OTC PINK Companies Now Qualify For Equity Line Financing
Posted by Securities Attorney Laura Anthony | August 29, 2021

Without fanfare, the issuance of guidance, or any other formal notice, the SEC quietly changed its policy related to the filing of an at-the-market resale registration statement for an equity line financing by OTC Pink listed companies.  To be clear, an OTC Pink listed company may now utilize a re-sale registration statement on Form S-1 for an equity line financing transaction, pursuant to which the securities may be sold by the investor, into the market, at market price.  This results in a dramatic shift, for the better, for OTC Pink companies in the world of capital markets.

Background

Rule 415 sets forth the requirements for engaging in a delayed offering or offering on a continuous basis.  Under Rule 415 a re-sale offering may be made on a delayed or continuous basis other than at a fixed price (i.e., it may be priced at the market).  It is axiomatic that for a security to be sold at market price, there must be a market.  Generally, and historically, a company that trades on the OTC Pink market may not rely on Rule 415 to file a re-sale registration statement whereby the selling shareholders can sell securities into the market at market price.  That is, until recently all registration statements, whether re-sale, primary or indirect primary, must be at a fixed price unless the issuer is trading on the OTCQB or higher.

As there is no actual rule that identifies what is a market for purposes of Rule 415, the SEC has looked to Item 501(b)(3) of Regulation S-K.  Item 501 provides the requirements for disclosing the offering price of securities on the forepart of a registration statement and outside front cover page of a prospectus.  Item 501 requires that either a fixed price be disclosed or a formula or other method to determine the offering price based on market price.  The SEC uses this rule to require a fixed price where a company trades on the OTC Pink since there is no identifiable “market” to tie a price to.

There was a time when the SEC refused to recognize any of the tiers of OTC Markets, as a “market” for purposes of at-the-market offerings.  On May 16, 2013, the SEC issued a C&DI recognizing the OTCQB and OTCQX as markets for purposes of filing and pricing a re-sale registration statement.  See HERE ). That C&DI specifically referred to the filing of a resale registration statement for an equity line financing, but the SEC and practitioners relied on the C&DI to allow the filing of an at the market resale registration statement by an OTC Markets traded company, in all circumstances, as long as the company traded on the OTCQB or OTCQX.

Of course, the re-sale registration statement would need to be a true re-sale and not an indirect primary offering.  The SEC generally views the registration of more than one-third (33.33%) of the company’s pre-transaction total shares outstanding, held by non-affiliates, as an indirect primary offering.  An indirect primary offering is treated the same as a primary offering and could not rely on Rule 415 to sell securities at other than a fixed price.

Equity Line Transactions:An equity line financing is a transaction whereby a company enters an investment contract to put shares to an investor (the equity line provider) at a price, generally determined by a formula based on a discount to market price.  The company generally has the right to require the investor to buy securities over a set period of time, subject to specific terms in the contract.  Assuming the contract terms are satisfied, the investor has no right to decline to purchase the securities (or a limited right to decline). The dollar value of the equity line is set in the written agreement, but the number of securities varies based on a formula tied to the market price of the securities at the time of each “put.”

Most equity line financing arrangements are similar to a PIPE (private investment into public entity) transaction such that the company relies on the private placement exemption from registration to sell the securities under the equity line and then files a registration statement for the resale of such securities by the investor.  However, whereas in a PIPE transaction the investor bears the risk, in an equity line transaction the investor often bears little risk due to the delayed nature of the puts coupled with the price of the securities being a formula tied to market price.  Accordingly, the SEC views equity line financing registrations as indirect primary offerings.

Over the years the SEC issued various guidance on equity line financings and the ability to file a re-sale registration statement for the financing, despite the fact that the securities would not have been issued at the time of filing the registration statement.  In May 2013, the SEC issued a new C&DI which was, until November 2020, the operative guida for equity line transactions.

In particular:

“Question: When may a company file a registration statement for the resale by the investors of securities sold in a private equity line financing?

Answer: In many equity line financings, the company will rely on the private placement exemption from registration to sell the securities under the equity line and will then register the ‘resale’ of the securities sold in the equity line financing. In these types of equity line financings, the delayed nature of the puts and the lack of market risk resulting from the formula price differentiate private equity line financings from financing PIPEs (private investment, public equity). We, therefore, analyze private equity line financings as indirect primary offerings.

While we analyze private equity line financings as indirect primary offerings, we recognize that the ‘resale’ form of registration is sought in these financings. As such, we will permit the company to register the ‘resale’ of the securities prior to its exercise of the put if the transactions meet the following conditions:

  • the company must have ‘completed’ the private transaction of all of the securities it is registering for ‘resale’ prior to the filing of the registration statement;
  • the ‘resale’ registration statement must be on the form that the company is eligible to use for a primary offering; and
  • in the prospectus, the investor(s) must be identified as underwriter(s), as well as selling shareholder(s).

We will not object that a private transaction is not ‘completed’ based on the lack of a fixed price if the agreement provides for pricing based on a formula tied to market price and there is an existing market for the securities as evidenced by trading on a national securities exchange or through the facilities of the OTC Bulletin Board or the OTCQX or OTCQB marketplaces of OTC Link ATS.  [May 16, 2013]”

In November 2008, the SEC issued a series of C&DI providing guidance as to when the private offering part of an equity line transaction could be considered “completed.”   This guidance was not changed by the March 2013 new C&DI (which only added the OTCQB and OTCQX as recognized markets).  In accordance with the November 2008 guidance, the SEC would allow the filing of resale type registrations if the following conditions are met:

  • The Issuer must have completed the private transaction prior to filing the registration statement (i.e., both parties must be fully contractually bound, with all material points agreed upon);
  • The “resale” registration statement must be on the form that the Issuer is eligible to use for a primary offering; and
  • In the prospectus, the investors must be identified as both underwriter(s) and selling shareholder(s).

For the first condition to be met, the investor must be irrevocably bound to purchase all the securities.  That is, only the issuer can have the right to exercise the put and, except for conditions outside the investor’s control, the investor must be irrevocably bound to purchase the securities once the Issuer exercises the put.  In addition, the obligations of the investor must be non-assignable to meet the “irrevocably bound” condition.

Moreover, if the investor has the ability to make investment-related decisions under the terms of the contract, they will not be deemed to be irrevocably bound allowing for the filing of a resale registration statement.  Examples of investment decisions that would be viewed by the SEC as creating a continuing transaction (and not a completed transaction allowing for the filing of a registration statement) include:

  • Agreements that give the investor the right to acquire additional securities (including through warrants) at the same time or after the Issuer exercises a put;
  • Agreements that permit the investor to decide when or at what price to purchase the securities underlying the put;
  • Agreements with termination provisions that have the effect of causing the investor to no longer be irrevocably bound to purchase the securities; and
  • Agreements that allow the Investor to exercise a “due diligence out.”

However, the agreements may allow for customary “bring-downs” as conditions to closing such as customary representations and warranties and customary clauses regarding no material adverse changes affecting the issuer that would be within the investor’s control.

On November 13, 2020, the SEC amended the C&DI it had issued in March 2013 and withdrew the five from November 2008 as moot.  The November 2020 C&DI provides:

“C&DI 139.13 Question: In many equity line financings, the company will rely on the private placement exemption from registration to sell the securities under the equity line and will then seek to register the “resale” of the securities sold in the equity line financing. When may a company file a registration statement for the resale by the investors of securities sold in a private equity line financing?

Answer: In these types of equity line financings, the company’s right to put shares to the investor in the future and the lack of market risk resulting from the formula price differentiate private equity line financings from financing PIPEs (private investment, public equity). We, therefore, analyze private equity line financings as indirect primary offerings, even though the “resale” form of registration is sought in these financings.

The at-the-market limitations contained in Rule 415(a)(4) would otherwise prohibit market-based formula pricing for issuers that are not eligible to conduct primary offerings on Form S-3 or Form F-3. Nevertheless, we will not object to such companies registering the “resale” of the securities prior to the exercise of the equity line put if the transactions meet the following conditions:

  • the company and the investor have entered into a binding agreement with respect to the private equity line financing at the time the registration statement is filed;
  • the “resale” registration statement is on a form that the company is eligible to use for a primary offering;
  • there is an existing market for the securities, as evidenced by trading on a national securities exchange or alternative trading system, which is a registered broker-dealer and has an active Form ATS on file with the Commission; and
  • the equity line investor is identified in the prospectus as an underwriter, as well as a selling shareholder.

We will not object to the filing of a registration statement for a private equity line financing prior to the issuance of securities by the company under the equity line even when there are contingencies attached to the investor’s obligation to accept a put of shares from the company, as long as the above conditions are satisfied and the following terms of the investment have been agreed upon by both parties and disclosed by the company at the time that the resale registration statement is filed:

  • the number of shares registered for resale;
  • the maximum principal amount available under the equity line agreement;
  • the term of the agreement; and
  • the full discounted price (or formula for determining it) at which the investor will receive the shares.”

The new C&DI succinctly combined the previous ones.  I thought it was interesting that the SEC had eliminated a reference to the OTCQB and OTCQX; however, equity line registrations filed shortly after the new C&DI for an OTC Pink entity were still required to be at a fixed price.

Recently, however, the SEC has confirmed that it will allow an equity line re-sale registration statement to be filed by an OTC Pink company and priced at the market if all the requirements of C&DI 139.13 have been satisfied.  In that regard, our firm has cleared at least one re-sale S-1 for an OTC Pink company in the past month.

Interestingly, the SEC is now clearly taking the position that the OTC Pink is an “existing market for the securities, as evidenced by trading on a national securities exchange or alternative trading system, which is a registered broker-dealer and has an active Form ATS on file with the Commission” for purposes of equity line financings, but has not yet expanded that view for purposes of straight re-sale registration statements.

I am hopeful that with the new 15c2-11 rules together with OTC Markets incredible job at regulating the marketplace, the OTC Pink will soon be recognized as an “existing market” for securities across the board.

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SPAC Nasdaq Listing Standards
Posted by Securities Attorney Laura Anthony | August 15, 2021 Tags:

I’ve written quite a bit about SPAC’s recently, but the last time I wrote about SPAC Nasdaq listing requirements, or any attempted changes thereto, was back in 2018 (see HERE).  Since that time, Nasdaq has a win and recently a loss in its ongoing efforts to attract SPAC listings.

Background on SPACs

Without reiterating my lengthy blogs on SPACs and SPAC structures (see, for example, HERE and HERE), a special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company.

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company that is issuing securities which fall within the definition of a penny stock. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of this Rule 419 discussion, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

Rule 419 requires that a blank check company filing a registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger. The securities of a blank check company which is required to comply with Rule 419 are not eligible to trade, but rather must remain in escrow.

A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of the SPAC, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

Accordingly, to derive the value that SPACs have in the marketplace (according to one source, $111 billion so far in 2021 alone), the SPAC must not be a penny stock, or put another way, must be priced over $5 and list and trade on a registered stock exchange such as Nasdaq.  Nasdaq, in turn, is motivated to attract these relatively plain vanilla blank check companies and the potential for a continued listing business combination entity.

SPAC Nasdaq Listing Requirements

Generally speaking, a SPAC must meet the same listing requirements as an operating entity.  For a review of the Nasdaq Capital Market’s current initial listing standards, see HERE.  Back in July 2019, Nasdaq amended its listing standard to exclude restricted securities from its calculations of a company’s publicly held shares, market value of publicly held shares and round lot holders (“Initial Liquidity Calculations”) and to impose a new requirement that at least 50% of a company’s round lot holders must each hold shares with a market value of at least $2,500 (see HERE).

Over the past couple of years, Nasdaq has successfully implemented and unsuccessfully tried to implement modifications to its listing rules to make it easier for SPACs to list and maintain a listing in a business combination transaction.  In addition, Nasdaq has several pending SEC rule amendment applications.

Round Lot Holders – Approved Rule Change

On January 26, 2021, the SEC approved a rule change from the Nasdaq listing requirements for SPACs to exclude the requirement that at least 50% of a company’s round lot holders each hold unrestricted securities with a market value of at least $2,500.  The rule requirement was initially meant to ensure that at least 50% of the required minimum number of shareholders hold a meaningful value of unrestricted securities and that a company has sufficient investor interest to support an exchange listing.  Prior to enacting the rule change, Nasdaq noticed that many companies seeded a shareholder base prior to the listing with shareholders holding exactly 100 shares often received for no or nominal value, and that these investors, were not supportive of liquidity and trading volume.

Nasdaq does not believe that this qualification requirement, and its underlying purpose, is relevant to SPACs.  Typically, the only investors holding shares in a SPAC prior to an IPO are its founders and that all other round lot holders generally represent new investors in the SPAC’s IPO.  SPACs do not present a similar risk as operating companies of circumventing the round lot holder requirement through share transfers for no value.  Also, shareholders of SPACs are afforded the opportunity to redeem or tender their shares for a pro rata portion of the value of the IPO proceeds maintained in a trust account in connection with the SPAC’s business combination, which must occur within 36 months of the IPO, and therefore, the SPAC structure provides an alternative liquidity mechanism that operating companies do not offer.

The rule change notes that at the time of the business combination, in order to remain listed, the combined company must meet Nasdaq’s initial listing requirements, which includes the required minimum amount of round lot holders and that at least 50% of the required amount hold shares valued at $2,500 or more.

Round Lot Holders – Disapproved Rule Change

On May 20, 2021, the SEC denied a rule change request from Nasdaq that would have allowed SPACs 15 calendar days following the closing of a business combination to demonstrate that the SPAC had satisfied the applicable round lot shareholder requirement.  Following each business combination, the combined company must meet the requirements for initial listing on Nasdaq including those requiring a minimum number of round lot shareholders.  If the combined company does not meet all the initial listing requirements following a business combination, Nasdaq will issue a delisting determination.

The current rule requires that the combined company meet the shareholder requirements (and all listing requirements) but does not provide a timetable to satisfy those requirements.  The proposed rule change would have provided a SPAC with a 15-day grace period to satisfy the round lot holder requirements and would have required an 8-K publicly announcing that it had not yet satisfied the requirement and relying on the grace period.  If the SPAC did not meet the requirement after the 15 days, it would halt trading on Nasdaq.

Nasdaq wanted to provide the 15 days because it can be difficult for a SPAC to know its round lot holders prior to closing of a business combination.  Shareholders in a SPAC may redeem or tender their shares until just before the time of the business combination, and the SPAC may not know how many shareholders will choose to redeem until very close to the consummation of the business combination.  Under the proposal, the SPAC must still demonstrate that it satisfied the round lot shareholder requirement immediately following the business combination, and the proposal merely would give the SPAC 15 calendar days to provide evidence that it had met the requirement.

In denying the proposed rule change, the SEC noted that it has consistently recognized the importance of the minimum number of holders and other similar requirements stating that such listing standards help ensure that exchange listed securities have sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly markets.  The SEC is concerned that rather than provide additional time to provide evidence of timely compliance, the change would, in fact, allow a SPAC more time to actually comply with the rule (such as by adding last-minute shareholders, or working to reduce redemptions during the 15-day period).

Further, the SEC sees a risk that as result of the change, non-compliant companies will continue to trade on the Exchange when they should not be allowed. In such circumstances, a SPAC could complete a business combination and very soon thereafter be subject to delisting proceedings, and during such time its securities may continue to trade with a number of holders that is substantially less than the required minimum raising concerns about the maintenance of fair and orderly markets and investor protection.

SPAC Spin-Offs – Enabling More than One Acquisition

Nasdaq has issued a proposed rule change that would permit a SPAC to contribute a portion of the amount held in its deposit account to a deposit account of a new SPAC and spin off the new SPAC to its shareholders, thereby enabling multiple business combinations to benefit the same shareholder base. The filing, pending SEC approval, will provide shareholders the right to redeem all of their holdings prior to the first transaction, similar to existing SPACs.

Generally, Nasdaq rules prohibit the listing of blank check companies, unless they meet certain requirements for a “special purpose acquisition company” or “SPAC.”  The requirements include, among other things, that at least 90% of the gross proceeds from the initial public offering be deposited  in an escrow account, and that the SPAC complete within 36 months, or a shorter period identified by the SPAC, one or more business combinations having an aggregate fair market value of at least 80% of  the value of the escrow account at the time of the agreement to enter into the initial combination.

Nasdaq has noticed cases where SPAC sponsors create multiple SPACs of different sizes at the same time, with the intention to use the SPAC that is closest in size to the amount a particular target’s needs.   This practice creates the potential for conflicts between the multiple SPACs (each of which has different shareholders) and still fails to optimize the amount of capital that would benefit the SPAC’s public shareholders and a business combination target.  The system is also inefficient in as much as the multiple SPACs are each filing separate registration statements and SEC reports, have separate boards of directors, multiple audits and multiple listing fees.

The proposed new rule would allow a SPAC to raise the maximum amount of capital it thinks it needs, then spin off any balance after a first acquisition into a new SPAC for future acquisitions.  The spin-off SPAC would need to file a separate registration statement and continue with its own listing.  The public shareholders would have a right to redeem as part of any business combination whether in the original SPAC or a new spin-off.  All other features would work the same as existing SPACs.  The spun-off SPAC would need to meet the initial listing requirements and would be subject to the same escrow rules as any SPAC including the 36-month period in which to complete a business combination.  Moreover, each initial acquisition, whether in the original or spin-off SPAC would need to meet the 80% requirement.

I see the benefit to an existing shareholder base; however, when multiple acquisitions of different values present themselves at the same time (like in a hot market), it seems a sponsor would want multiple SPACs at the ready instead of waiting for the spin-off process to be completed, by which time the opportunity may have passed.

Regardless of whether the SEC approves this rule proposal, I believe we will be seeing more and more of attempted deviations from the cookie-cutter SPAC structure and business combination process.  Recently, Bill Ackman attempted such divergence by proposing that his SPAC, Pershing Square Tontine Holdings Ltd., purchase a 10% interest in music giant Universal Music Group, then spin off that 10% to the SPAC shareholders, creating a separate public company and continuing to search for future business combinations with the balance.  As part of the process, Ackman asserted that the initial 10% acquisition would satisfy the acquisition time limits required for SPACs and remove any future pressure to close another acquisition within a particular period of time.

Ackman ultimately abandoned the plan after failing to obtain SEC and NYSE approval.  Although he cited that the regulators found a number of issues without specifying what these issues were, the most obvious to me is that upon purchasing the 10% interest in Universal Music, the SPAC would become an investment company subject to the Investment Company Act of 1940.  Also, since the plan was to purchase the interest and spin it off without a holding period, the transaction would likely have tax implications to the SPAC shareholders.  In any event, I expect more creativity in this arena.

Waiver of Annual Fee for Nasdaq Global Market

On July 7, 2021, the SEC approved a Nasdaq rule change that waives the annual fee for companies that complete a business combination with a SPAC that is listed on another tier of the Exchange and move the post business combination entity to a higher tier.  In particular, many SPACs list on the Nasdaq Capital Markets to save fees, and because they do not have a need for the added services of the higher tiers.  Upon closing a business combination, the company may wish to list on the Nasdaq Global Market.  Likewise, Nasdaq will provide a reduced fee to SPACs that this directly on the Nasdaq Global Market as these companies require fewer regulatory resources than operating companies.

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Digital Asset Securities – Progress For Broker Dealers
Posted by Securities Attorney Laura Anthony | August 15, 2021 Tags:

In December 2020, the SEC issued a statement and request for comment regarding the custody of digital asset securities by broker-dealers.  The Statement and request for comment sets forth suggestions for complying with the Customer Protection Rule and lists certain requirements that a broker-dealer could comply with to ensure that it would not be subject to an enforcement proceeding for violation of the Customer Protection Rule.

Two months later, in February 2021, the SEC Division of Examinations issued a risk alert focused on digital asset securities.  These statements were the first hitting head on the topic of digital asset custody since an August 2019 joint statement by the SEC and FINRA on the custody of digital assets (see HERE) and October 2019 joint statement by the SEC, FinCEN and the CFTC (see HERE).

The SEC and FINRA have been discussing issues of custody related to tokens and digital assets for years.  For example, issues surrounding the custody of digital assets have been continuously cited by the SEC as one of the reasons for the failure to approve a cryptocurrency ETF.  The SEC defines a digital asset as an asset that is issued and/or transferred using distributed ledger or blockchain technology (“distributed ledger technology”), including, but not limited to, “virtual currencies,” “coins,” and “tokens.”

Any entity that transacts business in digital asset securities must comply with the federal securities laws.  An entity that buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers will be required to register with the SEC as a broker-dealer and become a member of and comply with the rules of FINRA.  Likewise, entities that make markets in securities (i.e., buy or sell for their own account) may also need to be registered as a broker-dealer. However, historical rules do not adequately cover the complex issues related to digital assets, including rules related to the loss or theft of a security.

Since the SEC issued its Section 21(a) Report on the DAO investigation, finding that digital assets and cryptocurrencies are, in most instances, securities, there has been a significant rise in the number of SEC applications for broker-dealer registration and membership applications with FINRA.  There has also been a large increase in applications to FINRA by existing members to expand their business operations to include digital assets.   On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens, and to continue to update FINRA on such activities through July 31, 2019.  FINRA subsequently extended to the time to require firms to report activity through July 31, 2020.

Statement and Request for Comment

The SEC is looking into innovating the Customer Protection Rule to encompass digital assets. Broker-dealers that hold funds and securities must comply with Exchange Act Rule 15c3-3 (the “Customer Protection Rule”), which generally requires the broker to obtain and thereafter maintain physical possession or control over the customer’s fully paid and excess margin securities it carries for the account of customers. Where funds and securities are purely digital, consideration needs to be made over how they are accounted for and who has the obligation. In addition, certain activities and access levels could amount to “receiving, delivering, holding or controlling customer assets,” such as having access to a private key code for a customer.

The purpose of the Customer Protection Rule is to protect the customer funds, provide for processes in the event of a broker-dealer’s failure, and put systems in place so that the SEC can oversee and monitor business practices.  Like attorney escrow accounts, a broker-dealer must keep the customer’s assets segregated from their own and properly labeled and tracked as that customer’s property.

To satisfy the Customer Protection Rule, most broker-dealers use a third party, such as the Depository Trust Company (DTC), a clearing firm or a transfer agent (for book entry or DRS securities) as the actual custodian of the securities.  Using a third party creates a check and balance, eliminating the risk of comingling or the loss of the security in the event the broker-dealer fails, and allowing for the reversal or cancellation of a mistaken or unauthorized transaction.  Simply, a broker-dealer’s employees, regulators, and outside auditors can contact these third parties to confirm that the broker-dealer is, in fact, holding the traditional securities reflected on its books and records and financial statements.

Digital assets are unique in that the way they are issued, held, and transferred is different from other securities up to this point.  One of the principal concerns with the custody of digital assets relates to cybersecurity.  The issue is prolific for all companies, but even more so for those working with cyber assets.   Another unique concern with digital assets relates to the ramifications if a broker-dealer or customer loses their “private key” necessary to transfer a client’s digital asset securities.  If a private key is lost, there is no method for retrieving the information and the digital assets could be lost forever.  Likewise, if digital assets are unintentionally or fraudulently transferred to an unknown or unintended address, there would be no meaningful recourse to invalidate the fraudulent transactions, recover or replace lost property, or correct errors.

In addition to these real-world issues, technical compliance with the Customer Protection Rule is not easy with digital assets.  The rule requires that “not later than the next business day, a broker-dealer, as of the close of the preceding business day, shall determine the quantity of fully paid securities and excess margin securities in its possession or control and the quantity of such securities not in its possession or control.”  If possession and control results from possession of a customer’s private key and the ability to transfer digital assets using the private key, it may be difficult to establish that no other party has a copy of the private key and could therefore also exercise possession and control over the assets.  However, to satisfy the Rule’s requirements, a broker-dealer to solve this problem.  In that regard, the SEC has made suggestions for controls and procedures that are discussed below.

With that said, the SEC realizes that it is only a matter of time before broker-dealers are providing a full set of functions with respect to digital assets, including maintaining custody of the assets in a way that addresses the unique attributes of digital asset securities and minimizes risk to investors and other market participants.  In order to accomplish these goals, a broker-dealer would need to have policies and procedures in place to be able to assess a particular digital asset’s distributed ledger technology and to be able to protect the private keys of holders.

Moreover, the Customer Protection Rule only covers cash and securities.  If a customer has digital assets held at a broker that are not securities (such as bitcoin), the potential liability from a cyber-theft or loss of those assets could be catastrophic to the broker-dealer and therefore all its customers.  SIPC would not cover such a loss.

In a striking development since its 2019 statements, the SEC December 2020 statement asserts an outright position of support for innovation in the digital asset securities market to develop its infrastructure.   The SEC further asserts that, for a period of five years, it will not initiate enforcement action against a broker-dealer that claims to have obtained and maintained physical possession or control of customer fully paid and excess margin digital asset securities for the purposes of the Customer Protection Rule.   The five-year period is designed to provide market participants with an opportunity to develop practices and processes that will enhance their ability to demonstrate possession or control over digital asset securities. It also will provide the SEC with experience in overseeing broker-dealer custody of digital asset securities to inform further action in this area.  The statement and SEC’s position related to enforcement, relate solely to the Customer Protection Rule and not other obligations of broker-dealers.

Enforcement Protection

The SEC states that it will not recommend enforcement proceedings against a broker-dealer related to the Customer Protection Rule when it holds and transacts business in digital assets, in the following circumstances:

  • The broker-dealer has access to the digital asset securities and the capability to transfer them on the associated distributed ledger technology;
  • The broker-dealer limits its business to dealing in, effecting transactions in, maintaining custody of, and/or operating an alternative trading system for digital asset securities. In this case, the broker-dealer may hold positions in traditional assets for purposes of meeting the firm’s minimum net capital requirements and for hedging.  Although not required by the SEC for enforcement protection a broker-dealer could refuse to hold or engage in transactions involving non-security digital assets (such as cryptocurrencies and some NFTs);
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies and procedures to conduct and document an analysis of whether a particular digital asset is a security offered and sold pursuant to an effective registration statement or an available exemption from registration, and whether the broker-dealer meets its requirements to comply with the federal securities laws with respect to effecting transactions in the digital asset security, before undertaking to effect transactions in and maintain custody of the digital asset security;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies and procedures to conduct and document an assessment of the characteristics of a digital asset security’s distributed ledger technology and associated network prior to undertaking to maintain custody of the digital asset security and at reasonable intervals thereafter. Such a review should include an examination of: (i) performance (i.e., does it work and will it continue to work as intended); (ii) transaction speed and throughput; (iii) scalability; (iv) resiliency (can it absorb the impact of a problem in one or more parts of its system and continue processing transactions without data loss or corruption); (v) security and relevant consensus mechanism (can it detect and defend against malicious attacks); (vi) complexity (can it be understood, maintained and improved); (vii) extensibility (can it have new functions added); and (viii) visibility (are its associated code, standards, applications, and data publicly available and well documented);
  • The broker dealer will not maintain custody of a digital asset security if the firm is aware of any material security or operational problems or weaknesses with the distributed ledger technology and associated network used to access and transfer the digital asset security, or is aware of other material risks posed to the broker-dealer’s business by the digital asset security;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies, procedures, and controls that are consistent with industry best practices to demonstrate the broker-dealer has exclusive control over the digital asset securities it holds in custody and to protect against the theft, loss, and unauthorized and accidental use of the private keys necessary to access and transfer the digital asset securities the broker-dealer holds in custody. These policies and procedures should address: (i) the on-boarding of a digital asset security such that the broker-dealer can associate the digital asset security to a private key over which it can reasonably demonstrate exclusive physical possession or control; (ii) the processes, software and hardware systems, and any other formats or systems utilized to create, store, or use private keys and any security or operational vulnerabilities of those systems and formats; (iii) the establishment of private key generation processes that are secure and produce a cryptographically strong private key that is compatible with the distributed ledger technology and associated network and that is not susceptible to being discovered by unauthorized persons during the generation process or thereafter; (iv) measures to protect private keys from being used to make an unauthorized or accidental transfer of a digital asset security held in custody by the broker-dealer; and (v) measures that protect private keys from being corrupted, lost or destroyed, that back-up the private key in a manner that does not compromise the security of the private key, and that otherwise preserve the ability of the firm to access and transfer a digital asset security it holds in the event a facility, software, or hardware system, or other format or system on which the private keys are stored and/or used is disrupted or destroyed;
  • The broker-dealer establishes, maintains, and enforces reasonably designed written policies, procedures, and arrangements to: (i) the steps and responses to events such as blockchain malfunctions, attacks, hard forks and airdrops; (ii) to allow the broker-dealer to comply with a court-ordered freeze or seizure; and (iii) to allow the transfer of the digital asset securities held by it to another special-purpose broker-dealer, a trustee, receiver, liquidator, a person performing a similar function, or another appropriate person, in the event the broker-dealer can no longer continue as a going concern and self-liquidates or is subject to a formal bankruptcy, receivership, liquidation, or similar proceeding;
  • The broker-dealer provides written disclosures to prospective customers, including: (i) explaining how SIPA defines securities and that digital assets, even those that are investment contracts under Howey may be excluded from the definition and therefore not covered by SIPC in the event of a loss; (ii) a description of the risks of fraud, manipulation, theft, and loss associated with digital asset securities; (iii) a description of the risks relating to valuation, price volatility, and liquidity associated with digital asset securities; and (iv) a description of the processes, software and hardware systems, and any other formats or systems utilized by the broker-dealer to create, store, or use the private keys and protect them from loss, theft, or unauthorized or accidental use; and
  • The broker-dealer enters into a written agreement with each customer that sets forth the terms and conditions for receiving, purchasing, holding, safekeeping, selling, transferring, exchanging, custodying, liquidating, and otherwise transacting in digital asset securities on behalf of the customer.

Request for Comments

The SEC also specifically requests comments on:

  • What are industry best practices with respect to protecting against theft, loss, and unauthorized or accidental use of private keys necessary for accessing and transferring digital asset securities? What are industry best practices for generating, safekeeping, and using private keys?
  • What are industry best practices to address events that could affect a broker-dealer’s custody of digital asset securities such as a hard fork, airdrop, or 51% attack?
  • What are the processes, software and hardware systems, or other formats or systems that are currently available to broker-dealers to create, store, or use private keys and protect them from loss, theft, or unauthorized or accidental use?
  • What are accepted practices (or model language) with respect to disclosing the risks of digital asset securities and the use of private keys? Have these practices or the model language been utilized with customers?
  • Should the SEC expand this position in the future to include other businesses such as traditional securities and/or non-security digital assets? Should this position be expanded to include the use of non-security digital assets as a means of payment for digital asset securities, such as by incorporating a de minimis threshold for non-security digital assets?
  • What differences are there in the clearance and settlement of traditional securities and digital assets that could lead to higher or lower clearance and settlement risks for digital assets as compared to traditional securities?
  • What specific benefits and/or risks are implicated in a broker-dealer operating a digital asset alternative trading system that the Commission should consider for any future measures it may take?

SEC Risk Alert

In February 2021, the SEC Division of Examinations issued a risk alert focused on digital asset securities.  The risk alert highlights observations made by SEC staff during examinations of investment advisers, broker-dealers, and transfer agents regarding digital asset securities that may assist firms in developing and enhancing their compliance practices.  These observations also provide a view of future regulatory focus in examinations.

Specifically related to investment advisers that are managing digital assets securities, either directly or through pooled vehicles, the SEC will focus on:

  • Portfolio management – whether digital assets are classified as securities; due diligence including that the adviser understands the digital assets, wallets and other devices or software used in the network; Evaluation and mitigation of risks related to trading venues and trade execution or settlement facilities, including KYC/AML procedures; management of risks and complexities associated with forks and airdrops; and fulfillment of fiduciary duties.
  • Books and Records – are advisers keeping accurate books and records. Digital asset trading platforms vary in reliability and consistency with regard to order execution, settlement methods, and post-trade recordation and notification, which an adviser should consider when designing its recordkeeping practices.
  • Custody – unauthorized transactions, including theft of digital assets; controls around safekeeping of assets; business continuity plans where personnel have access to private keys; how the adviser evaluates harm due to loss of private keys; reliability of software; storage of digital assets; and security procedures for software and hardware wallets.
  • Disclosures – disclosure to investors regarding the unique risks of digital assets.
  • Pricing Client Portfolios – valuation methods for digital assets.
  • Registration Issues – how the investment adviser calculates its regulatory assets under management and characterizes digital assets in pooled vehicles.

Specifically related to broker-dealers that are transacting in digital assets securities, the SEC will focus on:

  • Safekeeping of funds and operations – considering unique safety and custody issues of digital assets.
  • Registration requirements – including activities by affiliates.
  • Anti-money laundering – general AML procedures that take into account digital assets including routine searches to check against the Specially Designated Nationals list maintained by the Office of Foreign Assets Control (“OFAC”) at the U.S. Department of the Treasury.
  • Offerings – including disclosure and due diligence obligations.
  • Disclosure of conflicts of interest – including compliance policies and procedures.
  • Outside Business Activities – FINRA-member broker-dealers must evaluate the activities of their registered persons to determine whether such activity constitutes outside business activities or an outside securities activity and therefore should be subjected to the approval, supervision, and recordation of the broker-dealer.

Specifically related to National Securities Exchanges that are transacting in digital assets securities, the SEC will focus on:

  • Exchange Registration – the staff will examine platforms that facilitate trading in Digital Asset Securities and review whether they meet the definition of an exchange.
  • Compliance with Regulation ATS – Examinations will include a review of whether an ATS that trades Digital Asset Securities is operating in compliance with Regulation ATS, including, among other things, whether the ATS has accurately and timely disclosed information on Form ATS and Form ATS-R, and has adequate safeguards and procedures to protect confidential subscriber trading information.

Finally, related to transfer agents that are transacting in digital assets securities, the SEC will focus on:

  • Compliance with Transfer Agent Rules – the staff will focus on prompt and accurate clearance and settlement of securities transactions.
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NYSE Annual Compliance Guidance Memo And Amended Rules
Posted by Securities Attorney Laura Anthony | July 22, 2021 Tags: ,

In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies.  Although we are already halfway through the year, the annual letter has useful information that remains timely.  As discussed in the Compliance Memo, the NYSE sought SEC approval to permanently change its shareholder approval rules in accordance with the temporary rules enacting to provide relief to listed companies during Covid.  The SEC approved the amended rules on April 2, 2021.

Amendment to Shareholder Approval Rules

The SEC has approved NYSE rule changes to the shareholder approval requirements in Sections 312.03 and 312.04 of the NYSE Listed Company Manual (“Manual”) and the Section 314 related party transaction requirements.  The rule changes permanently align the rules with the temporary relief provided to listed companies during Covid (for more on the temporary relief, see HERE

Prior to the amendment, Section 312.03 of the Manual prohibited certain issuances to (i) directors, officers or substantial shareholders (related parties), (ii) a subsidiary, affiliate, or other closely related person of a related party; or (iii) any company or entity in which a related party has a substantial direct or indirect interest.  In particular, related party issuances were prohibited if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance.  The rule had limited exception if the issuances were for cash, above a minimum price, no more than 5% of the outstanding common stock and the related party was a related party solely because it is a substantial shareholder of the company.

The amended rules modify the class of persons for which shareholder approval would be required prior to an issuance.  The amended rules only require shareholder approval prior to issuances to directors, officers and substantial shareholders.  The restriction on a subsidiary, affiliate, or other closely related person of a related party or any company or entity in which a related party has a substantial direct or indirect interest has been removed.  In addition, the amended rule broadens the exception such that all cash sales at or above the minimum price would be exempted.    Other provisions of the NYSE rules may still require shareholder approval prior to issuances to officers and directors, such as the equity compensation rules that require shareholder approval for issuances to employees, officers, directors and service providers.

The amendment also adds a provision whereby shareholder approval is required prior to any acquisition transaction or series of related transactions in which any related party has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in either the number of shares of common stock or voting power outstanding of 5% or more before the issuance.

The amendments more closely align the NYSE rules with those of the NYSE American and Nasdaq.  For a review of the NYSE American and Nasdaq rules for affiliate issuances associated with acquisitions, see HERE.  For a review of the NYSE American and Nasdaq rules governing equity compensation shareholder approval requirements, see HERE.

The NYSE has also amended its 20% Rule.  In particular, NYSE Section 312.03(c) requires shareholder approval of any transaction relating to 20% or more of the company’s outstanding common stock or voting power outstanding before such issuance but provides the following exceptions: (i) any public offering for cash; and (ii) any bona fide private financing involving a cash sale of the company’s securities that comply with the minimum price requirement.  A “bona fide private financing” referred to a sale in which either: (i) a registered broker-dealer purchases the securities from the issuer with a view to the private sale of such securities to one or more purchasers; or (ii) the issuer sells the securities to multiple purchasers, and no one such purchaser, or group of related purchasers, acquires, or has the right to acquire upon exercise or conversion of the securities, more than 5% of the shares of the issuer’s common stock or voting power before the sale.

Under the amended rules, the NYSE has replaced the term “bona fide financing” with “other financing (that is not a public offering for cash) in which the company is selling securities for cash.”  This change eliminated the requirement that the issuer sell the securities to multiple purchasers, and that no one such purchaser, or group of related purchasers, acquires more than 5% of the issuer’s common stock or voting power.  Also, under the rule change, the provision related to broker-dealer purchases becomes moot.

Of course, the new rules would not eliminate shareholder voting requirements under other NYSE rules such as the acquisition rules where the issuance equals or exceeds 20% of the common stock or voting power.  Like the affiliate rule change, the amendment is meant to further align NYSE rules with those of the NYSE American and Nasdaq.  For a review of the NYSE American and Nasdaq 20% rules, see HERE.

The NYSE has also made a change to Section 314 of the Manual requiring related party transactions to be reviewed by the audit committee.  The Exchange has updated the definition of “related party” from officers, directors and principal shareholders to align with the definition provided in Item 404 of Regulation S-K of the Exchange Act.

Annual Compliance Guidance Memo

The NYSE Memo provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news.  Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FD compliant method.  For news being released between 7:00 a.m. and 4:00 p.m. EST, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email.

For news releases outside the hours of 7:00 a.m. and 4:00 p.m. EST companies are generally not required to call the Exchange in advance of issuing news, although companies should still provide a copy of material news once it is disclosed, by submitting it electronically through Listing Manager or via e-mail to nysealert@nyse.com.  Where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement either by a call within operating hours or in writing after hours.

The requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference.  In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.

Between the hours of 9:25 a.m. and 4:00 p.m. EST, NYSE will determine if a temporary trading halt should be implemented to allow the market time to fully absorb the news.  Between the hours of 7:00 a.m. and 9:25 a.m. EST, NYSE will implement news pending trading halts only at the request of the company.

Companies are prohibited from publishing material news after the official closing time for the NYSE’s trading session until the earlier of 4:05 p.m. EST or the publication of the official closing price of the listed company’s security. This requirement is designed to alleviate confusion caused by price discrepancies between trading prices on other markets after the NYSE official closing time, which is generally 4:00 p.m. EST, and the NYSE closing price upon completion of the auction, which can be after 4:00 p.m. EST.

NYSE notes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination. The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information.

The compliance letter also addresses the following matters:

Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 302 of the Manual, which requires that a company hold an annual meeting during each fiscal year.

Record Date Notification – To participate in shareholder meetings as well as receive company distributions and other important communications, investors must hold their securities on the relevant record date established by the listed company. For this reason, the NYSE disseminates record date information to the marketplace so that investors can plan their holdings accordingly.  Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date.  Record dates should be set for business days.  A press release or filing with the SEC cannot satisfy the notice requirements.  The NYSE has no power to waive these requirements and so, if notice is not provided to NYSE as required, a record date may have to be reset.

Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security.  The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards.  Also, the NYSE relies on a listed company’s transfer agent or depositary bank to report share information. Transfer agents are required to report shares no later than the 10th day following the end of each calendar quarter.

Annual Report Website Posting Requirement – Section 203.01 of the Manual requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC.  A listed company that is not required to comply with the SEC proxy rules (such as foreign issuers) must also post a prominent undertaking on its website to provide all holders the ability, upon request, to receive a hard copy of the complete audited financial statements free of charge; and issue a press release that discloses that the Form 10-K, 20-F, 40-F or N-CSR has been filed with the SEC, includes the company’s website, and indicates that shareholders have the ability to receive hard copy of the complete audited financial statements free of charge upon request.

Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements.  The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC.  In addition, a listed company must file an Interim Written Affirmation promptly (within 5 business days) after any triggering event specified on that form. Domestic companies are not required to submit an Interim Written Affirmation for changes that occur within 30 days after the annual meeting, as these can be included in the Annual Written Affirmation.

Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants).  No additional securities can be issued until the NYSE authorizes the LAS.  Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date.  Authorization takes approximately 2 weeks.

Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners.  The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed.  The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.

NYSE Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions.  The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.

Shareholder Approval and Voting Rights Requirements – Sections 303A.08 and 312.03 of the Manual outline the Exchange’s shareholder approval requirements including the 20% rules.  Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).

Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.

Voting Requirements for Proposals at Shareholder Meetings – Section 312.07 of the Manual provides that, where shareholder approval is required under NYSE rules, the minimum vote that constitutes approval for such purposes is approval by a majority of votes cast (i.e., the number of votes cast in favor of the proposal exceeds the aggregate of votes cast against the proposal plus abstentions).

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SEC Rules Requiring Disclosures for Resource Extraction Companies
Posted by Securities Attorney Laura Anthony | July 9, 2021 Tags: ,

As required by the Dodd-Frank Act, in December 2020, the SEC adopted final rules requiring require resource extraction companies to disclose payments made to foreign governments or the U.S. federal government for the commercial development of oil, natural gas, or minerals.  The last version of the proposed rules were published in  December 2019 (see HERE )The rules have an interesting history.  In 2012 the SEC adopted similar disclosure rules that were ultimately vacated by the U.S. District Court.  In 2016 the SEC adopted new rules which were disapproved by a joint resolution of Congress.  In December 2019, the SEC took its third pass at the rules that were ultimately adopted.

The final rules require resource extraction companies that are required to file reports under Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) to disclose payments made by it or any of its subsidiaries or controlled entities, to the U.S. federal government or foreign governments for the commercial development of oil, natural gas, or minerals.

FINAL RULES

The Dodd-Frank Act added Section 13(q) to the Exchange Act directing the SEC to issue final rules requiring each resource extraction issuer to include in an annual report information relating to any payments made, either directly or through a subsidiary or affiliate, to a foreign government or the federal government for the purpose of the commercial development of oil, natural gas, or minerals. The information must include: (i) the type and total amount of the payments made for each project of the resource extraction issuer relating to the commercial development of oil, natural gas, or minerals, and (ii) the type and total amount of the payments made to each government.

As noted above, the first two passes at the rules by the SEC were rejected.  The 2016 Rules provided for issuer-specific, public disclosure of payment information broadly in line with the standards adopted under other international transparency promotion regimes. In early 2017, the President asked Congress to take action to terminate the rules stemming from a concern on the potential adverse economic effects.  In particular, the rules were thought to impose undue compliance costs on companies, undermine job growth, and impose competitive harm to U.S. companies relative to foreign competitors.  The rules were also thought to exceed the SEC authority.

The final rules make many significant changes to the rejected 2016 rules.  In particular, the final rules: (i) revise the definition of project to require disclosure at the national and major subnational political jurisdiction as opposed to the contract level; (ii) amend the definition of “not de minimis” to mean any payment or series of related payments that equals or exceeds $100,000; (iii) add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure; (iv) add an exemption for smaller reporting companies and emerging growth companies; (v) revise the definition of “control” to exclude entities or operations in which an issuer has a proportionate interest; (vi) limit disclosure liability by deeming the information to be furnished and not filed with the SEC; (vii) permit an issuer to aggregate payments by payment type made but require disclosure of aggregated amounts for each subnational government payee and identify each subnational government payee; (viii) add relief for companies that recently completed a U.S. IPO; and (ix) extend the deadline for furnishing the payment disclosures.

The rules add a new Exchange Act Rule 13q-1 and amend Form SD to implement Section 13(q).  Under the rules, a “resource extraction issuer” is defined as a company that is required to file an annual report with the SEC on Forms 10-K, 20-F or 40-F.  Accordingly, Regulation A reporting companies and those required to file an annual report following a Regulation Crowdfunding offering are not covered.  Moreover, smaller reporting companies and emerging growth companies are exempted.  However, if the SRC or EGC is subject to disclosure requirements by an alternative reporting regime will have to report on a scaled basis.

The rules define “commercial development of oil, natural gas, or minerals” as exploration, extraction, processing, and export of oil, natural gas, or minerals, or the acquisition of a license for any such activity.  The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development.  The definition of “commercial development” captures only those activities that are directly related to the commercial development of oil, natural gas, or minerals, and not activities ancillary or preparatory to such commercial development.  The SEC intends to keep the definition narrow to reduce compliance costs and negative economic impact.

Likewise, the definitions of “extraction” and “processing” are narrowly defined and do not include downstream activities such as refining or smelting.  “Export” is defined as the transportation of a resource from its country of origin to another country by an issuer with an ownership interest in the resource.  Companies that provide transportation services, without an ownership interest in the resource, are not covered.

Under Section 13(q) a “payment” is one that: (i) is made to further the commercial development of oil, natural gas or minerals; (ii) is not de minimis; and (iii) includes taxes, royalties, fees, production entitlements, bonuses, and other material benefits.  The rules define payments to include the specific types of payments identified in the statute, as well as community and social responsibility payments that are required by law or contract, payments of certain dividends, and payments for infrastructure.  Furthermore, an anti-evasion provision is included such that the rules require disclosure with respect to an activity or payment that, although not within the categories included in the rules, is part of a plan or scheme to evade the disclosure required under Section 13(q).

A “project” is defined using three criteria: (i) the type of resource being commercially developed; (ii) the method of extraction; and (iii) the major subnational political jurisdiction where the commercial development of the resource is taking place.  A resource extraction issuer will have to disclose whether the project relates to the commercial development of oil, natural gas, or a specified type of mineral.  The disclosure would be at the broad level without the need to drill down further on the type of resource.  The second prong requires a resource extraction issuer to identify whether the resource is being extracted through the use of a well, an open pit, or underground mining.  Again, additional details are not required.  The third prong requires an issuer to disclose only two levels of jurisdiction: (1) the country; and (2) the state, province, territory or other major subnational jurisdiction in which the resource extraction activities are occurring.

Under the rules, a “foreign government” is defined as a foreign government, a department, agency, or instrumentality of a foreign government, or a company at least majority owned by a foreign government. The term “foreign government” includes a foreign national government as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government.  On the other hand, “federal government” refers to the government of the U.S. and does not include subnational governments such as states or municipalities.

The annual report on Form SD must disclose: (i) the total amounts of the payments by category; (ii) the currency used to make the payments; (iii) the financial period in which the payments were made; (iv) the business segment of the resource extraction company that made the payments; (v) the government that received the payments and the country in which it is located; and (vi) the project of the resource extraction business to which the payments relate.  Under the rules, Form SD expressly states that the payment disclosure must be made on a cash basis instead of an accrual basis and need not be audited.  The report covers the company’s fiscal year and needs to be filed no later than nine months following the fiscal year-end.  The Form SD must include XBRL tagging.

As noted above, the rule includes two exemptions where disclosure is prohibited by foreign law or pre-existing contracts.  In addition, the rules contain a targeted exemption for payment related to exploratory activities.  Under this targeted exemption, companies will not be required to report payments related to exploratory activities in the Form SD for the fiscal year in which payments are made, but rather could delay reporting until the following year.  The SEC adopted the delayed approach based on a belief that the likelihood of competitive harm from the disclosure of payment information related to exploratory activities diminishes over time.

Finally, the rule allows a similar delayed reporting for companies that are acquired and for companies that complete their first U.S. IPO.  When a company is acquired, payment information related to that acquired entity does not need to be disclosed until the following year.  Similarly, companies that complete an IPO do not have to comply with the Section 13(q) rules until the first fiscal year following the fiscal year in which it completed the IPO.

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ESG – The Disclosure Debate Continues
Posted by Securities Attorney Laura Anthony | July 2, 2021 Tags:

The ESG debate continues, including within the SEC and amongst other regulators and industry participants.  Firmly in support of ESG disclosures, and especially climate change matters, is SEC Chair Gary Gensler and Commissioner Allison Herren Lee, while opposing additional regulation is Commissioners Eliad L. Roisman and Hester M. Peirce.  Regardless of whether new regulations are enacted (I firmly believe they are forthcoming), like all SEC disclosure items, the extent of disclosure will depend upon materiality.

Materiality

The U.S. Supreme Court’s definition of materiality is that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public [TSC Industries, Inc. v. Northway, Inc.].  The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.

Rule 405 of the Securities Act defines “material” as “[T]he term material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”

Despite the case law and statutory definition, the concept remains fact-driven and difficult to apply.  There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available.  Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure. The SEC has been consistent in its description of materiality for purposes of disclosure in all of its guidance, commentary and rule releases.  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.

In its recent request for public comment on climate change disclosure, the SEC sought input on, among other items, what disclosure would be material to an investment or voting decision.  Likewise, the SEC’s 2010 Climate Disclosure Guidance seeks disclosure of material information.  Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if they fell under the general materiality bucket of information (i.e., 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) (see for more information on the request for comment and 2010 guidance HERE.

In determining materiality, practitioners need to consider Regulation FD, which prohibits the selective disclosure of material information.  Regulation FD requires that if material information is to be disclosed, it must be disclosed to the entire market, either through a press release or Form 8-K or both, and not selectively, such as to certain analysts or market professionals.

In May 2021 Commissioner Allison Herren Lee gave a speech on ESG disclosures expressing her well known support for disclosure.  As the concept of materiality has arisen as a gating question in the need for ESG disclosure, Ms. Lee focused on that concept in her speech.  Beginning with the inarguable position that materiality is based on “information that is important to reasonable investors,” she posits that management, lawyers and accountants often get it wrong.  Rather, she believes that a “disclosure system that lacks sufficient specificity and relies too heavily on a broad-based concept of materiality will fall short of eliciting information material to reasonable investors.”

Ms. Lee continues that despite this concept of materiality, she does not believe that the disclosure rules are, or should be, constrained by materiality.  She points to many prescriptive disclosure requirements that are not guided by materiality, such as related party transactions, share repurchases and executive compensation – which leads to ESG disclosures.  Commissioner Lee believes that ESG is material in and of itself and thus disclosure is required.  She continues that “investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”

This is where I put the brakes on.  SEC disclosures are not meant to provide specific factions of, or for that matter any faction of, investors with particular disclosures.  Rather, the standard is well settled that disclosures are meant to provide a “reasonable investor” with information useful in making decisions (investment, voting, etc.).  The test is objective.  The SEC should not be catering to particular factions on investors, especially on a clearly partisan political subject.  That doesn’t mean that I am opposed to climate change disclosures, but rather, that I don’t agree the rulemaking on such disclosures should deviate from the long-standing objective principals of materiality.

More on ESG and Climate Change Disclosures

The SEC request for public comment has been met with an enthusiastic response on both sides of the fence.  However, as many great thinkers are pointing out, although the view that climate change will impact society is fairly accepted, the view that it will impact specific economic sectors, is far less so.  For a financial regulator like the SEC, that discrepancy between societal costs and costs to public companies and markets creates a potential disconnect.

On June 3, 2021, Commissioner Elad L. Roisman gave a poignant speech on ESG disclosure, and its inevitable costs.  Mr. Roisman is vocally against the SEC issuing prescriptive, line-item disclosure requirements on ESG matter and in particular environmental and social issues.  Echoing prior speeches by former Chair Jay Clayton, Mr. Roisman states the obvious that standardization is extremely difficult.  The data is imprecise and fraught with political motivations.

Commissioner Roisman is focused on the costs of disclosure.  The SEC has a mandate to consider the costs of compliance with any new regulations.  Certainly, companies would incur costs in obtaining and presenting the new information and liability for the adequacy of such information. To counter some of these costs, Roisman suggests (i) scaled disclosure for smaller reporting companies; (ii) flexibility in methodologies in fashioning disclosure (for example, a company’s ability to calculate Scope 3 greenhouse emissions depends on it gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities and can be daunting and expensive); (iii) safe harbors similar to forward looking statements disclaimers to reduce litigation risks; (iv) allow disclosures to be furnished not filed; and (v) an extended implementation period.

He also poses basic structural questions such as what standards would the SEC use; if they rely on third parties, how will those standards be monitored and supervised going forward (especially if that party changes political views); and is the SEC the best regulator to require disclosures, especially related to the external impact a company has on society/the environment (as opposed to the potential impact on the company itself).

Staying true to form, Commissioner Hester M. Peirce made a pragmatic and pointed statement on ESG disclosures.  Ms. Peirce points out that “[T]he task before us is to find a way to bring about lasting, positive change to our countries on a range of issues without sacrificing in the process the very means by which so many lives have been enriched and bettered.”  Ms. Peirce also takes aim at the push to follow European disclosure requirements and to create a comprehensive international disclosure regime.  However, ESG factors are complex, evolving and not readily comparable across issuers and industries.  Peirce notes that “[T]he European concept of ‘double materiality’ has no analogue in our regulatory scheme and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of ‘stakeholders,’ would mark a departure from these fundamental aspects of our disclosure framework.”  Clearly, the U.S. capital markets are number one for a reason and an international homogenous disclosure system is likely to impose new costs on public companies, decrease the attractiveness of our capital markets, distort the allocation of capital, and undermine the role of shareholders in corporate governance.

Turning back to the SEC request for comments, one such comment letter response submitted by UVA law professors Paul and Julia Mahoney, argues that the movement to require disclosure is being led by institutions whose purpose is in part “to pursue public policy goals outside the normal political process,” and whose statements asserting the supposed financial value of ESG are “cheap talk that conveys no information other than that the institution wants the SEC to require the disclosures.”  The article suggests that by requirement disclosure the SEC “risks eroding public trust in its capacity and willingness to serve as an apolitical, technocratic regulator of the capital markets.”

Realizing that climate change disclosures are likely forthcoming, the Securities Industry and Financial Markets Association (SIFMA) advocates for the SEC to start slowly with climate change disclosures and hold off on other ESG matters.  SIFMA suggests requiring disclosures of metrics related to greenhouse gas emissions and so-called carbon footprints based on a materiality standard and principles approach.

Illustrating that the issue follows party lines, supporting disclosure is the New York Department of Financial Services; California Attorney General Rob Bonta and the Attorney Generals for Connecticut, Illinois, Maryland, Massachusetts, Michigan, Minnesota, New York, Oregon, Vermont and Wisconsin.

Congress is getting in on the act as well.  On June 16, 2021, the U.S. Democratic run house narrowly passed H.R. 1187, the Corporate Governance Improvement and Investor Protection Act, which would require the SEC to issue rules within two years requiring every public company to disclose climate specific metrics in financial statements.  The Act would modify Section 14 of the Exchange Act which governs the solicitations of proxies, information statements following shareholder consents, and tender offers and require specified disclosures in proxy solicitations and information statements for annual meetings.  The Act also requires the SEC to create a Sustainable Finance Advisory Committee.  Next the Act goes to the Senate and if passed, to the President to be signed into law or vetoed.  Many Acts are passed by either the House or Senate but never go the distance.  Since this Act is so narrow compared to the SEC’s much broader request for comment on climate disclosure, even if passed, I suspect the SEC rulemaking will be broader than this requires.

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A Resolution For SPAC Warrant Accounting
Posted by Securities Attorney Laura Anthony | June 25, 2021 Tags: , ,

On April 12, 2021, the SEC effectively chilled SPAC activity by announcing that it had examined warrant accounting in several SPACs and found that the warrants were being erroneously classified as an asset.  The SEC identified two accounting issues, one related to the private placement warrants and the other related to both the private placement and public warrants.  These companies were required to restate previously issued financial statements to reclassify warrants as liabilities, and the ripple effect began.  Overnight SPAC management teams, accountants and auditors were scrambling to determine if a restatement was required (in most cases it was) and in-process SPACs were put on hold or at least delayed while market participants tried to figure out the meaning of the SEC guidance and how to address it.

The timing of the statement was interesting as well; most calendar year end SPACs had just filed their Form 10-K for FYE 2020 requiring a slew of 8-Ks to disclose non-reliance on previously issued financial statements.  Those that had filed a Form 12b-25 to obtain a 15-day extension scrambled to re-do the financial statements before filing and as such most were late in filing.  Likewise, many companies that had recently completed business combinations with SPACs had to restate previously issued financial statements and/or delay reports.

The SEC statement specifically indicated that where warrants had been improperly characterized as assets instead of liabilities, a company should consider its obligation to maintain internal controls over financial reporting and disclosure controls and procedures to determine whether those controls are adequate.  Further, a company needed to assess whether prior disclosure on the evaluation of internal controls over financial reporting and disclosure controls and procedures needs to be revised in the amended filings.  As a result, most restated Exchange Act reports contained a disclosure that previously disclosed internal controls were not, in fact, effective due to a material weakness and added risk factors related to inadequate internal controls including litigation risks.

However, the industry was extremely motivated (with just under $90 billion raised in 2021 so far alone) and it appears that accounting firms and the SEC have agreed on a form of warrant that can classified as equity and not as a liability for financial reporting purposes.  Despite the resolutions discussed below, the SEC has not issued any formal guidance or statements updating the April 12, 2021 statement.  Many market participants do not feel they can confidently rely on these changes to be sure that the SEC will not find further issues and have called for lawmakers to add clarity.

Indexation

The Accounting Standards Codification (“ASC”) provides rules and guidelines for when warrants can be classified as equity (and thus an asset) or treated as a liability.  Under the rules, a warrant can only be classified as equity if the warrant is indexed to the company’s common stock.  One of the features of indexing is that a warrant has a fixed strike price.  In its review of SPAC warrants, the SEC found that some warrants included variables that would impact the exercise price and in particular, a variable exercise price depending on whether the warrant was held by the sponsor or a non-permitted transferee.

In a typical SPAC structure (see HERE) the private placement (sponsor) warrants have different features than the public warrants.  For example, the private placement warrants are generally not redeemable and always have cashless exercise provisions.  The public warrants, on the other hand, are almost always redeemable by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days and only have a cashless exercise feature if there is no effective registration statement as to the underlying shares.  Furthermore, both the private warrants and public warrants usually have provisions adjusting the exercise price in certain circumstances associated with the business combination transaction, with the private warrants being entitled to a greater adjustment than the public.  The warrant agreement provides that once the private placement warrants are transferred to persons other than certain permitted transferees, they become public warrants and thus are treated differently depending on the holder of the warrant.  The SEC took issue with potential variations in exercise price depending on holder of the warrant as not being consistent with the rules allowing indexing, and thus treatment as equity and not a liability.

The SEC staff and market participants have come up with two alternatives to address this issue.  The first is to keep private placement warrants separate and distinct from public warrants with no possibility of changes to their terms regardless of transfer.  That is, the concept of “permitted transferee” could be removed and all transfers would then be permitted.  The issue is that the public warrants generally trade on a national exchange (or OTC Markets) and since the features of the private warrant are different, there would be no opportunity to sell such private warrants on the open market.  Liquidity would only be had in a private transaction or upon exercise (which may or may not be in-the-money).

The second alternative is to remove the distinctions between the private and public warrants.  Of course, this would change the economics significantly for the sponsor.

Another alternative, which is not a fix to the warrants but a different structure altogether, is to utilize rights instead of warrants.  Many SPACs include rights as part of their offering structure, though generally in addition to, and not instead of, a warrant.  A right entitles the holder to purchase a share of common stock for xx number of rights (such as one share of common stock for 10 rights).  A right generally has a fixed exercise price and is a short-term instrument.  Care would have to be given such that a Rights Agreement did not contain the same provisions that the SEC found problematic in the Warrant Agreement.

Forced Cashless Exercise

Some SPAC warrant agreements contain a provision that allows the company to force a cashless conversion (i.e., payment in net shares) if the stock price of the company equals or exceeds $10.00 for a period of time.  The exercise price for these warrants is based on a warrant table that varies based on the current stock price and period of time remaining prior to expiration of the warrants.  The formula is based on Black-Scholes and is meant to compensation warrant holders for lost value based on the forced exercise.  As this provision causes the warrant exercise price to be variable, the SEC found that it precluded the warrants from being treated as equity and instead had to be treated as a liability.

SEC staff, together with accounting professionals, have reached the conclusion that if the warrant table is removed or modified, the warrants could be treated as equity.  Removal of the table is straightforward.  Modification would need to be in such a manner that the SEC no longer views the exercise price as variable.

I note that if the table is removed, a post business combination company could still proceed with a tender or exchange offer to entice warrant holders to exchange their warrants for cash and/or stock, but the company would no longer have an absolute right to force conversion.

Tender Offer Provisions

In addition to being properly indexed to common stock, in order to qualify for equity treatment, the warrant must allow the company to settle the warrant with shares.  That is, GAAP accounting includes a general principle that if an event that is not within the entity’s control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity.  There is an exception to this rule if net cash settlement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, such as in a complete change of control.

In its statement the SEC pointed out a fact pattern in which, if a company made a tender or exchange offer that was accepted by the holders of more than 50% of the Class A common stock, all holders of the warrants would be entitled to receive cash for their warrants.  Since in the typical SPAC structure the sponsor’s Class B common stock represents 20% of the total issued and outstanding equity, there would not necessarily be a change of control of the company as a result of the tender offer, and thus the exception would not apply.  In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash.  The SEC staff concluded that, in this fact pattern, the tender offer provision would require the warrants to be classified as a liability measured at fair value, with changes in fair value reported each period in earnings.

SEC Staff, together with accounting professionals, have reached the conclusion that if the language in the tender offer provisions is modified such that the tender offer triggering cash settlement of the SPAC warrants results in the maker of the tender offer holding more than 50% of the voting power of the company’s securities, the company would not be precluded from classifying the warrants as equity.

 

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SEC Announces It Will Not Enforce Amended Rules Governing Proxy Advisors
Posted by Securities Attorney Laura Anthony | June 18, 2021 Tags:

On June 1, 2021, SEC Chair Gary Gensler and the SEC Division of Corporation Finance issued statements making it clear that the SEC would not be enforcing the 2020 amendments to certain rules governing proxy advisory firms or the SEC guidance on the new rules.

In particular, in July 2020 the SEC adopted amendments to change the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provide additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amended Rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.  On the same day, the SEC issued updated guidance on the new rules.  See HERE for a discussion on the new rules and related guidance.

Like all rules and guidance related to the proxy process, the amendments were controversial with views generally falling along partisan lines.  On June 1, 2021, Chair Gary Gensler issued an extremely brief public statement, as follows:

I am now directing the staff to consider whether to recommend further regulatory action regarding proxy voting advice. In particular, the staff should consider whether to recommend that the Commission revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments, among other matters.

On the same day, the SEC Division of Corporation Finance issued a public statement that CorpFin is following Chair Gensler’s direction and revisiting the rules and guidance.  CorpFin stated that, in light of the new direction, it will not recommend enforcement action based on the 2019 Interpretation and Guidance or the 2020 Rule Amendments during the period in which the SEC is considering further regulatory action in this area.  Moreover, even if the new rules are left in place, CorpFin will not recommend enforcement for a reasonable period of time thereafter, including until current litigation related to the rule changes have been addressed.

Refresher on Amended Rules and Guidance

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

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

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

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

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

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

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

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

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

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

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

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

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

Conflicts of Interest

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

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

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

Review and Feedback on Proxy Advisory Materials

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

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

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

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

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

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

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

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

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

Rule 14a-9 – the Anti-Fraud Provisions

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

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

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

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

Supplemental Guidance for Investment Advisors

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

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

 

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SEC Fall 2020 Regulatory Agenda
Posted by Securities Attorney Laura Anthony | May 21, 2021 Tags:

The SEC’s latest version of its semiannual regulatory agenda and plans for rulemaking has been published in the federal register.  The Fall 2020 Agenda (“Agenda”) is current through October 2020.  The Unified Agenda of Regulatory and Deregulatory Actions contains the Regulatory Plans of 28 federal agencies and 68 federal agency regulatory agendas. The Agenda is published twice a year, and for several years I have blogged about each publication.

Like the prior Agendas, the Fall 2020 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions.  The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that.  The number of items to be completed in a 12-month time frame is down to 32 items.  The Spring Agenda had 42 and the Fall 2019 had 47 on the list.

Items on the Agenda can move from one category to the next or be dropped off altogether.  New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.  Portfolio margining harmonization was the only item listed in the pre-rule stage in the Fall 2019 and Spring 2020 Agendas.  It remained in that category, but the newest Agenda added prohibition against fraud, manipulation, and deception in connection with security-based swaps to the pre-rule stage moving it down in priority from the previous proposed rule category.

Sixteen items are included in the proposed rule stage, down from 19 in Spring 2020 and 31 on the Fall 2019 list.  Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements) and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list.  In May 2018, SEC has amended the rules and issued a concept release (see HERE and HERE   In November 2020, the SEC proposed new rules to modernize Rule 701 and S-8 and to expand the exemption to cover workers in the modern-day gig economy.

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

Other items that are still on the proposed rule list include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to Guide 5 on real estate offerings and Form S-11; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; amendment to the registration of alternative trading systems (ATS) for government securities; investment company summary shareholder report and modernization of certain investment company disclosures; amendments to the family office rule; and broker-dealer reporting, audit and notifications requirements.  Also still in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC.

Items moved up from long-term to proposed-rule stage include execution quality disclosure; and records to be preserved by certain exchange members, brokers and dealers.

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

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

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

Fourteen items are included in the final rule stage, down from 21 on the Spring Agenda, including a few of which are new to the Agenda.  Proposed rules to the Investment Advisors Act of 1940 regarding investment adviser advertisements and compensation for solicitation were added to the list appearing in the final rule stage. Although an amendment to the definition for covered clearing agency was adopted in April 2020, a further amendment to the definition related to security-based swaps dealers now appear in the final rule stage.  Moved from proposed to final are amendments to the rules regarding the consolidated audit trail.

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

Also, still in the final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); use of derivatives by registered investment companies and business development companies; and market data infrastructure, including market data distribution and market access (proposed rules published in February 2020); and amendments to the SEC’s Rules of Practice.  Administration of the EDGAR system moved up from long-term to the final rule stage.

Still listed on the final rule stage is the harmonization of exempt offerings.  The SEC adopted final amendments updating the exempt offering rules and processes on November 2, 2020.  I published a five-part blog on the series, including related to integration (HERE); offering communications (HERE); amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (HERE); Regulation A (HERE); and Regulation CF (HERE ).  Likewise is the disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE).  However, final rules were adopted in December 2020.

Keeping with that trend, modernization and simplification of disclosures regarding MD&A, selected financial data and supplementary financial information remain on the final rule list.  Those amendments were adopted in November 2020 (HERE).  Further valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company remain on the final rule list although changes were enacted in December 2020.  Amendments to certain provisions of the auditor independence rules which were adopted in October 2020 still appear on the list (see HERE).  As noted at the beginning, the Agenda is current through October 2020.

Several items have dropped off the Agenda as they have now been implemented and completed, including some major overhauls such as: the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were adopted in August 2020 (see HERE); financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses which was finalized in May 2020 (see HERE); amendments to the rules governing proxy advisory firms (see HERE); amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); amendments to the definition of accredited investor (HERE ); and the revamping of the 15c2-11 rules and process (see HERE).

Other items that dropped off the list as rulemaking was completed include procedures for investment company act applications; NMS Plan amendments; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; fund of fund arrangements; customer margin requirements for securities futures; and amendments to the whistleblower program.

Thirty-two items are listed as long-term actions (up from 30 in Spring 2020), including many that have been sitting on the list for years, including implementation of Dodd-Frank’s pay for performance (see HERE) which has sat on the long-term list for several years now.

Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the Spring 2019 list and up to proposed in Fall 2019 and Spring 2020.  The topic has now been dropped down again to the long-term list.  The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes and is clearly not making this topic a top priority.  Clawbacks of incentive compensation at financial institutions which had previously been dropped are back on as a long-term plan.

Amendments to the custody rules for investment advisors moved from the proposed rule stage to long-term actions, as did amendments to Form 13F filer thresholds. Amendments to the 13F filer thresholds were proposed in July 2020, increasing the threshold for the first time in 45 years.  Surprisingly, the proposal was met with overwhelming pushback from market participants.  There were 2,238 comment letters opposing the change and only 24 in support.  Although the SEC continues to recognize that the threshold is outdated, it seems to be focusing on other more pressing matters.

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

Still on the long-term action list is custody rules for investment companies; asset-backed securities disclosures (last amended in 2014); conflict minerals amendments; corporate board diversity (although nothing has been proposed, it is a hot topic); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; the modernization of investment company disclosures, including fee disclosures; and prohibitions of conflicts of interest relating to certain securitizations.

Executive compensation clawback (see HERE) which had been on the proposed rule list in Spring 2020 is back as a long-term action.  Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.

Also still on the long-term action list are removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; requests for comments on fund names; additional changes to exchange-traded products; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); amendments to improve fund proxy systems; short sale disclosure reforms; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings; and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.

Several swap-based rules remain on the long-term list including end user exception to mandatory clearing of security-based swaps; registration and regulation of security-based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.

New to the list are money market fund reforms; amendments to municipal securities exemption reports; and amendment to reports of the Municipal Securities Rulemaking Board.

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

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Annual Report of Office of Advocate for Small Business Capital Formation
Posted by Securities Attorney Laura Anthony | May 14, 2021 Tags:

The Office of the Advocate for Small Business Capital Formation (“Office”) issued its 2020 Annual Report and it breaks down one of the strangest years in any of our lives, into facts and figures that continue to illustrate the resilience of the U.S. capital markets.  Although the report is for fiscal year end September 30, 2020, prior to much of the impact of Covid-19, the Office supplemented the Report with initial Covid-19 impact information.

Background on Office of the Advocate for Small Business Capital Formation

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.

Despite the shift to virtual, the Office managed to attend or speak at numerous conferences, sit on panels, host roundtables and otherwise engage in a surprising number of events in 2020.

State of Small Business Capital Formation

The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties.  According to the Annual Report, most capital raising transactions by small businesses are completed in secondary registered offerings ($1.5 trillion), followed by Rule 506(b) of Regulation D ($1.4 trillion), Rule 506(c) ($69 billion), initial public offerings ($60 billion), Regulation A ($1.3 billion), Rule 504 ($171 million), and Regulation CF Crowdfunding ($88 million).  Another $1.2 trillion was raised in a variety of other exempt offerings such as Rule 144A, Regulation S and Section 4(a)(2) directly.

I note this represents a change since last year when the numbers were: Rule 506(b) of Regulation D ($1.4 trillion) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).  Interestingly, the amount of registered offerings increased substantially (including Regulation A which is technically an exempt public offering) and the amount of once popular Rule 506(c) offerings dropped by more than half.

Both years fail to take into account the new exempt offering rules and structure which went into effect on March 14, 2021.  My 5-part blog on the new rules can be found here broken down by topic – Integration (HERE), offering communications (HERE), Rule 504, 506(b) and 506(c) (HERE), Regulation A (HERE), and Regulation CF (HERE).  My belief is that we will continue to see a big uptick in Regulation A.  Regulation CF will also garner more interest due to the increased offering limits and ability to use special purpose vehicles (SPVs) to complete the transaction.

Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds.  Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets.  Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.

Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited and angel investor financing has remained strong.  The SEC amended the definition of accredited investor in August 2020 (see HERE) to add a few more categories of individuals and entities that qualify.  I would like to see further expansion to the list including based on education level and professional expertise.

As the typical seed round is approximately $1.1 million, by the time a company reaches seed financing stage, it is generally a little further along in its life cycle.  Following a seed round there is typically a Series A ($2-$15 million), Series B ($10 million ++), possibly a Series C (also $10 million ++) and finally IPO.  Venture Capital funds often participate in the Series A and B rounds.  However, 70% of VC funds are in the San Francisco, New York or Boston areas and many of those funds prefer to say local.  Moreover, venture capital funds generally take a control position, or assert management control, and set a timeline for exit.  That can cause a lot of pressure on a growing company.  As a result, many groups such as family offices and other institutions that historically invested in venture capital funds are now investing directly in these growing companies.  Covid-19 increased that impact with a drop of over 40% in the first quarter alone.

The industries raising the most capital include banking, technology, energy, manufacturing, real estate, and health care.  Although private capital is raised throughout the country, the East Coast states and larger states such as California, Colorado, Florida and Texas are responsible for higher amounts of capital raised in aggregate.  Regulation A is particularly popular in Florida, California and New York.

Although the Office’s fiscal year end only accounted for the first quarter of the Covid-19 crisis, the Report does discuss its impact.  The economic impact was felt most acutely by founders and investors in historically underrepresented groups, in emerging ecosystems, and among smaller fund managers.  Reduction in spending has been particularly harsh at businesses that require in-person interaction, such as retail, entertainment, transportation, personal services, food services and hospitality.

From January 2020 through September 2020, the number of small businesses decreased by 27% across the U.S.  That number represents an average.  The percentage decrease in certain states such as California, Texas, Alaska and states in the northeast was higher.  Not surprisingly, the hardest hit industry was leisure and hospitality with a decrease of 37% in small businesses.  Even those businesses that managed to stay open saw a dramatic decrease in revenue during the same period.

Those businesses that were able to adopt new technology and virtual processes have the best chances of surviving.  As such, businesses in the fintech, ed tech, telemedicine and cloud computing and collaboration software have accelerated.  In fact, in the midst of the pandemic, Americans started new businesses at the fastest rate in more than a decade.  As with any crisis, entrepreneurs have spotted opportunity.  Many of those businesses relied on Regulation CF for capital raising.  During July and August of 2020, more money was raised through Reg CF online fundraising then in the full prior year.

IPOs have continued strong, flourishing despite, or maybe because of, a shift to virtual roadshows (see HERE for more information about virtual roadshows and roadshows in general).  The Report notes many benefits of the virtual roadshow, including (i) shorter roadshows; (ii) decreased market risk due to the reduction in launch time; (iii) cost savings associated with travel, printing and employee time on the road; (iv) longer test the waters meetings; (v) greater visibility in pricing with prospective investors indicating interest earlier in the process; (v) increased accessibility with video conferencing allowing for access to a wider pool of investors; and (vi) more sophisticated and detailed disclosures.  The Report does not opine on whether these systemic changes to the process will continue post pandemic, but I firmly believe they will.

While last year’s annual report glumly talked about the decrease in IPO activity and jumped on the news headlines of the time, this year, IPOs are way up.  The number of IPOs increased by 51% and the amount of proceeds raised went up by 81%.   Of course, a huge percentage of the increase is a result of the unprecedented increase in SPACs (for more on SPACs see HERE). However, business services, manufacturing, and banking and financial services all saw increased IPO activity.  Only technology, health care and hospitality/retail saw a decline.

The new surge doesn’t make up for the prior years’ downturn.  The number of public companies has decreased from a high of 7,414 in 1997 to 3,559 in 2020; however, during the same time period, aggregate market cap has almost doubled.  The logical reason for that is the dramatic growth of public company giants over the same time period coupled with the trend towards waiting for an IPO until further in the company life cycle.

Women continue to found more start-ups than ever before, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue.  There has also been an uptick of minority-owned women start-ups.   Interestingly, although revenue is up for all woman-owned businesses, the increase in revenues for Asian American woman owned businesses far outpaces that of other groups.  Companies with women on their founding teams on average exited 1 year faster than all-men founding teams, returning capital back to investors faster.

Besides minority women, all minorities are increasing business ownership.  Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. With that said, while all-white founding teams raise the majority of funding rounds, when diverse founding teams do raise capital from VCs, they tend to raise more.

Covid-19 is not the only disaster creating challenges.  Natural disasters (hurricanes, fires, tornadoes, etc.) have a significant impact on capital raising and business failures.  Ninety-six percent of companies that are in geographical areas that are hit with a natural disaster see a decline in revenues, and 90% of business will fail within a year if they do not resume operations within 5 days.

Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses.  Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.  Covid had a crippling effect. Employment in nonmetropolitan communities, including rural communities, is heavily concentrated in the services sector, which includes health care, food, administration, professional, arts, education, and management.

Policy Recommendations

                Education to Ease Challenges of Offering Complexity and Friction

Last year the Office recommended rule changes to modernize and clarify the exempt offering framework in line with what was then just a concept release on the subject.  This year, following the adoption of those final rule changes, the Office is recommending education.  Although the new laws are a simplification of the old system, securities laws, of any kind, are complex and difficult to navigate.  It is unlikely that even the most well-intentioned business owner could do so properly without securities counsel, which is expensive.  However, a well-educated client can use counsel more efficiently and certainly with less stress.

The Office recommends targeted educational programs that (i) provide information to help promote compliance with the federal securities laws; (ii) provide tools (forms possibly) and other information to understand the offering choices; and (iii) target different groups including minorities and those in rural communities.

Clear Finders Framework

Although the SEC proposed a conditional finder’s exemption (see HERE), the exemption remains a proposal and even if passed, leaves the arena needing more guidance and a much deeper bench of regulation.  I have advocated in the past and continue to advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.  Although the SEC proposal does have bad actor prohibitions, it is limited to private companies, does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.

Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.

As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black-market industry has developed, and it is a large industry.  Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders.  The Office continues to encourage the SEC, as it has in the past, to provide certainty and to finalize a framework that delineates the legal obligations of persons who match small businesses with investors.

Pooled Funding

Small businesses also look for capital from private funds, such as venture capital funds and private equity funds that operate under various exemptions from registration. The increasing concentration of capital into larger, private funds has resulted in a growing unmet need among entrepreneurs looking for seed and early-stage capital, with larger funds finding it inefficient or lacking bandwidth to make multiple small investments.

The Office advocates for increased diversity among fund managers, the location of funds, and the size of funds.  To achieve the goal, the Office encourages Congress and the SEC to explore initiatives to increase diversity among investment decision makers to help shift the pattern matching that historically has negatively impacted women and minority entrepreneurs.

Attractiveness of Public Markets

Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth.  Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high.  Naturally, when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth.  The Office states that this could be one of the larger reasons companies are choosing to stay private longer.

The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns.  Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive.  For my blog on changes to the management’s discussion and analysis section of SEC reports, see HERE and on business descriptions, risk factors and legal proceedings see HERE.  The Office encourages further initiatives to incentivize public offerings, including through more liberal direct listing rules and continued use of SPACs.

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