selling digital assets, some of which the SEC determined were investment contracts and therefore securities. Unlike many exchanges today, Poloniex was open to U.S. investors. The theme is that that the SEC intends to investigate trading platforms that purport to only host non-security digital assets to ensure that is the case. In Gensler’s speech he indicated that if a trading platform offered 50 or more cryptocurrencies, he is certain there are securities in the bunch. For perspective, crypto giant Binance offers more than 500 different cryptocurrencies.
The SEC is not the only U.S. regulator targeting the cryptocurrency space. The CFTC settled two enforcement actions against cryptocurrency companies totaling $140 million. CFTC Chair Rostin Behnam, like Gary Gensler, calls the actions the tip of the iceberg and is also asking Congress to expand his agency’s scope of authority over the markets. Similar to swap markets, Gensler and Behnam envision joint authority and a division of responsibility overseeing the entire crypto market.
Other Commission Views
Cyrpto Mom/Hester M. Peirce
On October 8, 2021, Crypto Mom and SEC Commissioner Hester M. Peirce gave a speech at the Texas Blockchain Summit directly responding to Chair Gensler’s Wild West depiction of the cryptocurrency markets. Ms. Peirce has a different take on the Wild West – as opposed to a criminal playground, she sees the Wild West as a place where people go to build a new and better future. Sure, things are tough at first, but the spirit and energy form the basis for a thriving community. The West represents opportunity and the future.
Despite a lack of formal government regulation, the old West had a system of effective private regulation inspired by competition and societal needs. Once there was wealth in the West government regulation was inevitable. Ms. Peirce sees the analogy to the crypto frontier – “[T]he crypto frontier, like the Wild West, appears pretty wild at first glance: home to lots of codeslingers and speculators and some hucksters too, this new West also has its inter- and intra-protocol fights, friendships forged through shared difficulties and successes, colorful personalities, passions, dreams, hardships, spectacular failures, and remarkable victories.” Also, the crypto community itself has built a system of protocols and has consistently called on Congress for regulatory clarity illustrating that lawlessness is not the prevailing culture.
Ms. Peirce continued her speech with actual suggestions and comments surround digital asset regulation. The SEC Commissioner does not believe that the current regulatory framework offers clarity for the digital asset space. She continues to advocate for her safe harbor proposal (see HERE). Moreover, despite other members of the SEC asserting that Howey provides all that is needed to analyze whether a digital asset is a security or not, the best and brightest attorneys in the country continue to struggle with the real-world application.
Ms. Peirce points to the plethora of comments received by the SEC in response to its request for comments related to custody of digital assets by broker-dealers (HERE) mainly complaining that a broker-dealer will not be able to distinguish security vs. non-security digital assets without greater regulatory clarity. She also points out that the SEC has been relying on enforcement proceedings to provide regulatory guidance but settled enforcement proceedings do not provide a good basis for legal analysis.
Related to stablecoins, Commissioner Peirce feels the SEC is fighting for jurisdiction rather than protecting investors. Questions such as “Should stablecoin issuers be registered as banks? Should stablecoins be backed by deposit insurance? Should stablecoins be designated as systemically important by the Financial Stability Oversight Council? Are stablecoins money market funds? Should the Consumer Financial Protection Bureau step in to protect consumers?” all raise regulatory jurisdictional matters. Like cryptocurrencies in general, Ms. Peirce supports the use of stablecoins and calls for greater support and understanding of their role in the cryptocurrency marketplace.
Trading platforms are likewise in need of guidance. Deeming digital assets to be securities means that platforms that trade them and entities that intermediate them have to register with the SEC, but they cannot operate as a registered entity under the existing rules so they would not be able to register. It is the proverbial Catch-22.
The bottom line is that Hester Peirce’s views have been consistent for the four years she has sat on the SEC Commission. There is a complete lack of regulatory clarity over digital assets, including cryptocurrencies and DeFi businesses. Regulating through enforcement is not working. The SEC has not taken the time or effort to answer the hard questions and figure out a regulatory system that works.
Commissioner Caroline A. Crenshaw
On October 12, 2021, SEC Commissioner Caroline A. Crenshaw gave a speech at the SEC Speaks conference, focusing on digital assets. While maintaining that she supports the digital asset space, Commissioner Crenshaw also believes that the current regulatory framework, including Howey sufficiently provides enough guidance for those raising capital in the digital market space. However, Commissioner Crenshaw does admit that there has been a lack of clarity from the SEC and that it is difficult for developers to employ digital asset securities in new blockchain network applications in a compliant manner. Unfortunately, her answer to this problem is for businesses and entrepreneurs to engage in discussions with SEC staff. My experience is that the SEC is not willing to engage in meaningful conversations for fear of improperly giving legal advice.
Commissioner Crenshaw takes aim at Hester Peirce’s safe harbor proposal as not providing necessary investor protections. In particular, “granting a special exemption to these projects would provide unfair advantages to blockchain related businesses and disadvantage everyone else: participants who raise capital in compliant ways that support healthy markets and informed investors.”
« 2021 Annual Report of Office of Advocate for Small Business Capital Formation Public Market Listing Standards »
2021 Annual Report of Office of Advocate for Small Business Capital Formation
The Office of the Advocate for Small Business Capital Formation (“Office”) has delivered a report to Congress following the 40th annual small business forum (“Report”). The Report includes recommendations of the Office and its annual forum participants. The forum itself featured panelists and discussions on (i) navigating ways to raise early rounds; (ii) diligence including how savvy early-stage investors build diversified portfolios; (iii) tools for emerging and smaller funds and their managers; and (iv) perspectives on smaller public companies. The forum itself had a focus on diversity, including panel speakers and discussion topics. A clear message across the board is that women- and minority-owned businesses face the biggest challenges in the capital markets.
Background
The SEC’s Office of the Advocate for Small Business Capital Formation launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat.
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
The SEC hosts the annual Government-Business Forum on Small Business Capital Formation pursuant to the Small Business Investment Incentive Act of 1980. The SEC delivers a report to Congress each year following the forum. Since its formation, the Office of the Advocate for Small Business Capital Formation has been responsible for the report’s preparation and dissemination.
Report on the 40th Annual Small Business Forum
Navigating Ways to Raise Early Rounds
From a high level, the vast majority of early financing comes from friends and family. Following that, companies also look to angel investors, venture capital investors, Regulation CF offerings, Regulation A offerings, and public offerings (less common in early stages). To help source investors, companies tend to look to network referrals, broker-dealers, accelerators and incubators, social media, demo days and even the public press.
The largest barriers to early round financings include: (i) networks and finding connections to investors; (ii) navigating laws, policies and regulations; (iii) investor bias; (iv) personal wealth or assets (finding accredited investors); (v) information, education and knowledge; and (vi) valuations or offering terms. In my experience, the biggest barrier to initial capital raising efforts is simply finding investors. The forum spent a significant time touching on the difficulties facing minority and business owned women as well as the social impact of diversity matters in today’s world. Once a company begins to raise capital, puts the funds to good use, and illustrates execution on its business plan, each round of capital raising becomes relatively easier. However, businesses and founders should be particular to work with investors with the same goals and management views.
Forum participants discussed many topics and concerns surrounding early capital raising efforts. Although details of the discussion on preparation were not included in the report, a discussion of this important topic is warranted. Businesses and entrepreneurs should be prepared for capital raising opportunities including by maintaining complete and well-organized corporate records, an up-to-date business plan, executive summary or PowerPoint deck and up to date (conservative) projections. Before a company can package a private placement offering or effectively negotiate with a venture or angel investor, it has to have its proverbial house in order. See HERE for a discussion on pre-deal considerations.
Preparation also means understanding various fund-raising options and structures. All securities offerings must either be registered with the SEC or subject to an available exemption. Generally, very early rounds of financing are completed with friends and family acting as the investor base, but even then there must be an available securities law exemption. Most friends and family rounds rely on an intrastate exemption, such as Rule 504 or Rule 147 (see HERE for more information on intrastate offerings ) or Rule 506 where investors are accredited (see HERE and HERE for more information on Rule 506). Likewise, when accepting funds from angel and venture capital investors, a company generally relies on Rule 506.
As a company passes the initial friends-and-family round, crowdfunding is a great option and gives entrepreneurs an opportunity to learn to pitch and present to a larger audience. For more on crowdfunding, see HERE. Now that the offering limit for crowdfunding has increased to $5,000,000 and special-purpose vehicles can be used to streamline a cap table, crowdfunding has become and will continue to become a great option, either concurrently with or before larger angel and VC rounds. Ultimately, a company can move to public Regulation A offerings (see HERE) and IPO.
In addition to understanding the allowable offerings, a business and entrepreneur needs to be prepared to discuss the offering structure. An equity instrument can take the form of common stock, preferred stock, securities token, LLC membership interest, limited partnership interest, or warrant or option or any other right, title or interest in a company’s ownership, including its profits or revenue streams. In addition, some equity instruments, such as preferred stock or LLC membership interests, can have numerous different features including dividend rights, voting rights, liquidation preferences, conversion rights, redemption or put rights, anti-dilution provisions and negative covenants, just to name a few.
A debt instrument can take the form of a promissory note, convertible note, or debenture each having the same general meaning. A debt instrument can either be convertible into equity or not convertible. Like equity interests, a debt instrument can have a plethora of features and deal terms to best suit the needs of the investor and business. For a detailed discussion of investment structures, see HERE.
Reverting back to the Report, the forum participants made several recommendations to the SEC related to assisting in early capital raising efforts. The SEC responses to the recommendations were unfortunately very generic and political, not providing any assurance of forward action. The recommendations and SEC responses, include:
- Recommendation – Ensure capital raising rules provide equitable access to capital for underrepresented founders and investors.
SEC Response – The SEC points to the exempt offering rule amendments adopted on November 2, 2020. For a summary of those rules, see my five-part blog series – HERE; HERE ; HERE; HERE; and HERE. The SEC indicates that in the rule release, they acknowledged concerns about how capital markets are serving underrepresented founders and investors, encouraged further specific, tangible suggestions for action by the SEC, and expressed its commitment to continued engagement on this topic. Unfortunately, that answer does not move the needle.
- Recommendation – Establish a micro-offering exemption with minimal disclosure requirements.
SEC Response – The SEC has sought and received comment on a micro-offering exemption as part of its general requests for comments related to the exempt offering structure. The SEC will continue to consider comments and recommendations in this regard.
- Recommendation – Revise Regulation Crowdfunding to remove the GAAP financial statement requirement for businesses seeking to raise a small amount.
SEC Response – The SEC sought comment on this prior to the recent amendments to Regulation Crowdfunding and will continue to consider comments and recommendations in this regard.
- Recommendation – Provide state preemption for secondary transactions for shares issued under Regulation A and Regulation Crowdfunding.
SEC Response – The SEC sought comment on this prior to the recent amendments to Regulation Crowdfunding and will continue to consider comments and recommendations in this regard.
- Recommendation – Clarify the status of digital assets to make clear when it is a security
SEC Response – The SEC referred to its DAO Report published in 2017 and the Howey test analysis (see HERE) and its 2019 Analysis Matrix applying Howey (see HERE). Despite the SEC’s rather flippant reference to previous guidance, SEC Chair Gary Gensler has been vocally pushing Congress to expand the regulatory framework related to digital assets and in particular cryptocurrencies to strengthen and solidify the SEC’s role as top regulator over the digital asset marketplace.
Due Diligence
The second topic the forum focused on was due diligence including understanding what savvy investors the importance of introducing minority accredited investors to the work of angel investors and start-up financing as a method to improve financing options for minority- and women-owned businesses. Investors that have trouble finding opportunities can use social media and other public methods of expressing interest, though I note that kind of approach can result in a deluge of unqualified leads.
An integral part of preparation for fund raising, as discussed above, is ensuring that due diligence materials are well organized and complete. Corporate records should be maintained, asset ownership documented, and intellectual property protected. Every company should have a well-put-together investor-facing deck, business plan and/or executive summary. Advisors, friends and mentors are a great source to review materials and issue spot. The forum specifically discussed the importance of having a business thesis that aligns with investment goals of angel and VC groups.
The forum participants made several recommendations to the SEC on this second topic. The recommendations and SEC responses include:
- Recommendation – Expand the accredited investor definition to include other measures of sophistication, such as specialized industry knowledge or professional credentials.
SEC Response – The SEC referred to the amended accredited investor definition adopted in August 2020 – see HERE and the expansion of the definition to include certain licensed securities representatives. The SEC would consider designating additional qualifying professionals and will consider specific requests to do so. Any request must address how a particular certification, designation, or credential satisfies the non-exclusive attributes discussed in the rule release.
- Recommendation – Expand retail investor access to funds that invest in private offerings and support underrepresented entrepreneurs.
SEC Response – The SEC is considering the recommendation.
- Recommendation – Expand the accredited investor definition to include an investor certification course or test whose curriculum has been approved by FINRA or the SEC.
SEC Response – The SEC repeated its response to the fist recommendation above.
- Recommendation – Create more and better wealth-building opportunities for retail investors to build and support resilient and equitable local economies.
SEC Response – The SEC once again pointed to the amended accredited investor definition but also indicates it is open to any specific ideas or recommendations.
- Recommendation – Adopt rules and coordinate with the states to allow community investment funds with sufficient regulatory oversight and flexibility to pursue community-based investments.
SEC Response – The SEC indicates that it will consider any specific recommendations.
Tools for Emerging and Smaller Funds and Their Managers
The third topic of the forum focused on small and emerging fund managers including the challenges for this group such as a lack of track record, access to investors, regulatory barriers to entry and the significant personal financial risk for a fund’s general partner. However, these small and emerging funds are hugely important to our economic ecosystem as a whole and are the most likely institutional investor to invest in women and minority owned businesses.
The recommendations and SEC responses on this third topic include:
- Recommendation – Increase the number of investors allowed in 3(c)(1) funds above the 99 limit.
SEC Response – Any amendment to this provision would require congressional action.
- Recommendation – Increase the $10 million cap for 3(c)(1) qualified venture capital funds to allow a larger number of investors in small funds.
SEC Response – Any amendment to this provision would require congressional action.
- Recommendation – Support underrepresented and emerging fund managers and their investors through targeted resources, in collaboration with other federal agencies.
SEC Response – The SEC clearly believes that it already is making strides in this regard, citing its recent publication of a “Cutting Through the Jargon” glossary helping individuals learn the capital markets lingo. The SEC cited a few other similar initiatives. Like the rest of the responses, I’m sure this response did not resonate as a significant effort.
- Recommendation – Expand venture capital funds’ qualifying investments to include fund-of-funds investment in another venture capital fund, secondary securities acquired from founders and early stage investors, and follow-on investments in emerging growth companies.
SEC Response – An investment adviser to venture capital funds may qualify as an exempt reporting adviser that is not required to register with the SEC if the fund invests at least 80 percent of its assets in “qualifying investments” under Rule 203(I)-1 the Investment Advisers Act of 1940. A “qualifying investment” generally consists of any equity security issued by a qualifying portfolio company that is directly acquired by a qualifying fund and certain equity securities exchanged for the directly-acquired securities. Although such qualifying investment does not now include secondary purchases and investments, the SEC will consider adopting changes.
- Recommendation – Support underrepresented emerging fund managers – specifically minorities and women – building funds that diversity capital allocators, engage sophisticated investors, and challenge pattern matching trends.
SEC Response – The SEC believes it supports such efforts and indicates that it will consider any specific recommendations.
Perspectives on Smaller Public Companies
The final topic of the forum focused on smaller public company issues. The top issues discussed include costs of compliance, the burden of reporting requirements, short-termism or the pressure for short-term results and stock movement, obtaining research coverage and supporting trading volume and liquidity. Generally, all smaller companies have the same top priorities including understanding their shareholder base, meeting the demands of investors including those focused on ESG issues, attracting more institutional investors, engaging with retail investors and communicating effectively with shareholders.
The recommendations and SEC responses on this final topic include:
- Recommendation – Improve research coverage of smaller public companies in light of challenges from the Global Research Settlement, FINRA 2241, MiFID II, and other obligations on broker-dealers.
SEC Response – The SEC is looking into the matter. Also in November 2019, SEC staff extended temporary no-action position until July 2023 and stated its view that the use of certain client commission arrangements does not affect whether the broker-dealer exclusion may be available in connection with the receipt of payments for research under Exchange Act section 28(e).
- Recommendation – Increase the public float thresholds in the “smaller reporting company” and “accelerated filer” definitions.
SEC Response – The SEC amended the smaller reporting company definition in June 2018 (see HERE) and the accelerated filer definition in March 2020 (see HERE).
- Recommendation – Increase the transparency of short selling and dark pool activities.
SEC Response – NYSE, Nasdaq, FINRA and OTC Markets publish short selling information. The SEC is considering the recommendation.
- Recommendation – Facilitate creation of venture markets that provide investors with a transparent and regulated environment for trading in stocks of smaller companies.
SEC Response – A one-size fits-all approach to market structure does not work for many public issuers, particularly small and medium-sized companies. The SEC has invited exchanges and other market participants to submit proposals designed to improve the secondary market structure for exchange-listed equity securities that trade in lower volumes, commonly referred to as “thinly traded securities” (see HERE). I note that the request for input was issued two years ago and the SEC has not taken any action since.
- Recommendation – In connection with any new environmental, social, or governance (ESG) disclosure requirements, provide exemptions or scaled requirements for small and medium-sized companies.
SEC Response – The SEC will consider the recommendation.
« OTCQX And OTCQB Rule Changes SEC Cracking Down on The Crypto Wild West and Other Digital Asset Updates »
OTCQX And OTCQB Rule Changes
In September 2021, the OTCQB and OTCQX tiers of OTC Markets instituted amendments to their rules, to, among other things, align with the market changes resulting from amended Rule 15c2-11.
The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. Companies trading on the OTCQX, OTCQB and OTC Pink tiers of OTC Markets have the option of reporting directly to OTC Markets under its Alternative Reporting Standards. The Alternative Reporting Standards are more robust for the OTCQB and OTCQX in that they require audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor in the same format as would be included in SEC registration statements and reports.
Companies that report to the SEC under Regulation A and foreign companies that qualify for the SEC reporting exemption under Exchange Act Rule 12g3-2(b) may also qualify for the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets if they otherwise meet the listing qualifications. For more information on the OTCQB and OTCQX listing requirements, see HERE, HERE and HERE.
On September 28, 2021, amended Rule 15c2-11 became effective. From a high level, the amended rule requires that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; narrows reliance on certain of the rules exceptions, including the piggyback exception; adds new exceptions for lower risk securities; and adds the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allows for broker-dealer to rely on that confirmation. See HERE and HERE for an in-depth discussion of the new rules.
OTCQB Amendments
Effective September 26, 2021, the OTCQB Standards, Version 4.0, went into effect. The new Version 4.0 modified the prior rules as follows:
Bid Price Rule. Companies applying to the OTCQB in conjunction with an initial review for quotation eligibility under Rule 15c2-11 shall have three (3) business days to meet the requirement for proprietary priced quotations to be entered. That is, a company will need to coordinate with a market maker to enter a quotation within three business days of OTC Markets determination that the 211 information requirements have been satisfied. Upon application, OTC Markets may exempt these companies from the general requirement of having a minimum bid price of $.01 per share as of the close of business for the prior 30 consecutive calendar days.
Disclosure Requirements – Alternative Reporting Companies. – A Company that follows the Alternative Reporting Standard must have posted audited financials dated within 16 months at all times in order to maintain compliance with Rule 15c2-11.
Disclosure Requirements for International and Insurance Companies. Foreign issuers that report to the SEC using Forms 20-F and 40-F must also file an interim Form 6-K containing, at minimum, an interim balance sheet and an income statement as of the end of its second quarter. The Form 6-K must be filed within six months from the company’s second quarter end. International companies relying on Rule 12g3-2(b) must provide annual confirmation of 12g3-2(b) compliance through the Add Financial Report link in www.otciq.com using the report type titled “12g3-2(b) Confirmation.” For more on Rule 12g3-2(b), see HERE.
All insurance companies must post their most recent “Insurance Company Annual Regulatory Statement” per Securities Exchange Act Section 12(g)(2)(G)(I), through the OTC Disclosure & News Service, initially and annually.
Application Process. The OTCQB application and supporting materials must be submitted through the new online application portal at https://gateway.otcmarkets.com.
OTCQX Amendments
Effective September 23, 2021, the OTCQX Standards, Version 9.0, went into effect. The new Version 9.0 modified the prior rules as follows:
Bid Price Rule. Companies applying to the OTCQX in conjunction with an initial review for quotation eligibility under Rule 15c2-11 shall have three (3) business days to meet the requirement for proprietary priced quotations to be entered. That is, a company will need to coordinate with a market maker to enter a quotation within three business days of OTC Markets determination that the 211 information requirements have been satisfied. Upon application, OTC Markets may exempt these companies from the general requirement of having a minimum bid price of $.25 per share as of the close of business for the prior 30 consecutive calendar days. This same rule change applies to U.S., International and U.S. Bank issuers.
SPACs. SPACs with at least $20 million public float and a bid price of at least $5.00 can qualify to trade on the OTCQX. A company formerly operating as a SPAC that has effected or is in the process of effecting a business combination and becoming an operating company may request a 90-day exemption to the float requirement in Section 2.1(i) (i.e., minimum float of $10 million). A qualifying company must meet all other OTCQX eligibility criteria and must have been publicly traded prior to the business combination.
Insurance Companies. All insurance companies must post their most recent “Insurance Company Annual Regulatory Statement” per Securities Exchange Act Section 12(g)(2)(G)(I), through the OTC Disclosure & News Service, initially and annually.
Disclosures. All companies must verify their Company Profile through the OTCIQ.com web portal as an initial disclosure obligation. A Company that follows the Alternative Reporting Standard must have posted audited financials dated within 16 months at all times in order to maintain compliance with Rule 15c2-11.
Fees. Companies may be removed for non-payment of outstanding fees to OTC Markets, including fees for services such as press releases.
International Companies. All companies must either be listed on a Qualified Foreign Stock Exchange and eligible to rely on the exemption from registration provided by Rule 12g3-2(b), be an SEC Reporting Company or be a Regulation A Reporting Company. Exemptions for companies listed on a foreign exchange that is not a Qualified foreign Exchange and for companies that cannot rely on the exemption provided by 12g3-2(b) because they do not meet the definition of “foreign private issuer” have been eliminated from the rules.
International companies that are SEC or Regulation A reporting and not listed on a qualified foreign exchange must have a public float of at least 10%.
« Climate Disclosure Guidance 2021 Annual Report of Office of Advocate for Small Business Capital Formation »
Climate Disclosure Guidance
Ahead of the imminent publication of updated climate disclosure rules, the SEC has published a sample comment letter providing companies with guidance as to the regulator’s current focus and expectations under the rules. The last official SEC guidance on climate-related guidance was published in 2010; however, the SEC, and individual top brass, have been vocal about the need for updated regulations. In that regard, in March 2021, the SEC published a statement requesting public input on climate change disclosures. It is expected that either a rule proposal or temporary final rules are forthcoming. For more information on differing views following the March 2021 request for public comment, including from regulators, industry groups and individual SEC Commissioners, see HERE.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures: HERE). In addition to MD&A, climate-change-related disclosures, including risks and opportunities, may be required in disclosures on a company’s description of business, legal proceedings, and risk factors. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information. Disclosure may also be necessary under the anti-fraud rules which require a company to include such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.
Disclosure matters discussed in the 2010 guidance include: (i) the impact of pending or existing climate-change-related legislation, regulations, and international accords; (ii) the indirect consequences of regulation or business trends; and (iii) the physical impacts of climate change. I’ve included a recap of the March 2021 request for public comment and 2010 guidance at the end of this blog.
Sample SEC Comment Letter
The SEC sample comment letter is broken down by disclosure topic.
General
As I’ve discussed in previous blogs, some companies opt to publish an ESG report, often referred to as a social responsibility report (“CSR”), on their website but not include the report in their SEC reports. There are many reasons for this including the obvious, that information included in SEC reports is subject to Sarbanes-Oxley (SOX)-related requirements including that reports be generated as part of a system of internal controls over financial reporting (ICFR), that management assess such ICFR, and in the case of 10-Q’s and 10-K’s, file CEO and CFO certifications attesting to such assessment (see HERE). There is also the matter of auditor involvement in the preparation of reports, and responsibilities of the board of directors (see HERE).
At the same time as advocating for increased climate change disclosures, the SEC has been clear that it is focused on the veracity of such disclosures. There is a concern that some companies, including investment companies, are publishing ESG goals with no real underlying commitment or execution. Likewise, as there are no standard requirements related to third-party CSR reports, a company could obtain a positive report, regardless of underlying metrics.
With that backdrop in mind, the SEC sample comment letter includes the following general comment: “We note that you provided more expansive disclosure in your corporate social responsibility report (CSR report) than you provided in your SEC filings. Please advise us what consideration you gave to providing the same type of climate-related disclosure in your SEC filings as you provided in your CSR report.” The SEC is clearly sending a warning that published CSR reports should be consistent with disclosure in an SEC report, and if not, the company needs to explain themselves.
Risk Factors
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation. For more information on risk factor disclosure requirements, see HERE.
Despite the SEC’s consistent message that risk factors should not merely be generic disclosures that could apply to any public company, most companies, big and small, continue to copy and paste a list of boilerplate risks. The sample comment letter is focused on the degree to which companies are merely addressing climate risk in a generic and abstract sense or are adequately considering and disclosing particular material matters.
The two sample comments include: (i) [D]isclose the material effects of transition risks related to climate change that may affect your business, financial condition, and results of operations, such as policy and regulatory changes that could impose operational and compliance burdens, market trends that may alter business opportunities, credit risks, or technological changes; and (ii) [D]isclose any material litigation risks related to climate change and explain the potential impact to the company.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
It is in the area of MD&A that the SEC is pushing companies to really improve disclosures, with the underlying necessity that the issues be well vetted and thought through. The sample SEC comment letter includes 6 multi-part comments that, I believe, provide the most insight into what we can expect in the new disclosure rules.
The SEC is asking that companies consider the impact on their business of the significant developments in federal and state legislation and regulation and international accords regarding climate change. Companies should include a discussion of any material pending or existing climate-change-related regulatory or similar changes that may impact their business and describe the effect on the business, financial condition, and results of operations. This disclosure would necessarily include climate-related litigation, challenges to permits, and impacts on customers and suppliers.
Although it seems obvious that companies should have been including material climate-related capital expenditures in their reports, the sample comment letter includes a request to “Revise your disclosure to identify any material past and/or future capital expenditures for climate-related projects. If material, please quantify these expenditures.” Similarly, the SEC asks for disclosure of any material increased compliance costs related to climate change and challenges companies to quantify that increase. Making sure that a company provides rounded disclosure, the sample comment letter also asks for disclosure about a company’s purchase or sale of carbon credits or offsets.
The SEC clearly assumes that climate change has and will continue to alter the economy and supply chains. Indirect consequences of these changes should also be analyzed and discussed, including: (i) decreased demand for goods or services that produce significant greenhouse gas emissions or are related to carbon-based energy sources; (ii) increased demand for goods that result in lower emissions than competing products; (iii) increased competition to develop innovative new products that result in lower emissions; (iv) increased demand for generation and transmission of energy from alternative energy sources; and (v) any anticipated reputational risks resulting from operations or products that produce material greenhouse gas emissions.
Climate change is not just an esoteric discussion about the future of the planet but has a current real-world physical impact as well. In that regard, the SEC comment letter requests information on the physical impact to a company, including: (i) the severity of weather, such as floods, hurricanes, sea levels, arability of farmland, extreme fires, and water availability and quality; (ii) quantification of material weather-related damages to your property or operations; (iii) potential for indirect weather-related impacts that have affected or may affect your major customers or suppliers; (iv) decreased agricultural production capacity in areas affected by drought or other weather-related changes; and (v) any weather-related impacts on the cost or availability of insurance.
March 2021 Request for Comment
On March 15, 2021, the SEC issued a statement requesting public input on climate change disclosures. The request for public comment outlined specific questions for consideration, including:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)? Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures delineating areas that could require such disclosure, including:
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business, both historically and intended. Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Legal Proceedings
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Risk Factors
Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate-related information.
« A Review of FINRA’s Corporate Finance Rule OTCQX And OTCQB Rule Changes »
A Review of FINRA’s Corporate Finance Rule
As the strongest U.S. IPO market in decades continues unabated, it seems a good time to talk about underwriter’s compensation. FINRA Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements) governs the compensation that may be received by an underwriter in connection with a public offering.
Rule 5110 – The “Corporate Financing Rule”
Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities. The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA. The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest. As more fully described herein, underwriter’s compensation is subject to lock-up provisions.
Filing Requirements
Rule 5110 requires a member that participates in a public offering to file documents and information with FINRA about the underwriting terms and arrangements. The 5110 filing must be made within three (3) business days after any documents (generally an S-1 or Form 1-A but the Rule is broad enough to cover any public offering filing) are filed with or submitted to the SEC, including confidential filings. I note that the Rule used to require a filing to be made within one business day, but the time was extended by amendment in March 2020. The material submitted is confidential and not available to the general public.
Where an offering is syndicated amongst multiple firms, only the managing underwriter, or where multiple managers, only one syndicate member firm, is required to make the filing. The filing firm must keep the other syndicate members apprised of FINRA comments which are generally in the form of a letter stating that one or more term is unfair or unreasonable. The underwriting may not continue until FINRA has confirmed that it has no objection to the underwriting terms and arrangements.
A 5110 filing is accomplished through the submittal of certain documents and information through the FINRA portal and in particular:
- the registration statement, offering circular, offering memorandum, notification of filing, notice of intention, application for conversion, and any other document used to offer securities to the public (the firm may provide the document number on the EDGAR database in lieu of actual documents);
- all documents relevant to the underwriting terms and arrangements, including any proposed underwriting agreement, agreement among underwriters, selected dealer’s agreement, agency agreement, purchase agreement, letter of intent, engagement letter (to the extent it impact’s underwriter’s compensation), consulting agreement, partnership agreement, underwriter’s warrant agreement, or escrow agreement, provided that industry-standard master forms of agreement need not be filed unless otherwise specifically requested by FINRA;
- any amendments to the previously filed documents to the extent they impact underwriter’s compensation;
- final registration or equivalent document declared effective by the SEC and the notice of effectiveness; and
- all requests for withdrawal of any documents filed with the SEC.
In addition to the document filing requirement, the 5110 filing must include:
- an estimate of the maximum offering price;
- an estimate of the maximum value for each item of underwriting compensation;
- a representation as to whether any officer, director, or 10%+ shareholder of the issuer is an associated person or affiliate of the member firm (prior to March 2020, the ownership threshold was 5%);
- a description of any securities acquired or beneficially owned by the member firm and a copy of any non-convertible or non-exchangeable debt instrument or derivate security obtained in connection with the public offering must be filed with FINRA;
- any applicable representations when claiming any compensation can be excluded from underwriting compensation under the Rule;
- the SEC registration statement number for any shelf offering on Form S-3, F-3, F-10 or similar (to facilitate quick access to capital, FINRA will review this filing on a post-takedown basis); and
- an explanation and documents related to any modification of any documents or information previously submitted in accordance with Rule 5110.
A member firm must also inform FINRA if an offering is not completed and underwriting compensation is received, such as expense reimbursements. Similarly, a member must inform FINRA when an agreement’s termination provision is triggered. If there is a revised offering is within the review period (as discussed below) of the terminated offering, FINRA will aggregate compensation received in the prior terminated offering.
Issuer Disclosure
Although Item 508 of Regulation S-K requires an issuer to disclose underwriter’s compensation as part of its plan of distribution, and Item 501 requires an issuer to disclose underwriter discounts on the forepart of a registration statement and outside front cover page of a prospectus, Rule 5110 extends these obligations to the underwriter itself. In particular, Rule 5110 imposes a requirement that each item of underwriter compensation received or to be received be disclosed in the section on distribution arrangements in the prospectus or similar document. The Rule 5110 underwriter compensation lock-up provisions must also be disclosed in this section. Rule 5110 also requires that any underwriting commission or discount to the public offering price be disclosed on the cover page of the prospectus or similar document and that such disclosure include a footnote cross-referencing the distribution section for a complete explanation of underwriter’s compensation.
Filing Requirement Exemptions
Rule 5110 includes two categories of exempt public offerings—offerings that are exempt from filing but remain subject to the substantive provisions of Rule 5110 and offerings that are exempt from both the filing requirements and substantive provisions of Rule 5110. The amendment reorganizes, expands and clarifies the scope of these exemptions.
Underwriters need not file under rule 5110 (unless there is a conflict of interest such as that a member firm is a control person of the issuer) for offerings: (i) by a bank, corporation or foreign government that has outstanding investment grade unsecured non-convertible debt or preferred securities with a term of at least four years except if the offering is an initial public offering of equity; (ii) investment grade non-convertible debt or preferred securities; (iii) offerings registered with the SEC on Forms S-3, F-3 or F-10 for experienced issuers (i.e., an issuer with a 36-month reporting history and at least $150 million aggregate market value of voting stock held by nonaffiliates or, alternatively, the aggregate market value of voting stock held by non-affiliates is at least $100 million and the issuer has an annual trading volume of three million shares or more in the stock); (iv) investment grade rated financing instrument-backed securities; (v) exchange offers where the securities to be issued are listed on a national exchange or the company listing securities qualifies for (iii) above; (vi) public offerings by a church or other charitable institution; and (vii) offerings of securities issued by a pooled investment vehicle not registered under the Investment Company Act and which already has a class of redeemable securities listed for trading on a national securities exchange.
What is Considered Underwriter’s Compensation?
Underwriter’s compensation is broadly defined as “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering. In addition, underwriting compensation shall include finder’s fees, underwriter’s counsel fees, and securities.” Any payment, right, interest or benefit that meets the definition of “underwriting compensation” received by participating members during the applicable review period will be presumed to be underwriting compensation.
FINRA considers any compensation received or to be received within a “review period.” “Review period” is defined as: (i) for a firm commitment offering, the 180-day period preceding the required filing date through the 60-day period following the effective date of the offering; (ii) for a best efforts offering, the 180-day period preceding the required filing date through the 60-day period following the final closing of the offering; and (iii) for a firm commitment or best efforts takedown or any other continuous offering made pursuant to Securities Act Rule 415, the 180-day period preceding the required filing date of the takedown or continuous offering through the 60-day period following the final closing of the takedown or continuous offering.
Non-convertible or non-exchangeable debt securities and derivative instruments acquired in a transaction unrelated to a public offering is not considered underwriting compensation. Where such instruments are considered compensation, Rule 5110 provides mathematical formulas for valuing these convertible and non-convertible securities for purposes of determination of total underwriter’s compensation. However, a member firm may reduce the value of any securities received as underwriting compensation by voluntarily agreeing to a lock-up of such securities for successive 180-day periods. Each additional 180-day period will reduce the proposed maximum value attributable to such securities by 10%.
Rule 5110 also provides a non-exhaustive list of examples of payments or benefits that are not considered underwriters compensation (and thus not subject to the required lock-up provisions). Payments or benefits are generally not underwriting compensation when received by members for providing services unrelated to the public offering and when the payments or benefits are consistent with those received by other similarly situated persons and which are customary and appropriate for the services provided. Securities acquired in some transactions identified in the examples (e.g., securities acquired in a dividend paid during the review period or as a result of a conversion of securities originally acquired before the review period) are the result of bona fide financing or investing activities that are unrelated to the public offering.
Similarly, investments by a member firm, prior the filing of a registration statement or similar document, on the same terms and conditions as other investors, will generally not be considered underwriters compensation. Rule 5110 has a series of Venture Capital Exceptions in that regard. FINRA also allows for funding of a company when a public offering has been delayed. Whereas the Venture Capital Exceptions are more prescriptive, determining whether a particular financing or investment is underwriter’s compensation when a public offering is delayed following the filing of a registration statement, is principles based. Among other factors, FINRA will consider (i) the length of time between the date of filing a registration statement or similar document and the relevant funding; (ii) the length of time between the date of a funding and the anticipated public offering; and (iii) the nature of the funding provided.
On the other hand, examples of securities acquisitions that are intended to provide underwriting compensation to a participating member related to the public offering under review include acquisitions where the terms of the securities were altered to provide additional compensation to the participating member during the review period or where the securities were acquired in a transaction that was intended primarily to compensate the participating member related to the public offering, such as a transaction where only the participating member is offered the opportunity to invest.
Rule 5110 also restricts certain types of non-cash compensation. A FINRA member or associated person may only accept non-cash compensation as follows: (i) gifts valued under $100 per year and only if the gift is not preconditioned on achieving a sales target; (ii) an occasional meal, a ticket to a sporting event or the theater, or comparable entertainment which is neither so frequent nor so extensive as to raise any question of propriety and is not preconditioned on achievement of a sales target; (iii) payment or reimbursement by offerors in connection with meetings held by an offeror or by a member for the purpose of training or education of associated persons of a member and limited to certain circumstances; (iv) non-cash compensation arrangements between a member and its associated persons or a company that controls a member company and the member’s associated persons; or (v) contributions by a non-member company or other member to a non-cash compensation arrangement between a member and its associated persons under certain circumstances.
Lock-Up Restrictions
Subject to some exceptions, Rule 5110 requires a 180-day lock-up restriction on any securities that constitute underwriters compensation. During the lock-up period the securities may not be sold or transferred, pledged as collateral or made subject to any derivative contract (put or call option, etc.). The lock-up period takes effect on the date of commencement of sales (rather than the date of effectiveness of the prospectus).
Exceptions to the lock-up restrictions include: (i) securities acquired from an issuer that is S-3, F-3 or F-10 eligible; (ii) securities acquired in a transaction meeting one of the Venture Capital exceptions; (iii) securities that are “actively traded” (i.e., have an average daily trading volume value of at least $1 million and are issued by an issuer whose common equity securities have a public float value of at least $150 million—provided, however, that such securities are not issued by the distribution participant or an affiliate of the distribution participant); (iii) securities that were received as underwriting compensation and are registered and sold as part of a firm commitment offering; and (iv) the security is required to be transferred by operation of law or by reason of a reorganization of the issuer; (v) the aggregate amount of securities of the issuer beneficially owned by a participating member does not exceed 1% of the securities being offered; (vi) non-convertible or non-exchangeable debt securities acquired in a transaction related to the public offering; (vii) if the security is beneficially owned on a pro-rata basis by all equity owners of an investment fund, provided that no participating member manages or otherwise directs investments by the fund, and participating members in the aggregate do not own more than 10% of the equity in the fund; and (viii) derivative instruments acquired in connection with a hedging transaction related to the public offering and at a fair price.
The lock-up restrictions do not prohibit: (i) the transfer of any security to any member participating in the offering and its officers or partners, its registered persons or affiliates, if all transferred securities remain subject to the lock-up restriction for the remainder of the 180-day lock-up period; (ii) the exercise or conversion of any security, if all securities received remain subject to the lock-up restriction for the remainder of the 180-day lock-up period; or (iii) the transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC.
Unreasonable Terms and Arrangements
Rule 5110 sets forth certain terms and arrangements which are considered unreasonable. These include:
- receipt of any underwriting compensation, including in the form of securities, for which a value cannot be determined;
- any accountable expense allowance that includes payment for general overhead, salaries, supplies, or similar expenses incurred in the normal conduct of business;
- any non-accountable expense allowance in excess of 3% of offering proceeds;
- any underwriting compensation paid prior to the commencement of sales of the public offering, except an advance against accountable expenses expected to be incurred and that will be reimbursed if not incurred or advisory or consulting fees for services provided in connection with the offering;
- any underwriting compensation in connection with a public offering that is not completed according to the terms of an agreement entered into by an issuer and a participating member, except expense reimbursement or a termination fee or right of first refusal provided there is a written agreement allowing the issuer to terminate for cause and that in the event of such termination for cause, no fee is due;
- a termination fee and right of first refusal must be reasonable in relation to the underwriting services and must be customary for those type of services;
- a termination fee cannot be imposed for a transaction that is consummated later than two years form the date the engagement is terminated with the issuer;
- a right of first refusal cannot be longer than three years and cannot have more than one opportunity to waive or terminate the right of first refusal in consideration of any payment or fee;
- any payment or fee to waive or terminate a right of first refusal to participate in a future public offering, private placement or other financing that is not paid in cash;
- the receipt of underwriting compensation consisting of any option, warrant or convertible security that: (a) is exercisable or convertible more than five years from the commencement of sales of the public offering; (b) has more than one demand registration right at the issuer’s expense; (c) has a demand registration right with a duration of more than five years from the commencement of sales of the public offering; (d) has a piggyback registration right with a duration of more than seven years from the commencement of sales of the public offering; (e) has anti-dilution terms that allow the participating members to receive more shares or to exercise at a lower price than originally agreed upon at the time of the public offering, when the public shareholders have not been proportionally affected by a stock split, stock dividend, or other similar event; or (f) has anti-dilution terms that allow the participating members to receive or accrue cash dividends prior to the exercise or conversion of the security;
- any overallotment option providing for the overallotment of more than 15% of the amount of securities being offered, computed excluding any securities offered pursuant to the overallotment option;
- the receipt by a participating member of any compensation in connection with the exercise or conversion of any warrant, option, or convertible security offered in the public offering if: (a) the market price of the security into which the warrant, option, or convertible security is exercisable or convertible is lower than the exercise or conversion price; (b) the security is held in a discretionary account at the time of exercise unless specific approval is received from the customer; (c) the compensation arrangements are not disclosed in the offering documents provided to security holders at the time of exercise or conversion; or (d) the exercise or conversion is not solicited by the participating members; and
- for a member to participate in a public offering of securities where the issuer hires persons primarily for the purpose of solicitation, marketing, distribution or sales of the offering, unless such persons that are required to be registered, are registered.
Independent Financial Advisor Exception
Rule 5110 provides that an “independent financial adviser” that provides advisory or consulting services to the issuer would not meet the definition of “participation in a public offering” would therefore not be subject to the compensation limitations of Rule 5110, lock-up period and information filing requirements. The Rule defines an independent financial adviser as “a member that provides advisory or consulting services to the issuer and is neither engaged in, nor affiliated with any entity that is engaged in, the solicitation or distribution of the offering.” The Rule allows issuers to engage member firms to provide advice and consultation regarding financing options, the advantages and disadvantages of these options, the terms and conditions of an underwriting proposed by another member firm (assuming the advisory and underwriter firm are independent of each other), and all matters of corporate finance without automatically being deemed to be engaged in a public offering should one ensue. If the firm also engages in solicitation or distribution activities in addition to providing advisory or consulting services, the exclusion of the advisory-related compensation is not be available and all of the compensation received by that firm in connection with the offering is subject to the compensation limitations and disclosure requirements.
Definition of Public Offering
A “public offering” is broadly defined to include any primary or secondary offering of securities made in whole or in part in the US pursuant to a registration statement, offering circular (i.e., Form 1-A in a Regulation A offering) or similar offering document including exchange offers, rights offerings, and offerings of securities made pursuant to a merger or acquisition except for:
- securities exempt from registration under the Securities Act by Sections 4(a)(1) (i.e., transactions by a person other than an issuer, underwriter or dealer); 4(a)(2) (transactions not involving a public offering); or 4(a)(5) (limited accredited investor exemption);
- securities exempt under Rule 504 as long as the securities will be restricted, and Rule 506 of Regulation D;
- securities exempt under Rule 144A or Regulation S; or
- securities exempt under Section 3(a)(12) of the Securities Act (bank holding company acquisitions).
The Author
« SEC Chair Gary Gensler Testifies To Congress Sharing is caring! Climate Disclosure Guidance »
SEC Chair Gary Gensler Testifies To Congress Sharing is caring!
On September 14, 2021, SEC Chairman Gary Gensler gave testimony to the U.S. Senate Committee on Banking, Housing and Urban Affairs highlighting the priorities of the SEC under his rule. After giving the obligatory opening statements on the size and impact of the U.S. capital markets, Gensler broke down the SEC agenda into four topics including market structure, predictive data analytics, issuers and issuer disclosure and funds and investment management.
Market Structure
Chair Gensler began his speech market structure by talking about the U.S. Treasury Market, which I found interesting mainly because I do not recall any speech or testimony by recent SEC chairpersons that focused on the topic (albeit I haven’t read them all, but I’ve read a lot!). During Covid, the Treasury Market suffered from liquidity issues prompting the SEC to consider rule and process changes, including those related to clearing, that could make the Treasury Markets more resilient and competitive. The SEC is also considering Treasury trading platforms and efforts to ensure that firms that significantly trade in the market are licensed dealers with the SEC. Likewise, the SEC is looking at updating the corporate bond and asset-backed securities markets.
Turning to equity markets, the SEC is focused on the impact of technology including the ability for retail investors to trade using commission-free apps, gamification, high-speed high-frequency trading and access to market data. In that regard, the SEC is looking at ways to improve competition and efficiency on an order-by-order basis. Over half of trading volume is completed by wholesalers in dark pools, and retail trading is dominated by only a few clearing firms.
Also on the SEC priority list is reducing conflicts of interest in the market, including payment for order flow, a topic that was included on in Chairman Gensler’s May 6, 2021 speech to the House Financial Services Committee (see HERE) and on the SEC Spring 2021 Regulatory Agenda (see HERE). One of the items on the agenda is reducing the current T+2 to T+1 or even T0 to reduce costs and market risks.
Security-based swaps is always a hot topic for the SEC and remains so. Chair Gensler knows the area very well, having headed up the security-based swaps regulatory structure at the CFTC. Some rules have already been passed and are now being implemented, including the requirement that security-based swap dealers and major participants begin registering with the SEC by November 1. On November 8, new post-trade transparency rules will go into effect, requiring transaction data to be reported to a swap data depository and thus available to the SEC and, under appropriate circumstances, other regulators. Then, beginning on February 14, 2022, the swap data repositories will be required to disseminate data about individual transactions to the public, including the key economic terms, price, and notional value.
The Crypto Assets Market is a major focus this year (in a blog coming in the next few weeks, I will delve much deeper into this topic). Reiterating prior comments about the Crypto Wild West, Gensler believes that the Crypto Markets are lacking investor protections and, as such, is rife with fraud, scams and abuse. The SEC is working on two tracks. The first is to figure out how to work with other regulators to help add investor protections. The second is to figure out legislative gaps and ask Congress to step up.
Further regulation is needed on (i) the offer and sale of crypto tokens; (ii) crypto trading and lending platforms; (iii) stable coin valuation; (iv) investment vehicles providing exposure to crypt assets or crypto derivatives; and (v) custody of crypto assets (see here for recent information on custody issues – HERE).
Building on his past experience with swaps, Chair Gensler is leading the SEC to work with the CFTC to both develop regulatory frameworks related to crypto assets. With respect to a broader set of policy frameworks, the SEC is also working with the Federal Reserve, Department of Treasury, Office of the Comptroller of the Currency, and other members of the President’s Working Group on Financial Markets on these matters.
Predictive Data Analytics
Related to market structure technology is predictive data analytics. Artificial intelligence, predictive data analytics, and machine learning are shaping and will continue to reshape many parts of the economy. Trading platforms have new capabilities to tailor marketing and products to individual investors. While this can increase access and choice, such differential marketing and behavioral prompts raise new questions about potential conflicts within the brokerage, wealth management, and robo-advising spaces, particularly if and when brokerage or investment advisor models are optimized for the platform’s revenue and data collection.
Gensler also expresses concern about historical biases that may be imbedded in data sets and add to discrimination against protected classes including race and gender. Finally, there is a concern about concentration of information and interconnectedness that could increase systemic risk in the marketplace.
Issuers and Issuer Disclosure
As we all know, the disclosure rules have changed and evolved over time. The current SEC, under Gensler, will look to expand disclosure requirements related to climate risk (see HERE), human capital (see HERE), and cybersecurity. Cybersecurity disclosures are a hot topic at the SEC these days, with enforcement also investigating inadequate disclosures under the current rules (see HERE for more on current disclosure requirements).
The SEC is also focused on increased SPAC disclosures including related to fees and potential conflicts of interest. Although I write about SPACs often, this particular blog provides a good foundation to understand the SEC’s disclosure concerns – HERE.
Issues related to China and the ability to inspect audit records remain a primary concern (see HERE). The SEC also feels that basic disclosures, such as the risks related to audits and what it really means to be set up with a VIE structure, are inadequate.
Finally, on the topic of disclosures, the SEC is concerned with insider trading and is looking at developing new rules on the topic. I note that insider trading laws are largely judicially created, and the area really does need a redo.
Funds and Investment Management
Related to Funds and Investment Management, Gensler first expresses concern about the popular “green,” “sustainable,” and “low-carbon” marketing terms. The SEC is considering ways to determine what information stands behind those claims. Like public companies, cybersecurity risk governance in the fund markets is a high priority for the SEC.
Another priority is private fund management and disclosures. The SEC is looking at developing additional disclosure rules including related to fees and conflicts of interest. The private equity world, I’m sure, is not pleased with this development.
« Consequences Of Failing To File A Form D A Review of FINRA’s Corporate Finance Rule »
Consequences Of Failing To File A Form D
I often get calls from clients or potential clients that have engaged in exempt offerings, have not filed a Form D and are wondering what the consequences might be. Taking it further, what are the consequences of not complying with the minor state blue sky requirements for any federally covered securities?
Form D – In General
A Form D is a brief fill-in-the-blank form that is filed with the SEC in connection with an offering or issuance of securities in reliance on the exemptions from the Securities Act of 1933 (“Securities Act”) registration requirements found in Regulation D. The offering exemptions in Regulation D consist of Rules 504, 506(b) and 506(c) (see HERE).
A Form D is a notice filing. Rule 503 of Regulation D, which was last amended in November 2016, requires that a company relying on Rules 504 or 506 must file a Form D, notice of sales, with the SEC for each new offering of securities no later than 15 calendar days after the first sale of securities in the offering. The Rule requires that a Form D by filed via EDGAR and be signed by an authorized person.
Rule 503 also sets out requirements requiring amendments to the Form D and the timing of filing of such amendments. The Rule is very specific. A company may amend a Form D at any time voluntarily. A company must amend a Form D (i) to correct a material mistake of fact or error; or (ii) to reflect a change in the information provided as soon as practicable after that change; and (iii) annually on or before the first anniversary of the filing of the Form D or most recent amendment.
No amendment is required under item (ii) if the change occurs after the offering is terminated or solely relates to: (a) the address of the company or an identified person; (b) the companies’ revenues or aggregate net asset value; (c) the minimum investment amount if the change is an increase or if a decrease, does not result in a decrease of more than 10%; (d) any address or state of solicitation; (e) the total offering amount if the change is a decrease or if an increase, does not result in an increase of more than 10%; (f) the amount of securities sold in the offering or amount remaining to be sold; (g) the number of non-accredited investors as long as the change does not increase the number to more than 35; (h) the total number of investors in the offering; or (i) the amount of sales commissions, finders fees, or use of proceeds for payments to executive officers, directors or promoters if the change is a decrease, or if an increase, that increase is not more than 10%.
Federal Consequences of Failure to File
Rule 503 gives no indication that a Form D filing is voluntary, but rather uses the word “must” throughout. Rule 507 disqualifies a company from relying on Regulation D if it or any of its predecessors or affiliates have been subject to any order, judgment, or decree of any court of competent jurisdiction temporarily, preliminarily, or permanently enjoining such a company for failure to comply with Rule 503. Rule 507 does allow for the SEC to overrule this provision if it determines, upon a showing of good cause, that it is not necessary under the circumstances to deny the exemption. Rule 507 was also last amended in November 2016. Rule 507 certainly appears to add teeth to the Rule 503 Form D filing requirement.
However, in 2009, the SEC issued a C&DI clearly indicating that the failure to file a Form D does not impact the availability of an exemption under Regulation D. In particular:
Question: Is the filing of a Form D in connection with an offer or sale a condition to the availability of a Regulation D exemption for that offer or sale?
Answer: No. The filing of a Form D is a requirement of Rule 503(a), but it is not a condition to the availability of the exemption pursuant to Rule 504 or 506 of Regulation D. Rule 507 states some of the potential consequences of the failure to comply with Rule 503.
In conversations with the SEC staff members, I have confirmed that the SEC will not pursue an enforcement action or otherwise take a negative position against a company for the failure to file a Form D alone. However, if an enforcement action is pursued for other reasons, such as fraud, the SEC may bolt on a claim for a violation of Rule 503.
Over the years, some industry professionals have proffered the idea that although the SEC did not require the filing of a Form D, a state may take the position that a federally pre-empted offering is not perfected, and thus pre-emption not secured, unless a Form D is filed. To address this concern, the SEC issued another C&DI in 2017 and in particular:
Question: Will a Rule 506 offering lose “covered security” status under Section 18 of the Securities Act if an issuer fails to file a Form D with the SEC?
Answer: No. A “covered security” under Section 18 of the Securities Act is defined to include a security with respect to an offering that is exempt from registration under the Act pursuant to SEC rules or regulations issued under Section 4(a)(2) of the Act. Rule 506(b) was issued under Section 4(a)(2) of the Act; Congress determined in the JOBS Act that Rule 506(c) would be treated as a regulation issued under Section 4(a)(2). Filing a Form D is not a condition that must be met to qualify for the Rule 506 exemption.
Although it appears that the failure to file a Form D has no real impact, the fact is that the failure to file is a stand-alone violation of Rule 503 and if a court temporarily, preliminarily, or permanently enjoining such a company for failure to comply with Rule 503, the ability to rely on Regulation D will be lost. Also, the SEC has only protected the use of Rule 506, which is a federally covered transaction, a Rule 504 offering could still be challenged on the state level if the mandated Form D is not filed.
State Blue Sky Consequences of Failure to File
Generally, an offering and/or sale of securities must be either registered or exempt from registration under both the federal Securities Act and state securities laws. As a result of a lack of uniformity in state securities laws and associated burden on capital-raising transactions, on October 11, 1996, the National Securities Markets Improvement Act of 1996 (“NSMIA”) was enacted into law. The NSMIA amended Section 18 of the Securities Act to pre-empt state “blue sky” registration and review of specified securities and offerings. The pre-empted securities are called “covered securities.” For an in-depth discussion of the NSMIA and state blue sky laws, see my two-part blog HERE and HERE.
Among other NSMIA covered transactions/securities are securities issued in a Rule 506 offering, and as noted above, Rule 506 will not lose its covered status as a result of a failure to file a Form D. However, Rule 504 is not a covered transaction and requires compliance with state blue sky laws. It is possible that an individual state would deem the failure to file a Form D, an actionable violation of their offering requirements. In the event a state received a judgment that included a violation of Rule 503, Rule 507 would kick in and have a devastating effect on future capital raising efforts for a company.
Moreover, the NSMIA specifically contains a provision allowing a state to require a notice filing and the payment of a fee. That notice filing is generally the Form D. NSMIA also reserves power for a state to pursue fraud actions. Accordingly, even if a state could not claim that a Rule 506 offering was no longer federally pre-empted for the failure to file a Form D, the state could bolt on a Rule 503 violation in a fraud claim, again, with a potentially disastrous impact on future capital raising efforts.
Section 4(a)(5)
Section 4(a)(5) is a rarely, if ever, used exemption from the registration requirements for sales made to accredited investors. Section 4(a)(5) has the following requirements: (i) delivery of a prospectus that complies with Securities Act disclosure requirements; (ii) no general solicitation or advertisement; (iii) an offering maximum of $5,000,000; and (iv) the filing of a Form D. In this case, the filing of a Form D is an actual requirement to rely on the exemption and the SEC has not watered down that requirement through any guidance. However, since a Section 4(a)(5) offering does not pre-empt state law and offers no benefits over a Regulation D offering (but does obviously have several detriments), it is almost never used. I suspect, this offering exemption will go the way of Rule 505 and eventually be eliminated.
« FINRA Granted Oversight Of OTC Markets In The 211 Process SEC Chair Gary Gensler Testifies To Congress Sharing is caring! »
FINRA Granted Oversight Of OTC Markets In The 211 Process
Clearly not completely pleased with the power bestowed on OTC Markets as part of the amended Rule 15c2-11, on June 9, 2021, FINRA filed a request for a rule change to increase its regulatory oversight and require OTC Markets to file a Form 211 as part of the new process. The SEC published the proposal on June 15 and sought comments. Only one comment letter was received, and that was from OTC Markets itself. On September 10, 2021, SEC approved the rule change with an effective date of September 28, 2021, the same day as the compliance date for the amended Rule 15c2-11. On that date, any company that does not comply with the current publicly available information requirements in the amended 15c2-11 rules (see HERE and HERE for in-depth discussions on the new rules), will cease to trade and become what the industry refers to as “grey market.”
Amended Rule 6432 will: (i) require OTC Markets to submit a modified Form 211; (ii) require OTC Markets to make a daily security file submission with information on all securities quoted on its platform; and (iii) prohibit OTC Markets from receiving compensation in connection with the 211 process. FINRA is expected to file a notice to members any day now to include a copy of the form of the modified Form 211.
From a high level, FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. The specific information required to be maintained by the broker-dealer when it initiates a quotation is delineated in Exchange Act Rule 15c2-11. For a broker-dealer, compliance with the Rule is demonstrated by filing a Form 211 with FINRA.
The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE ); or (v) specified information that is similar to what would be included in items (i) through (iv).
In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. This reasonable basis requirement has altered the initial quotation process dramatically over the last ten years. In particular, FINRA uses this requirement to conduct a deep dive into the due diligence and background of a company when processing a 211 Application.
Effective September 28, 2021, Rule 15c2-11 allows a qualified IDQS (i.e., OTC Markets) to comply with the information review requirements, to publish an affirmative determination that it has conducted such review, and for the broker-dealer to rely on OTC Markets’ determination without conducting an independent review. As long as OTC Markets makes known to the public that it has completed a review, a broker-dealer can quote or resume quoting the securities and be in compliance with Rule 15c2-11. Likewise, OTC Markets can make a determination that a company qualifies for an exception to the 211 rule requirements and a broker-dealer can rely on that determination.
Importantly, as written the Rule specifically did not require that OTC Markets comply with FINRA Rule 6432 and did not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies, to file a Form 211 with FINRA. That changed on September 10 although a broker-dealer relying on OTC Markets publicly available determination of compliance with Rule 211 or the availability of an exception, will still not be required to file a separate Form 211.
Amended Rule 6432
Under FINRA Rule 6432, no member may publish quotations for a non-exchange-listed security in a quotation medium unless the member has demonstrated compliance with FINRA Rule 6432 and the applicable requirements for information maintenance under Rule 15c2-11 by making a filing with, and in the form required by, FINRA (i.e., the Form 211). As noted above, amended Rule 15c2-11 explicitly excluded OTC Markets from this requirement. Amended Rule 6432 requires that (i) a qualified inter-dealer quotation system (“Qualified IDQS”) (i.e. OTC Markets) submit a modified Form 211 filing to FINRA in connection with each initial information review that it conducts; (ii) a Qualified IDQS (OTC Markets) that makes a certain publicly available determination under Rule 15c2-11 submit a daily security file to FINRA containing applicable summary information for all securities quoted on its system; and (iii) other changes to FINRA Rule 6432 and the Form 211 to further clarify the operation of the rule and conform it to amended Rule 15c2-11.
Although OTC Markets will now be required to file a modified Form 211, it may do so after the fact. The modified Form 211 must be filed with FINRA no later than 6:30 pm EST on the business day following OTC Markets’ publicly available determination of compliance with Rule 211, as to a particular company. FINRA also indicates it intends to conduct a focused review of the filing. Broker-dealers that are not relying on OTC Markets review and determination, will continue to go through the same historical process with FINRA including what has been a lengthy comment and review process.
Like the standard Form 211, the modified Form 211 will contain requests for the items of information specified in Rule 15c2-11(b) with respect to the type of issuer involved. In addition, the modified Form 211, like the standard Form 211, must be reviewed and signed by a principal of OTC Markets, who must certify, among other things, that neither the firm nor its associated persons have accepted or will accept any payment or other consideration prohibited by FINRA Rule 5250 for filing the Form 211. In other words, OTC Markets cannot charge or receive compensation in connection with the 211 process.
Amended Rule 6432 also requires OTC Markets to submit a daily security file as to all companies quoted on its platform, including the following information:
- Security symbol;
- Issuer name;
- If the company is being quoted pursuant to a processed Form 211;
- If application, the type of publicly available determination – for example, that OTC Markets conducted an initial review or that an exception is available – and the date of such publicly available determination;
- If the company is a shell company and if so, the number of days remaining in the applicable 18-month period to complete a business combination (or no longer be piggyback eligible);
- If the security is not relying on OTC Markets publicly available determination of compliance (such as that a broker-dealer made its own determination); and
- Such other information as FINRA may request.
Amended Rule 6432 also clarifies that a broker-dealer must receive notification from FINRA that a standard Form 211 has been processed (i) before initiating or resuming quotations in a quotation medium for a security; and before entering a priced quotation for the security. In other words, FINRA confirms that the historical process is unchanged when a broker-dealer chooses to submit a Form 211 instead of relying on OTC Markets.
The SEC strongly supported the rule change, finding it appropriate for FINRA to oversee OTC Markets in relation to quotations. The SEC found the rule change will protect investors and prevent fictitious or misleading quotations, and promote orderly procedures for collecting, distributing, and publishing quotations.
« SEC Approves Nasdaq Board Diversity Rule Consequences Of Failing To File A Form D »
SEC Approves Nasdaq Board Diversity Rule
On August 6, 2021, the SEC approved Nasdaq’s board diversity listing standards proposal. Not surprisingly, the approval vote was divided with Commissioner Hester Peirce dissenting and Commissioner Elad Roisman dissenting in part. On the same day as the approval, Chair Gary Gensler and Commissioners Peirce, Roisman and Allison Herren Lee and Caroline Crenshaw issued statements on the new Rules.
As more fully explained below, new Nasdaq Rule 5605(f) requires Nasdaq listed companies, subject to certain exceptions, to: (i) to have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latino, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above. The rule changes also made headlines in most major publications. One of the most common themes in the press was the lack of inclusion of people with disabilities in the definition of an “underrepresented minority” for purposes of complying with the new Rules.
Clearly anticipating backlash and recognizing the controversy surrounding the Rules, in its approving release, the SEC made sure to point out that it is required to approve a proposal if it meets the requirements of the Exchange Act and the Rules and regulations applicable to SROs. The SEC states that it does not have the authority to make any changes to the rule proposal as submitted, or to disapprove the rule proposal on the ground that the SEC would prefer some alternative rule on the same topic.
Nasdaq Final Board Diversity Rule
Nasdaq has added Rule 5606(a) to the corporate governance requirements for listing and continued listing which requires Nasdaq listed companies, to publicly disclose, in an aggregated form, to the extent permitted by law (for example, some foreign countries may prohibit such disclosure), information on the voluntary self-identified gender and racial characteristics and LGBTQ+ status of the company’s board of directors. Each company will need to provide an annual Board Diversity Matrix disclosure including: (i) the total number of directors; (ii) the number of directors based on gender identity (female, male or non-binary); (iii) the number of directors that did not disclose gender; (iv) the number of directors based on race and ethnicity; (v) the number of directors who self-identify as LGBTQ+; and (vi) the number of directors who did not disclose a demographic background.
Foreign issuers may elect to use an Alternative Board Diversity Matrix format. Foreign issuers using the Alternative Matrix are required to disclose: (i) the total number of directors; (ii) its country of principal executive offices; (iii) whether it qualifies as a Foreign Private Issuer; (iv) whether disclosure is prohibited under its home country law; (v) the number of directors based on gender identity and the number of directors who did not disclose gender; (vi) the number of directors who self-identify as underrepresented individuals in its home country; (vii) the number of directors who self-identify as LGBTQ+; and the number of directors who did not disclose a demographic background.
The Board Diversity Matrix is required to be included in an annual report or proxy statement, or on the company’s website beginning in 2022. If a company files its 2022 proxy before August 8, 2022, and does not include the Matrix, it will need to either amend or post the Matrix by August 8, 2022. If a company files its 2022 proxy after August 8, 2022, it must either include the Matrix or the Matrix must be posted on its website within one day of filing the proxy.
Although not required, the rule encourages disclosure of other diverse attributes such as nationality, disability or veteran status. Failure to provide the disclosure will result in a listing deficiency with the ability to submit a plan within 45 days that would provide for cure within 180 days. Ultimate non-compliance could result in delisting. I’ve included both the Board Diversity Matrix and Alternative Board Diversity Matrix at the end of this blog.
Nasdaq has also added Rule 5605(f), pursuant to which, subject to certain exceptions, each listed company will be required to: (i) have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.
Foreign issuers are required to have at least two diverse directors including at least one female. Both foreign issuers and smaller reporting companies may satisfy the two diverse director requirements by having two female directors.
Nasdaq stresses that it is not establishing quotas or mandating diversity as companies that do not meet the objectives need only explain why they do not. The Exchange has provided examples of what might be contained in an explanation. It could be that a company’s reasoning for not having board members that specifically fit the diverse attributes in the Rule, is that it has otherwise a diverse board composition based on other considerations. However, as noted in my introduction, disability advocacy groups are very disappointed that those with disabilities are not included in the definition of diverse attributes under the Rule.
Under the Rule, Nasdaq will not assess the substance of an explanation but will just verify that the company has provided one. In fact, the final rule release reiterated many times that Nasdaq will not evaluate the substance of the explanation and that a company has full flexibility and discretion in drafting such explanation, including how much detail to provide.
Nasdaq has also added to its list of services for listed companies, a complimentary board recruiting solution to help advance diversity on company boards. The service provides companies that have not yet achieved a certain level of diversity with one-year complimentary access for two users to a board recruiting solution, which will provide access to a network of board-ready diverse candidates. The service is intended to allow companies to identify and evaluate diverse board candidates, and act as a tool to support board benchmarking. To access the service, a listed company must make a request on or before December 1, 2022.
The following types of companies are exempt from the requirements: (i) SPACs; (ii) asset backed issuers; (iii) cooperatives; (iv) limited partnerships; (v) management investment companies; (vi) issuers of non-voting preferred securities, debt securities or derivative securities; and (vii) ETFs and similar funds.
The Rule provides each company with one year from its adoption to comply with the Rule’s requirement to provide statistical information disclosures. A company that goes public via a business combination with a SPAC, an IPO, a direct listing, a transfer from another exchange or an uplisting from the OTC Markets has one year to comply with the disclosure requirements.
A Nasdaq Global Select Market and Nasdaq Global Market listed company, other than a smaller reporting company, SPAC or other exempt company, must have at least one diverse director by August 7, 2023 and two diverse directors by August 6, 2025, or explain the reasoning as to why not. A Nasdaq Capital Market listed company must have at least one diverse director by August 7, 2023, and two diverse directors by August 6, 2026, or explain the reasoning as to why not. Companies with boards of five or fewer directors, regardless of listing tier, are required to have, or explain why they do not have, one diverse director by August 7, 2023.
Purpose of the Rule
Simply put, Nasdaq is of the view that diversity in the board room equates to good corporate governance. They believe that increased diversity brings fresh perspectives, improved decision making and oversight and strengthened internal controls. Further, Nasdaq asserts that the increased focus on diversity by companies, investors, legislators and corporate governance organizations provides evidence that investor confidence is enhanced by greater board diversity. In conducting an internal study on diversity amongst listed companies, Nasdaq found they fell short and that a regulatory impetus would help.
Nasdaq indicates it conducted extensive research including reviewing a substantial body of third-party research and conducting interviews. Among the questions it sought to answer were (i) whether there is empirical evidence to support the proposition that board diversity increases shareholder value, investor protections and board decision-making; (ii) investors interest in board diversity information; (iii) the current state of board diversity and disclosure; (iv) causes of underrepresentation; (v) various approaches to encourage board diversity; and (vi) the success of approaches taken by other groups, both domestic and foreign.
Clearly, Nasdaq is confident that the answers to these questions support not only the value of board diversity and related disclosure, but the value of regulations requiring same. In addition to the results of its studies, Nasdaq cites the increasing call for diversity by large institutional investors such as Vanguard and BlackRock in their corporate engagement and proxy guidelines. Nasdaq also believes that the SEC disclosure regime supports disclosure requirements in this context.
Both the 127-page Nasdaq proposed rule release and 82-page approval of the Rules contain an in-depth discussion of Nasdaq’s research, findings, and conclusions. Nasdaq also presents counter-information. There is a lack of studies or information of the association between LGBTQ+ diversity and board representation, stock or other financial performance. Many studies support a correlation between women on the board and increased earnings and other financial metric performance, but some also show a lack of correlation between the two. Studies which include other factors, such as strong shareholder rights, show a decreasing impact of diversity to performance.
Interestingly, I believe it is the non-financial aspects, including investor protections (through increased internal controls, public disclosure, and management oversight) and confidence, that compelled Nasdaq adopt the rule. As it states in its release, “[A]t a minimum, Nasdaq believes that the academic studies support the conclusion that board diversity does not have adverse effects on company financial performance.” Moreover, as most directors are chosen from the current directors and C-Suite executive’s social and business network, without a compelling reason to search elsewhere, such as regulatory compliance, a natural impediment to increased diversity will remain.
Commissioner Public Statements
On the same day as the approval, Chair Gary Gensler and Commissioners Peirce, Roisman and Allison Herren Lee and Caroline Crenshaw issued statements on the new Rules. Whereas Chair Gary Gensler issued a very brief statement confirming that the new Rules are consistent with the requirements of the Exchange Act and will provide investors with additional information that they have been seeking, Commissioners Peirce and Roisman were not convinced. Following Gary Gensler’s format, Commissioners Allison Herren Lee and Caroline Crenshaw issued a brief joint statement showing their support for the rule as a first step, but noting that other diverse categories, such as those with disabilities or seniors should be considered as well.
Commissioner Roisman took a somewhat middle of the road approach, commending Nasdaq’s commitment to diversity but dissenting to the Rule itself. Like Commissioner Peirce, Roisman does not believe the Rule meets the required legal preconditions for adoptions. Roisman, however, did vote in favor of the recruitment service offered by Nasdaq.
Strongly dissenting across the board, Commissioner Peirce issued a lengthy statement, reading like a judiciary ruling, citing the numerous legal deficiencies with the Rules, including Constitutional issues. First, the Exchange Act requires national exchange rules to be:
“designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade… to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange.”
Although the rule release cites the Exchange Act standards, Commissioner Peirce does not believe it provides any valid argument that the new Rules meet the listed criteria. Peirce questioned the empirical weakness with the data and studies propounded by Nasdaq in support of its position. She notes that “commenters and studies persuasively demonstrate that the studies used by the Exchange are generally of low quality; that several do not make public the underlying data and the others that make the underlying data available show, at best, correlation; and that the Exchange has disregarded several high-quality studies that contradict the studies upon which the Exchange relies.”
Further, the studies cited only focus on gender and, to a lesser extent, racial diversity. The Exchange makes no effort to explain why studies examining the effects of gender and, to a lesser extent, racial diversity support its decision to include in its rule other types of diversity for which there is no evidence linking board membership to corporate performance. She believes the Exchange sidestepped these issues by arguing that various stakeholders desire consistent and comparable information relating to diversity in making their investment decisions. However, this type of anecdotal support for the rule is insufficient to meet the Exchange’s burden to show that its proposal is consistent with the Exchange Act. Commissioner Peirce is clearly concerned with regulating disclosures at the whim of current societal sentiment. Likewise, she believes the SEC itself failed in its obligation to take a deeper dive and not unquestioningly rely on the Exchange’s analysis. The SEC itself bended to a small group of investor pressure.
Continuing her dissent, Commissioner Peirce posits that the new Rules do not protect investors. The Exchange’s designation of relevant demographic categories is arbitrary, as it has not shown that they are tailored to provide the “consistent” and “comparable” diversity-related information the Exchange believes investors are demanding. Of the many issues raised, she notes that relying on self-identification cannot result in comparable information. Even worse, she is concerned that shifting focus away from the actual business experience and qualifications of individual board members to demographic characteristics of the board as a whole will not benefit investors. Companies may also be encouraged to recruit board members that check the boxes without even considering other meritorious candidates with unique, hard-won expertise and knowledge that would add meaningful value to the company.
Commissioner Peirce argues that the new Rules harm market integrity. By micro-managing the delicate process of board selection, the Exchange is encouraging companies to forgo individual qualification that may be necessary for its success, in favor of meeting demographic standards. The requirement to explain why a board is not diverse is likely to lead to poorly reasoned and poorly substantiated rationales. Further, the new Rules could lead to less effective investor oversight of the board as investment managers will be less concerned with individual qualifications, skills and experience. Commissioner Peirce also questions the unfair advantage foreign issuers have under the Rules, not only through more flexible disclosures but also as a result of an inability to police compliance.
Worse, the new Rules will incentivize misleading disclosures. By setting diversity objectives, requiring companies that fail to reach those targets to explain publicly why they have failed to do so, and relying on director self-identification, the Rules invite disclosure that pushes the envelope of plausibility. To avoid having to admit noncompliance with the Exchange’s “diversity objectives,” a confession that likely will draw negative attention, including perhaps shareholder litigation, customer boycotts, and higher capital costs, companies will be under tremendous pressure to fit their directors into one of the favored categories.
Hitting every important category, Commissioner Peirce continues that the new Rules are contrary to public interest. Commissioner Peirce believes the Rules promote stereotyping, pushing the view that all women are interchangeable providing a “womanly perspective.” Likewise, with those in the LBGTQ+ category. Moreover, since a person must self-identify in a particular category, those that do not wish to label themselves but are otherwise qualified may be overlooked for valuable board positions, leading further to conformists who are unwilling to push back against management. Also, Nasdaq offers no explanation for its arbitrary inclusion of some diverse categories and exclusions of others.
Commissioner Peirce also believes the new Rules are unconstitutional, encouraging discrimination and compelling speech by both individuals and companies in a way that offends protected constitutional interests. Both the Exchange and the SEC dismissed these concerns on the basis that an Exchange is not a “state actor.” Peirce isn’t buying it and citing the role of the SEC in the rule making – and the SEC is certainly a “state actor.”
Board Diversity – Beyond Nasdaq
Putting aside Nasdaq’s rule, a lot of groups and thought leaders have been tackling the question of whether board diversity is a benefit or detriment to corporations, with thorough arguments to support both sides of the fence. Board composition is consistently one of the most important topics on the agenda for shareholder engagement, and voting.
Harvard Law Professor Jesse Fried has publicly questioned the empirical value of Nasdaq’s board diversity data. Also, University of MN Law Professor and former chief White House ethics lawyer Richard Painter wrote a thorough rebuttal to Nasdaq’s findings. That rebuttal was met with its own rebuttal’s pointing out the lack of, and age, of the data presented. It seems one of the best sources of information is California, which imposed a board diversity obligation on corporations domiciled in the state two years ago. Since the enactment of the statute, there has been a significant increase of women on the boards of California entities, though other minorities, including women of color, continue to lag.
Getting ahead of this year’s proxy season, Glass Lewis published an in-depth report on Board Gender Diversity with an overview of where things stand in the U.S. and internationally, investor and state efforts to promote balance in the boardroom, and academic research on the benefits of diversity. Glass Lewis recognizes the complexity of the issue and the recruiting involved to find uniquely qualified directors who bring a breadth of experience and insight to the board table. Simply adding women to the board for diversity’s sake and without careful consideration of qualifications and experience is unlikely to automatically effect any positive corporate change. With that said, the report also concludes that bringing women and diverse board members will add to the overall viewpoints and knowledge base of a board, thereby improving corporate performance.
Many companies are not waiting for a rule to increase diversity disclosure. To help stakeholders compare disclosure practices, KPMG recently launched a free new web-based tool that tracks disclosure about board diversity. The software compares disclosure practices by sector, index (Russell 3000 and S&P 500) and company size. There are several comparative publications as well with one by Deloitte and the Alliance for Board Diversity including information through 2020.
The voluntary increase in disclosure comes, at least partially, from pressure by institutional investors which have been vocal on the subject. In 2020 many of those entities promised to put their views to action by increasing diversity in their own house. The data is not in yet as to whether specific vocal proponents of diversity have made significant internal changes, but some are putting on a better show than others. The Carlyle Group announced a new policy calling for at least one candidate who is Black, Latino, Pacific Islander or Native American to be interviewed for every new position and that at least 30% of its portfolio companies will have ethnic diversity on the board of directors.
Besides investor financial incentives, D&O insurers have started to include diversity practices among the many considerations in granting and pricing liability policies.
On a positive note, the new Rules are adding pressure to states and other organizations to expand anti-discrimination laws and employment protections to those in the LGBTQ+ community.
Matrix Forms
| Board Diversity Matrix (As of [DATE]) | ||||
| Total Number of Directors | # | |||
| Female | Male | Non-Binary | Did Not Disclose Gender | |
| Part I: Gender Identity | ||||
| Directors | # | # | # | # |
| Part II: Demographic Background | ||||
| African American or Black | # | # | # | # |
| Alaskan Native or Native American | # | # | # | # |
| Asian | # | # | # | # |
| Hispanic or Latinx | # | # | # | # |
| Native Hawaiian or Pacific Islander | # | # | # | # |
| White | # | # | # | # |
| Two or More Races or Ethnicities | # | # | # | # |
| LGBTQ+ | # | |||
| Did Not Disclose Demographic Background | # | |||
| Board Diversity Matrix (As of [DATE])To be completed by Foreign Issuers (with principal executive offices outside of the U.S.) and Foreign Private Issuers | ||||
| Country of Principal Executive Offices: | [Insert Country Name] | |||
| Foreign Private Issuer | Yes/No | |||
| Disclosure Prohibited Under Home Country Law | Yes/No | |||
| Total Number of Directors | # | |||
| Female | Male | Non-Binary | Did Not Disclose Gender | |
| Part I: Gender Identity | ||||
| Directors | # | # | # | # |
| Part II: Demographic Background | ||||
| Underrepresented Individual in Home Country Jurisdiction | # | |||
| LGBTQ+ | # | |||
| Did Not Disclose Demographic Background | # | |||
« China Based Companies Continue To Face US Capital Market Scrutiny FINRA Granted Oversight Of OTC Markets In The 211 Process »
China Based Companies Continue To Face US Capital Market Scrutiny
On March 24, 2021, the SEC adopted interim final amendments to implement the congressionally mandated submission and disclosure requirements of the Holding Foreign Companies Accountable Act (HFCA Act). Following adoption of the HFCA, on July 30, 2021, SEC Chairman Gary Gensler issued a statement warning of risks associated with investing in companies based in China. Although the statement has a different angle, it joins the core continued concerns of the SEC top brass and Nasdaq expressed over the years.
In June 2020 Nasdaq published proposed rules which would make it more difficult for a company to list or continue to list based on the quality of its audit, which could have a direct effect on companies based in China (see HERE). In September 2020, the SEC instituted proceedings as to whether to approve or deny the proposed rule change. As of the date of this blog, the proposal has not been ruled upon by the SEC.
However, the proposal itself together with the HFCA has had a chilling effect on the listings of companies based out of China and is expected to continue to do so. The chilling effect has not been nominal. In discussions with colleagues with a strong China-based clientele, the focus now is on alternatives to U.S. listings.
Back in April 2020, former SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets (see HERE). Before that, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
Holding Foreign Companies Accountable Act
The Holding Foreign Companies Accountable Act (HFCA), adopted December 18, 2020, requires foreign owned issuers to certify that the PCAOB has been able to audit specified reports and inspect their audit firm within the last three years. If the PCAOB is unable to inspect the issuer’s public accounting firm for three consecutive years, the issuer’s securities are banned from trading on a national exchange or through other methods.
The HFCA requires that the SEC identify each “covered issuer” that has retained a registered public accounting firm to issue an audit report where that firm has a branch or office located in a foreign jurisdiction, and the PCAOB has determined that it is unable to inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.
To implement compliance with the requirements of the HFCA, the SEC has adopted final interim rules. The rules apply to covered companies that the SEC identifies as having filed an annual report on Forms 10-K, 20-F, 40-F or N-CSR with an audit report issued by a registered public accounting firm that is located in a foreign jurisdiction and that the PCAOB has determined it is unable to inspect or investigate completely because of a position taken by an authority in that jurisdiction.
The SEC rules are requiring identified companies to submit documentation to the SEC, on or before its annual report due date, establishing that it is not owned or controlled by a governmental entity in that foreign jurisdiction. The company will also be required to include disclosure in its annual report regarding the audit arrangements of, and governmental influence on the company. If the company is identified by the SEC (“Commission-Identified Issuers”) for three consecutive years, the SEC will prohibit trading of the company’s securities. The SEC is still considering how to implement the trading prohibition requirement.
Further Commission-Identified Issuers must disclose for each non-inspection year:
- Identifying the registered accounting firm that prepared an audit report;
- the percentage of shares owned by governmental entities where the issuer is incorporated;
- whether these governmental entities have a controlling financial interest;
- information related to any board members who are officials of the Chinese Communist Party; and
- whether the articles of incorporation of the issuer contain any charter of the Chinese Communist Party.
The HFCA requires the SEC to adopt rules within 90 days and, as such, it has adopted the interim final rules but is also seeking comment on potential changes or modifications to the interim rules.
Gary Gensler’s Statement
Chairman Gensler’s July 30, 2021, statement focuses on the Republic of China’s new guidance placing restrictions on China-based companies’ offshore capital raising efforts, including through offshore shell companies. To help enforce and monitor the new restrictions, China as development government-led cybersecurity reviews of certain companies raising capital through offshore entities.
China has always placed restrictions on foreign ownership of China entities and prohibited direct listing on exchanges outside of China. A work-around developed many years ago, whereby the China-based operating company establishes an offshore shell company in a foreign jurisdiction, most commonly the Cayman Islands, to raise capital and issue stock to public shareholders. In the U.S. it is generally that Cayman Island entity, that lists on a national stock exchange. The shell company enters into service and other contracts with the China-based operating entity such that the monetary substance of the operations flows through the Cayman Island shell company. Even though the Cayman Island entity does not have any direct ownership in the China-based operations, it is able to consolidate financial statements as it has the monetary benefit. The entire structure is known as a Variable Interest Entity (VIE).
Although the structure is common, and as mentioned, the vast majority of China based public companies are actually set up in a VIE structure, Chair Gensler, rightfully felt it necessary to explain the structure and associated risks. The fact is that neither the U.S. stockholders/investors nor the offshore shell company (VIE entity) have any direct ownership in the China based operating entity. They derive all rights and benefits through contractual arrangements. Gensler states, “I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.”
In light of the recent developments in China and the overall risks with the China-based VIE structure, Chair Gensler has asked SEC staff to seek certain disclosures from offshore companies associated with China-based operating companies before their registration statements will be declared effective. In particular, he has asked staff to ensure that these issuers prominently and clearly disclose:
- That investors are not buying shares of a China-based operating company but instead are buying shares of a shell company issuer that maintains service agreements with the associated operating company. Thus, the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the China-based operating company;
- That the China-based operating company, the shell company issuer, and investors face uncertainty about future actions by the government of China that could significantly affect the operating company’s financial performance and the enforceability of the contractual arrangements; and
- Detailed financial information, including quantitative metrics, so that investors can understand the financial relationship between the VIE and the issuer.
Additionally, for all China-based operating companies seeking to register securities with the SEC, either directly or through a shell company, Chair Gensler has asked the SEC staff to ensure that these issuers prominently and clearly disclose:
- Whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded; and
- That the Holding Foreign Companies Accountable Act, which requires that the PCAOB be permitted to inspect the issuer’s public accounting firm within three years, may result in the delisting of the operating company in the future if the PCAOB is unable to inspect the firm.
Finally, Chair Gensler has asked the SEC staff to engage in targeted additional reviews of filings for companies with significant China-based operations.
Refresher on Nasdaq Proposed Rule Changes
On June 2, 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 rule currently provides that Nasdaq may use its authority to deny listing or continued listing to a company when an individual with a history of regulatory misconduct is associated with that company. The rule sets out a variety of factors that may be considered by the exchange in making a determination. I’ve detailed the current rule below.
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.” The proposed rule change is meant to codify Nasdaq’s current interpretation of its discretionary authority to provide clarity to the marketplace on its position related to the importance of quality audits.
Nasdaq’s listing requirements are designed to ensure that a company is prepared for the reporting and administrative requirements of being a public company, to provide for transparency and the protection of investors, and to ensure sufficient investor interest to support a liquid market. Rule 5101 describes Nasdaq’s broad discretionary authority over the initial and continued listing of securities on Nasdaq in order to maintain the quality of and public confidence in the market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest.
Part of both the general federal securities laws and Nasdaq requirements relate to properly completed audits by an independent auditor. Investors need to be able to rely on the audit report to gain confidence that the financial statements are properly completed and free of material misstatements due to mistakes or fraud. For more on the requirements for an audit report, see HERE.
Auditors are subject to oversight by both the SEC and PCAOB. PCAOB inspections are designed to, among other things, identify deficiencies in audits and/or quality control procedures. Investigations can lead to the audited public company having to revise and refile its financial statements or its assessment of the effectiveness of its internal control over financial reporting. In addition, through the quality control remediation portion of the inspection process, inspected firms identify and implement practices and procedures to improve future audit quality. Accordingly, Nasdaq relies on auditors and the PCAOB oversight to maintain audit integrity.
Citing the recent joint public statement by SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III (see HERE), Nasdaq notes that audit work and the practices of auditors in certain countries, cannot be effectively reviewed or subject to the usual oversight. Those countries currently include Belgium, France, China and Hong Kong.
Currently, Nasdaq may rely upon its broad authority provided under Rule 5101 to deny initial or continued listing or to apply additional and more stringent criteria when the auditor of an applicant or a Nasdaq-listed company: (i) has not been subject to an inspection by the PCAOB, (ii) is an auditor that the PCAOB cannot inspect, or (iii) otherwise does not demonstrate sufficient resources, geographic reach or experience as it relates to the company’s audit, including in circumstances where a PCAOB inspection has uncovered significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls. The proposed rule change is meant to codify the existing rights of Nasdaq in that regard.
The proposed rule change would add a new paragraph (b) to IM-5101-1 detailing factors that Nasdaq will consider including:
(i) whether the auditor has been subject to PCAOB inspection including due to the audit firm being located in a jurisdiction that limits the PCAOB’s inspection ability;
(ii) if the auditor has been inspected, whether the results of the inspection indicate the auditor has failed to respond to inquiries or requests by the PCAOB or that the inspection revealed significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls;
(iii) whether the auditor can demonstrate that it has adequate personnel in offices participating in the audit with expertise in applying U.S. GAAP, GAAS or IFRS, in the company’s industry;
(iv) whether the auditor’s training program for personnel participating in the company’s audit is adequate;
(v) for non-U.S. auditors, whether the auditor is part of a global network or other affiliation of auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
(vi) whether the auditor can demonstrate to Nasdaq sufficient resources, geographic reach or experience as it relates to the company’s audit.
An auditor would not necessarily have to satisfy each of the factors, but rather Nasdaq will consider all facts and circumstances, and may impose additional or more stringent criteria to mitigate concerns. Additional criteria could include: (i) higher equity, assets, earnings or liquidity measures; (ii) that an offering be completed on a firm commitment basis (as opposed to best efforts); (iii) lock-ups for officers, directors or other insiders; (iv) higher float percentage or market value of unrestricted publicly held shares; or (v) higher average OTC trading volume before an uplisting.
The proposed rule change would also add a new subparagraph (c) to IM-5101-1 to confirm Nasdaq’s ability to impose additional or more stringent criteria in other circumstances, including when a company’s business is principally administered in a jurisdiction that Nasdaq determines to have secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction (a “Restrictive Market”). In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s: (i) principal business segments, operations or assets; (ii) board and shareholders’ meetings; (iii) headquarters or principal executive offices; (iv) senior management and employees; and (v) books and records.
In the event that Nasdaq relies on its discretionary authority and determines to deny the initial or continued listing of a company, it would issue a denial or delisting letter to the company that will inform the company of the factual basis for the Nasdaq’s determination and its right for review of the decision.
Current Rule IM-5101-1
Nasdaq may use its authority under Rule 5101 to deny initial or continued listing to a company when an individual with a history of regulatory misconduct is associated with the company. Such individuals are typically an officer, director, substantial shareholder, or consultant to the company. In making this determination, Nasdaq will consider a variety of factors, including:
(i) the nature and severity of the conduct, taking into consideration the length of time since the conduct occurred;
(ii) whether the conduct involved fraud or dishonesty;
(iii) whether the conduct was securities-related;
(iv) whether the investing public was involved;
(v) how the individual has been employed since the violative conduct;
(vi) whether there are continuing sanctions (either criminal or civil) against the individual;
(vii) whether the individual made restitution;
(viii) whether the company has taken effective remedial action; and
(ix) the totality of the individual’s relationship with the company including their current or proposed position, current or proposed scope of authority, responsibility for financial accounting or reporting and equity interest.
Nasdaq may also exercise its discretionary authority with a company filed for bankruptcy, when its auditor issues a disclaimer opinion or when financial statements do not contain a required certification.
Where concerns are raised, Nasdaq will consider remedial measures by the company including the individual’s resignation, divestiture of stock holdings, termination of contractual arrangements or the creation of a voting trust to vote their shares. Nasdaq will also consider past corporate governance.
Nasdaq may impose restrictions or heightened listing requirements where concerns are raised, but may not allow for exceptions or lower standards to the listing rules. In the event that Nasdaq staff denies initial or continued listing based on such public interest considerations, the company may seek review of that determination through the procedures set forth in the Rule 5800 Series. On consideration of such appeal, a listing qualifications panel comprised of persons independent of Nasdaq may accept, reject or modify the staff’s recommendations by imposing conditions.
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