The MEMX
Although overshadowed by all things ESG and SPAC related, a new Wall Street backed national exchange, the Members Exchange (MEMX), launched in Q4 2020 with ambitions to rival the NYSE and Nasdaq. In the same month, the long-anticipated launch of the Silicon Valley backed Long-Term Stock Exchange (LTSE) came to fruition. The MEMX, founded as a lower cost alternative to Nasdaq and the NYSE, started small, initially only trading the securities of 7 large cap companies including Alphabet and Exxon Mobil, but has since opened to all exchange traded securities.
The MEMX was backed by Blackrock, Charles Schwab, Citadel, Goldman Sachs, Bank of America, JP Morgan, E-Trade and Virtu, among others. These financial giants invested over $135 million into the platform and as such, have a vested interest in its success. They also have the power to direct significant trading activity onto the MEMX, where others will likely follow. In the 6 months since it went live, the MEMX has already locked in over 1% of the U.S. market share.
Just as retail trading activity has been forced to reduce its fees with the likes of Robinhood and E-Trade offering low-cost electronic alternatives, Wall Street expects the exchanges to reduce fees for market data and other services and is apparently forcing the issue with competition. The MEMX plans to undercut the big exchanges on price, initially giving away its data. Going further, the MEMX will pay out rebates that exceed its transaction fees, forgoing early profits in hopes of building a liquid marketplace.
Founded in 2012 by Silicon Valley heavyweights, the LTSE launched for all companies in Q3 2020. The LTSE is designed to support a longer-term vision for listed companies. All listed companies are required to maintain a series of policies that are designed to provide shareholders and other stakeholders with insight into their long-term strategies, practices, plans and measures. Although the Exchange Act still requires quarterly reporting, the LTSE concentrates on yearly and multi-year performance.
The MEMX and LTSE are not the only new exchanges. Also in Q4 2020, the new Miami based options exchange, the MIAX Pearl Equities, kicked off. The MIAX is a low-cost platform marketing itself as a tech savvy competitor to the NYSE and Nasdaq.
Even though new exchanges are a rarity, those that have developed in the past often fail because it is simply very difficult to move volume and participation from the NYSE or Nasdaq. Simply put, traders want to trade where they have the most counter-party choices. Even the Cboe Global Markets, which owns and operates the former BATS markets and is the third largest U.S. exchange, concentrates on ETF’s and ETP’s, thereby creating a niche for itself. Although the BATS does route approximately 15% of the NYSE/Nasdaq equities trading, it is not an equities IPO competitor. Keep in mind that regardless of what exchange an equity is listed on, Regulation NMS requires best execution and a single market structure for all US securities (see HERE).
The timing could be right for new exchanges as we see huge market shifts and expectations moving away from traditional Wall Street. Investors are frustrated with the existing system and feel it is time for competition, technological innovation and more efficiency. The rise of FinTech-based trading platforms such as Robinhood, social media driven stock picks (Reddit and GameStop), the current focus on all things ESG and the enormous shift into digital currency (Bitcoin) investing, together with the fact that the new exchanges are backed by big players, signals that the street is open to more options.
« ESG – Board of Directors and Auditor Matters Annual Report of Office of Advocate for Small Business Capital Formation »
ESG – Board of Directors and Auditor Matters
In a series of blogs, that is likely to be an ongoing topic for the foreseeable future, I have been discussing the barrage of environmental, social and governance (ESG) related activity and focus by capital markets regulators and participants. Climate change initiatives and disclosures have been singled out in the ESG discussions and as a particular SEC focus, and as such was the topic of the first blog in this series (see HERE). The second blog talked more generally about ESG investing and ratings systems and discussed the role of a Chief Sustainability Officer (see HERE). The last blog on the topic focused on current and prospective ESG disclosure requirements and initiatives, including the Nasdaq ESG Reporting Guide (see HERE).
ESG is not just a topic impacting social position disclosures but can go directly to the financial condition of a reporting company, and as such its financial statements. Accordingly, ESG reporting requires auditor and audit committee engagement.
Board of Directors, Audit Committees and ESG Disclosures
The “G” in ESG generally refers to the governing structure, policies, and practices employed by a company related to responsibilities and decision-making rights that provide the foundation for overall accountability and credibility. In other words, the “G” goes directly to corporate governance and internal controls, the oversight of which rests with the board of directors and its audit committee. Although not a completely new topic, ESG has gained momentum following the Covid-19 pandemic and social justice movement, prompting many companies to take a proactive instead of reactive approach to the matter.
A company that is either merely reacting to the ESG disclosure pressure or that simply has not developed an ESG thought process as of yet, generally does not have a system in place that integrates ESG considerations into its management decision ecosystem, nor does it have active board oversight on the topic. These companies are now developing controls and procedures that include reporting to and updating board members, creating accountability, often hiring a Chief Sustainability Officer and creating a reporting regime within the company that abides by specific standards. Although I am still skeptical on ESG-driven management decisions as a whole (my thoughts align more with Jay Clayton and Hester Peirce), the train has left the station and I wouldn’t be surprised if, in the near future, it goes so far as to include executive compensation tied to ESG performance.
Board oversight of an entity’s ESG reporting is critical for establishing and maintaining good governance, policies, and controls over the ESG reporting process. The board of directors’ responsibilities extend beyond simply reviewing past disclosures or current systems, but also include being proactive and ready for future implementation of new processes. Where ESG matters impact financial statements, oversight clearly lies with the audit committee of the board of directors, but the nominating and governance committee clearly has a role, and many boards are forming a separate ESG/Sustainability committee.
Where a board of directors is considering hiring a third party, such as its audit firm, to provide ESG attestation (and thus give assurances), it should be informed about (i) the purpose and objectives of the ESG information (SEC reports; separate sustainability reporting; future planning; investigation of potential deficiencies, etc..); (ii) the intended users of the ESG information (internal; public filings; investors; ratings organizations); (iii) why the intended users want or need the information; (iv) the potential risks associated with misstatements or omissions; (iv) the type of ESG information intended users are expecting; and (v) the level of ESG attestation service that will achieve the goals (full audit, review, etc.).
Regardless, all boards of directors should be considering (i) what are the company’s policies and processes with respect to the gathering and reporting of ESG information; (ii) how old or dated is the current available information; (iii) who in the company has responsibility for the oversight of ESG information; (iv) is ESG information material to or included in financial statement reporting; (v) what are the company’s internal controls vis-a-vis ESG information gathering and reporting; (vi) have ESG-related internal controls been tested; and (vii) what disclosure controls and procedures and related documentation are available for ESG information.
Auditor Role in ESG Disclosures
Generally, an auditor is only responsible for information contained in an SEC registration statement or report. However, under PCAOB auditing standards, an auditor must at least read the balance of a filing, including ESG information to ensure that such information is consistent with, and at least not materially inconsistent with, the financial statements and notes thereto. Where sustainability reports are presented by a company, either on its website or as an exhibit to a SEC filing, an auditor would have no responsibility for the information contained in those reports.
However, in today’s ESG-centric environment, some companies are seeking third-party assurance on its ESG information. Third-party assurance can (i) assist the board of directors in assessing the quality of ESG disclosures and in overall company oversight; (ii) enhance the reliability of ESG information for investor analysis; (iii) enhance management’s confidence in the integrity of the company’s disclosed ESG information; (iv) assist stakeholders such as customers, suppliers and prospective employees in making ESG based relationship decisions; and (v) impact a company’s ESG rankings and rating on sustainability indices (such as the Dow Jones Sustainability Index).
Public company auditors have stepped up to fill this role and are now regularly being engaged by their public company clients to provide ESG-related assurances. Other third parties, such as engineering or consulting firms, are also competing for this business. Where a public company audit firm is retained, they are guided by the American Institute of CPAs (AICPA) Statements on Standards for Attestation Engagements. That is, where an auditor is engaged to provide ESG attestations, they must comply with standards involving data and systems testing and evaluating evidence and procedures. Accordingly, there is a belief that auditor ESG assurances are reliable.
As when engaged to perform an audit, the auditor engaged for ESG matters must: (i) be independent of the company; (ii) be skilled in understanding the company including its business and processes; (iii) have the resources, such as specific expertise, to provide the requested services (think expert on greenhouse gas emissions); (iv) are required to plan and perform attestations with professional skepticism; (v) are experienced in reporting on compliance matters (not just standard audits); (vi) are required to maintain a system of quality controls; and (vii) are required to maintain continuing professional education and other licensing requirements. A company will often retain the same firm that is performing its regular audit work as that auditor will have a depth of knowledge about the company making the ESG attestation more economical and efficient.
Generally, an auditor’s ESG attestation is made more reliable because of their requirement to test against specific standards. Those standards must be recognized as reliable, such as those published by the Sustainability Accounting Standards Board or the Global Reporting Initiative. Where a company makes a broad statement related to ESG matters not supported by evidence or capable of being measured against a specific metric, the auditor would not be able to provide assurance.
Moreover, just like the difference between an annual audit and quarterly review of financial statements, an auditor can be retained to provide a full independent report and opinion on ESG information or a more limited review such as for material deficiencies with no separate report. An auditor may also provide consulting services helping a company determine its ESG reporting systems, internal controls and best metrics and standards.
« Section 12(g) Registration The MEMX »
Section 12(g) Registration
Unlike a Securities Act of 1933 (“Securities Act”) registration statement, a Securities Exchange Act of 1934 (“Exchange Act”) Section 12(g) registration statement does not register securities for sale or result in any particular securities becoming freely tradeable. Rather, an Exchange Act registration has the general effect of making a company subject to the Exchange Act reporting requirements under Section 13 of that Act. Registration also subjects the company to the tender offer and proxy rules under Section 14 of the Act, its officers, directors and 10%-or-greater shareholders to the reporting requirements and short-term profit prohibitions under Section 16 of the Act and its 5%-or-greater shareholders to the reporting requirements under Sections 13(d) and 13(g) of the Act.
A company may voluntarily register under Section 12(g) at any time and, under certain circumstances, may also terminate such registration (see HERE).
In addition, unless an exemption is otherwise available, a company must register under Section 12(g), if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more as shown on the company’s balance sheet; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year.
A company that is registering on a national securities exchange accomplishes its registration under Section 12(b) of the Exchange Act. Other than the referenced section, the process and registration statements used are the same as for a Section 12(g) registration.
Benefits of Registration
There are numerous business and legal benefits to registration under Section 12(g). Below are a few of the most compelling benefits.
Rule 144
Rule 144 is the most often used exemption to remove the restrictive legend and sell unregistered securities into the public marketplace. For more on Rule 144, see HERE and HERE. In order to utilize Rule 144, the security holder must satisfy certain requirements including a holding period. The holding period varies based on whether the company is subject to the SEC reporting requirements or not.
The holding period for a company subject to the SEC reporting requirements is six months whereas it is one year for a company that is not. An Exchange Act registration statement under Section 12(g) results in the company becoming subject to the SEC reporting requirements. Although a Securities Act registration statement, such as on Form S-1, will also make a company subject to the Exchange Act reporting requirements, that requirement may only be temporary. That is, a company only reporting as a result of a Securities Act registration statement may slip into voluntary reporting status whose security holders would be subject to the longer one-year Rule 144 holding period. For more on voluntary reporting status, see HERE.
Furthermore, w is not available for a company that is or was ever a shell company unless the company: (i) is no longer a shell company; (ii) is subject to the Exchange Act reporting requirements (such as through the filing of a 12(g) registration statement); (iii) has filed all reports under the Exchange Act during the preceding 12 months; (iv) has filed current Form 10 information with the SEC reflecting its status as no longer a shell company; and (v) one year has elapsed since the filing of the Form 10 information.
Regulation S
Similarly, registration under the Exchange Act has implications on the applicable distribution compliance period in a Regulation S offering. For more on Regulation S, see HERE. A distribution compliance period is defined in Rule 903 of Regulation S and provides for a holding period in which securities issued in a Regulation S transaction cannot be re-sold to a U.S. person or for the account or benefit of a U.S. person. There are three categories of distribution compliance periods. Rule 903 imposes duties on a company, a distributor and any affiliates of the company or a distributor to ensure that the distribution compliance periods are abided by to prevent the sale of securities to a U.S. person during the distribution compliance period.
Category 1 can only be relied on by a Foreign Private Issuer (“FPI”) with no substantial U.S. market interest and where the offering is directed into a single country other than the U.S. Category 1 does not impose any additional time restrictions on re-sales. Category 2 applies to equity securities of an Exchange Act reporting FPI and can be relied upon even if there is a substantial U.S. market interest in the securities. The category 2 distribution compliance period is 40 days. Category 3 applies to domestic reporting and non-reporting companies and non-reporting FPI’s where there is a substantial U.S. market interest in the securities. The distribution compliance period for category 3 companies tracks Rule 144 and, as such, is one year for non-reporting U.S. and FPI’s and six months for reporting U.S. companies. Accordingly, both U.S. companies and FPI’s may benefit from becoming subject to the SEC reporting requirements through the filing of an Exchange Act registration statement.
S-3 Eligibility
A basic requirement for any company to be able to use an S-3 registration statement is that it have a class of securities registered under Section 12(g) (or 12(b)) and has otherwise be required to file SEC reports for a period of 12 months. For more on S-3 eligibility, see HERE.
Exemptions; Section 12g3-2
A company that would otherwise be required to register under Section 12(g) may instead register under Section 12(b) by registering with and listing on a national securities exchange. Other than the referenced statutory section, the process and registration statements used are the same as for a Section 12(g) registration.
An FPI has two exemptions from the Section 12(g) registration requirement. First, Exchange Act Rule 12g3-2(a) exempts FPI’s who have fewer than 300 U.S. record holders from the registration requirement. In determining record holders for purposes of this exemption, the calculation is the same as described below except that where the record holder is a broker, dealer, bank or other nominee, the company must look through and count each of the accounts of customers held by such broker, dealer, bank or nominee.
Second, Exchange Act Rule 12g3-2(b) provides an automatic exemption from registration for an FPI if the following three conditions are met: (i) the FPI is not required to file reports under Exchange Act Sections 13(a) or 15(d) (such obligations arising generally as a result of a public offering of securities, a listing on a national securities exchange, or voluntary registration under the Exchange Act); (ii) the FPI maintains a listing of the subject class of securities on one or two exchanges in a non-U.S. jurisdiction(s) that comprise more than 55% of its worldwide trading volume (its “Primary Trading Market”) as of its most recently completed fiscal year; and (iii) the FPI publishes in English on its website or through another electronic delivery platform generally available to the public in its primary trading market certain material items of information.
Calculation of Holders of Record
As mentioned, a company is required to register under Section 12(g) if as of the last day of its fiscal year the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. The determination of record holders and the determination of accredited status are both made as of the last day of the fiscal year.
Accredited investor is defined in Securities Act Rule 501(a) (see HERE) and specifically provides that an accredited investor can be one that the company “reasonably believes” comes within the specific enumerated accreditation categories. In making the determination as to whether a company has over 500 non-accredited investors as of the last day of its fiscal year-end, a company must consider all facts and circumstances, including whether prior information obtained at the time of a sale of securities can reasonably be relied upon to still be correct.
It is important that all private companies with more than 500 shareholders consider the accredited status of its shareholders as of the last day of each fiscal year to be sure it is not inadvertently violating the federal securities laws requiring registration. During times of financial uncertainty and the dramatic impact upon some people’s net worth that has followed the Covid crisis, it is even more important to keep an eye on this ball. All such, companies should consult with competent securities counsel.
At the time of adopting the last amendment to Section 12(g) in 2016, the SEC was asked by many commenters to provide guidance or establish safe harbors related to the requirement to determine shareholder accreditation as of the last day of each fiscal year-end. At that time, the SEC declined to do so and as of today has still not done so, even using C&DI.
The calculation of held of record starts with the actual record holders on the company’s shareholder list, assuming that list has been properly maintained. If it was not properly maintained, any corrections should be made to get to a starting point. Securities held in similar names with the same address can be counted as one holder.
Securities held in the name of a corporation or other entity are counted as a single holder, regardless of the number of beneficial holders of that entity. This is one of the reasons that special purpose acquisition vehicles or SPV’s are very popular for use in investing in private placements.
Securities jointly owned, such as by a husband and wife, are counted as one record holder. Although bearer certificates (i.e., certificates that are owned by the person who is the physical bearer of such document) are rare in today’s world, where such certificates exist, each one is deemed to be held by a separate owner unless there is direct evidence otherwise.
Securities held by a trustee, executor, guardian or other fiduciary are deemed held by one record holder. Securities held of record by a broker, dealer, bank or nominee may be counted as a single shareholder. However, institutional custodians, such as Cede & Co. and other commercial depositories, are not single holders of record for purposes of the Exchange Act’s registration and periodic reporting provisions. Instead, each of the depository’s accounts for which the securities are held is a single record holder.
In addition, persons that received the securities under an employee compensation plan that was exempt from U.S. registration may be excluded (generally shares issued under Rule 701 – see HERE). Securities issued in a Regulation CF offering or a Regulation A, Tier 2 offering may also be excluded.
In order to exclude shares issued in a Regulation CF offering, the company must: (i) be current in its Regulation CF annual reporting (see HERE); (ii) have total assets of less than $25 million as of the end of its most recently completed fiscal year; and (iii) have engaged an SEC registered transfer agent. Moreover, if a company would be required to register solely because it exceeds the asset limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation CF annual reports.
In order to exclude shares issued in a Regulation A, Tier 2 offering, the company must: (i) be required to file SEC reports under Regulation A; (ii) be current in its annual, semi-annual and other Regulation A reports; (iii) have engaged an SEC registered transfer agent; and (iv) have a non-affiliate public float of less than $75 million as of the last day of the second quarter of its most recently completed fiscal year or if no public float, have annual revenues of less than $50 million as of its most recently completed fiscal year. If a company would be required to register solely because it exceeds the market value or revenue limit, it can avail itself of a two-year transition period as long as it continues to file its Regulation A SEC reports.
A few other securities are exempt from the 12(g) calculation, including (i) a security issued under an employee stock option or similar plan which is not transferable except upon death or incapacity; (ii) subject to certain regulations, any interest or participation in a common trust fund by a bank exclusively for collective investment; (iii) any class of equity security which will not be outstanding 60 days after a registration statement would be required to be filed with respect thereto; (iv) standardized options issued by a clearing agency and traded on a national exchange; (v) securities futures traded on a national exchange; and (vi) certain compensatory stock options.
Form of Registration Statement and Time for Effectiveness
Eligibility to use a particular form of registration is determined by a review of the instructions for such form at the time of use. A Form 10 is the general form of registration statement for a U.S. domestic company; however, the short Form 8-A may be used by a company that is already required to filed reports under the Exchange Act, usually as a result of having filed a registration statement under the Securities Act, or that is concurrently qualifying a Tier 2 offering statement relating to that class of securities using the Form S-1 or Form S-11 format.
A Form 20-F is the common basic registration statement for an FPI and a Form 40-F is favored for Canadian companies that qualify for its use. An FPI may voluntarily file a registration statement using a U.S. domestic form, but must meet FPI status within 30 days of filing its first registration statement in order to rely on an “F” form.
Generally, an Exchange Act registration statement automatically goes effective on the 60th day following filing; however, a company may request accelerated effectiveness from the SEC. A Form 8-A goes effective either upon filing, or if a Securities Act registration statement is concurrently being filed, upon effectiveness of that Securities Act registration statement.
« ESG Disclosures – A Continued Discussion ESG – Board of Directors and Auditor Matters »
ESG Matters – What a Difference A Year Makes
What a difference a year makes – or should I say – what a difference an administration makes! Back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s disclosure based regulatory regime. Enter Chair Allison Herron Lee and in a slew of activity over the past few weeks, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; Corp Fin has called for public comment on ESG disclosures and suggested a framework for discussion on the matter; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and the SEC issued a statement calling for public comment on climate related disclosures including a detailed list of questions to consider.
The ESG activity coming out of the SEC is so constant, I had to go back and add to this blog three times after I thought it was finished.
It seems that the SEC must answer the call from investors for valuable ESG disclosures. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
Net zero refers to operating such that global warming is limited to below 2o Celsius with net zero greenhouse gas emissions by 2050. But like all things ESG, there is a lot of disagreement on the best path forward. On March 10, 2021, the UK’s Institutional Investors Group on Climate Change, representing $35 trillion Euro in assets under management, published a Net Zero Investment Framework 1.0 specifically discouraging the use of carbon market offsets in achieving net zero goals. The problem is that many large companies use carbon offsets as an integral part of their stated net zero plans. Disclosure of plans may satisfy the SEC, but it is no guarantee that investors or stakeholders will approve of any course of action.
Back in 2010 the SEC issued guidance to public companies regarding disclosure requirements as they apply to climate change matters. Reviewing compliance with these guidelines is top of list for both Corp Fin and the Enforcement Taskforce. The Enforcement Task Force is also focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
In a series of blogs I will discuss ESG related matters including this first blog, which is focused on the climate change initiatives, a second discussing ESG investing, ratings and the role of a Chief Sustainability Officer and a third on ESG disclosures in general.
SEC Recent Climate Related Disclosure Initiative
As indicated, in the past 6 weeks, the SEC has issued a slew of statements and started numerous initiatives related to climate disclosures and environmental matters. Climate change is a top priority for the Biden administration. On February 1, 2021, the SEC announced that Satyan Khanna was named its first ever Senior Policy Advisor for Climate and ESG. Mr. Khanna was a former agency attorney and ex-adviser to Biden.
On February 24, 2021, acting SEC Chair Allison Herren Lee directed the Division of Corporation Finance to enhance its focus on climate related disclosures in public company filings. In her announcement, Chair Lee indicated that Corp Fin will review the extent to which public companies address the topics identified in the SEC’s 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The SEC staff has been directed to also update the 2010 guidance for present day efficacy. Then on March 15, 2021 the SEC solicited public comment on climate change disclosures with specific questions to consider.
The directive is not surprising as Chair Lee has always been vocal about her desire for increased climate and environment related disclosures. Stepping up initiatives for climate disclosure regulations, in March, Chair Lee, speaking at a virtual conference, stated that the SEC wants to implement a global framework for climate disclosures working in collaboration with global stakeholders and climate authorities. Certainly our markets are global and the SEC has made other recent disclosure changes to align with global practices, such as mining disclosure requirements (see HERE. New Corp Fin Director John Coates is fully on board. He is a former Harvard Law School professor who has pushed the SEC to update is corporate disclosures requirements on climate change and ESG matters.
On March 4, 2021, the SEC announced the creation of a Division of Enforcement Climate and ESG Task Force made up of 22 members from various offices. The task force will be focused on “ESG-related misconduct” including reviewing compliance with the 2010 climate disclosure guidelines and focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
I would also think that the Task Force will spend time reviewing the numerous ESG related financial products including high-yield debt instruments that have flooded the market. As one Wachtell Lipton memo pointed out, “[M]assive inflows into ESG-oriented investment funds and seemingly insatiable demand for ESG-related issuances have led to ‘greenium’ pricing (i.e., a lower cost of capital for issuers) of many ESG-related issuances. Moreover, credit rating agencies are increasingly factoring ESG risks – including related regulatory risks – into their ratings, as are credit committees at banks into their determinations.”
Also, on March 4, SECers Hester M. Peirce and Elad L. Roisman issued a joint statement questioning the practical meaning of the SEC’s climate and ESG related activities. As noted in the statement, Corp Fin has been reviewing companies’ disclosures, assessing their compliance with disclosure requirements under the federal securities laws, and engaging with them on climate change and a variety of issues that fall under the ESG umbrella, for decades. The concern is that the new initiative should be limited to reviewing public disclosures against the existing backdrop of regulation and not suddenly holding companies to a new undisclosed standard. The commissioners also questioned the timing of the enforcement task force, pointing out that it would be more prudent to wait until Corp Fin had completed its assessment on existing rules and until the Division of Examinations has completed this examination cycle. With that said, the statement concludes with a supportive call for adequate guidelines and rules resulting from input from SEC staff, investors, issuers and practitioners.
Request for Public Input on Climate Change Disclosure
On March 15, 2021, SEC Chair Allison Herren Lee issued a statement requesting public input on climate change disclosures. On the same day Ms. Lee gave a speech to the Center of American Progress outlining the SEC’s initiative on climate change matters. The request for public comment outlined specific questions for consideration and in particular:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant)? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)?[7] Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
SEC 2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures. In 2010 and the few years prior, climate change was not only a global topic of discussion, but a regulatory hotspot as well. The EPA passed regulations requiring the reporting of and reduction of greenhouse gases by the largest pollutants; internationally the Kyoto Protocol was passed; the European Union Emissions Trading System became effective; international climate change conferences became the norm; official and un-official groups banded together on the subject; and the insurance industry revamped its actuarial and risk assessment system to account for climate change.
For some public companies, the regulatory changes could have a significant impact on operating and financial decisions including capital expenditures to reduce emissions and compliance with new laws, including those requiring reporting. Also, companies not directly impacted by the changes could be indirectly impacted by changes in costs for goods and services and impacts on their supply chain. The SEC release also notes that changes in weather patterns, increased storm intensity, sea level rise, melting of permafrost and temperature extremes at facilities could affect operations and financial disclosures. Likewise, changes in the availability or quality of water or other natural resources can have impacts on machinery, equipment and operations. Climate can also impact consumer demand such as reduced demand for heating fuels and warm clothing in warmer temperatures.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures HERE. 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. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information (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).
The 2010 release delineated areas that could require such disclosure.
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business both historically and intended (see HERE for recent amendments to Item 101 including the addition of ESG related human capital disclosures). Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Legal Proceedings
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Like Item 101, Item 103 has recently been amended – see HERE.
Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Risk Factors
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 503 has also been amended – see HERE. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A- is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. Like the others, MD&A has been amended since 2010 – see HERE.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate related information.
« Finders – Part 3 ESG Investing and Ratings »
SEC Final Rule Changes For Exempt Offerings – Part 5
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this final blog discussing the changes to Regulation Crowdfunding. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE). The fourth blog in the series reviews the changes to Regulation A (see HERE).
Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions, including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation Crowdfunding – Background
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Although it took a while, Regulation Crowdfunding went into effect on May 16, 2016. The exemption allowed companies to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor could not exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. As written, regardless of the category, the total amount any investor could invest was limited to $100,000. For a summary of the provisions, see HERE.
In addition, all offerings must be conducted through a single offering portal and advertisements are limited to directing investors to that portal. Companies are required to provide specified information through the filing of a Form C with staggered information requirements based on the offering size. The financial statement requirements progressively increase based on increased offering size.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
On May 4, 2020, the SEC adopted temporary final rules under Regulation Crowdfunding for small businesses impacted by COVID-19, which include, among other things, an exemption from certain financial statement review requirements for companies offering $250,000 or less. These temporary rules were subsequently extended and apply to offerings initiated under Regulation Crowdfunding between May 4, 2020, and February 28, 2021 (see HERE).
The new rules increase the offering limits, adjusts the formula related to the maximum amount an unaccredited investor can invest, remove the investment limit for accredited investors, allow for investments through special purpose vehicles (SPVs), and align the bad actor provisions with those in Regulation A. The proposal to limit the type of securities that can be offered to align it with Regulation A was not adopted in the final rule amendments.
Increase in Offering Limit
The amendments increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding will become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The amendment rules increase the investment limits by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits no longer apply to accredited investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The amendment rules allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles can be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding offering. These special purpose entities may not have a separate business purpose beyond the crowdfunding investment and must not, in fact, conduct any business beyond the investment. The crowdfunding vehicle is a co-issuer in the offering and as such, investors in the crowdfunding vehicle will have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying company.
The rule benefits companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders. A cleaner cap table can make companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle will also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle will constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available, it is required to register if, as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Miscellaneous
Regulation Crowdfunding offerings have always meant to pre-empt state law; however, the language in the prior rule was somewhat ambiguous. To avoid any doubt, the SEC has amended Regulation Crowdfunding to specifically include crowdfunding investors in the definition of a “qualified purchaser” for purposes of Section 18 of the Securities Act, which section delineates federally covered securities and transactions (for more on federal pre-emption, see HERE).
The new rules also extend certain provisions of the Covid-related temporary relief for financial statements through August 28, 2022. That is, any offering under Regulation Crowdfunding, together with other Regulation Crowdfunding offerings in the last 12 months, where the target offering amount is between $107,000 and $250,000, may provide financial statements that are certified by the principal executive officer instead of reviewed by an independent public accountant. This temporary relief will apply only if reviewed or audited financial statements of the company are not otherwise available.
« Caremark Eroded – Director Liability In Delaware Finders – Part 3 »
Caremark Eroded – Director Liability In Delaware
This year has marked a string of cases eroding the long history of Delaware’s board of director protections from breach of fiduciary duty claims. In Re Caremark International Inc. Derivative Litigation was a civil action in the Delaware Court of Chancery in 1996 which drilled down on a director’s duty of care in the oversight context. Caremark found that generally directors do not need to approve or exercise oversight over most company decisions, other than mergers (see HERE), changes in capital structure and fundamental changes in business.
Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” In other words – bad faith. Not surprisingly, these claims routinely fail at the pleading stage.
However, following Marchand v. Barnhill and In re Clovis Oncology Derivative Litigation which upheld claims against a board under Caremark last year, this year the Delaware Chancery Court also upheld claims in Hughes v. Hu and Teamsters Local 443 Health Services & Insurance Plan v. Chou. Whether these cases are actually a change in the law or just examples of how boards are utterly failing at their duties remains to be seen. Also, since these cases are all relatively new, we have yet to see whether Board of Director defendants will actually face personal liability.
Either way, they certainly act as a reminder of the importance of active, engaged board oversight of material risk and compliance issues. Clearly boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight. Part of those proactive steps include making a good faith effort to implement an oversight system and then actually monitoring it. Protocols need to be in place so that issues are brought to the board or relevant board committee promptly.
Likewise, boards should regularly review what key or mission critical risks exist (or potentially exist) for oversight. The board also needs to properly respond to risks or issues in a timely fashion and follow up with management. Board minutes should include notes on all actions taken.
Marchand v. Barnhill
In Marchand v. Barnhill the Delaware Supreme Court overruled the Chancery Court’s order granting a motion to dismiss on Caremark claims. Following the Caremark decision in 1996, almost all attempted negligent supervision causes of action were dismissed at the pleading stage. Marchand, which resulted from a listeria outbreak at Blue Bell Creameries, marked the first in what is now a series of cases that survived a motion to dismiss and continue to be litigated. In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company’s products, a complete production shutdown, and a layoff involving 1/3rd of its workforce.
In determining that the Plaintiff had properly pled a case under Caremark, the Supreme Court noted that bad faith can be established by showing that no good faith efforts had been made. In this case no board committee had considered food safety protocols; no procedures were in place that required management to inform the board of food safety compliance practices, risks or reports; there was no schedule for the board to consider food safety on any sort of regular basis (even annually); prior to the outbreak red flags were presented to management who did not disclose these matters to the board; and board minutes showed a complete lack of discussion related to food safety. The Court noted that government inspectors found food safety problems at the company’s plants that were so systemic that any reasonable monitoring system would have resulted in them being reported to the board.
In other words, even though management did not disclose issues to the board, the board’s lack of inquiry or development of a plan to learn about food safety issues, in a food production company, rose to the level of bad faith supporting a complaint for lack of oversight. The Marchand parties agreed to a $60 million settlement, ten days before trial was set to commence.
In re Clovis Oncology Derivative Litigation
In re Clovis Oncology Derivative Litigation the court found that the plaintiffs had adequately pled that the board breached its fiduciary duties by failing to oversee a clinical trial for the company’s experimental lung cancer drug and then allowing the company to mislead the market regarding the drug’s efficacy. Clovis eventually disclosed these failures, resulting in a $1 billion drop in market value, a federal securities action, an SEC complaint, and the Delaware derivative action. Here the judge stated that Delaware courts are more likely to find liability under Caremark for oversight failures involving compliance obligations under regulatory mandates than for those involving oversight of ordinary business risks.
The court indicated that Caremark rests on the presumption that corporate fiduciaries are afforded “great discretion to design context and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.” But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law—including regulatory mandates.
Caremark requires a plaintiff to establish that the board either “completely fail[ed] to implement any reporting or information system or controls” or failed to adequately monitor that system by ignoring “red flags” of non-compliance. Here the board’s governance committee was responsible for overseeing compliance with regulatory requirements applicable to the clinical trial, the judge held that the plaintiff adequately pled that it knowingly ignored red flags indicating that the company was not complying with those requirements. Accordingly, he declined to dismiss the case. The case remains pending.
Hughes v. Hu
In Hughes v. Hu the Chancery Court held that the plaintiff adequately pled that the director defendants, who served on the company’s audit committee, breached their fiduciary duties by failing to oversee the company’s financial statements and related party transactions. The audit committee only met when they needed to discuss its annual 10-K and the meeting was brief and perfunctory. The plaintiff alleged that the directors made a conscious choice to avoid their duties and followed management blindly even after being presented with evidence of improper financial reporting and a failure to adequately disclose related party transactions.
In 2014 the public company even disclosed material weaknesses in its internal controls and a lack of oversight by the audit committee as financial controls and related party transactions. In 2017 the company had not fixed any of its problems and had to restate three years of financial statements. Although the case survived the motion to dismiss, it is still ongoing and none of the defendants have been found liable as of yet.
Teamsters Local 443 Health Services & Insurance Plan v. Chou
In Teamsters Local 443 Health Services & Insurance Plan v. Chou the court found that the defendants ignored red flags of illegal activity. The illegal activity involved a subsidiary of AmerisourceBergen Corporation (ABC) that was pooling excess overfill medication from cancer vials into additional syringes, which led to contamination. ABC, through a subsidiary, is in the business of buying single-dose vials of oncology drugs from manufactures, putting the drugs in syringes and selling the syringes for use by cancer patients. The vials included an overfill amount to account for human error in filling syringes and to avoid air bubbles. The overfill amount is supposed to be discarded. Instead, the subsidiary was pooling the drugs and filling additional syringes.
The company faced corporate criminal and civil penalties and stockholders brought a Caremark case against the directors. In refusing to dismiss the case, the Court found that the directors ignored three red flags including: (i) a report from an outside law firm that the subsidiary was not integrated into ABC’s compliance and reporting function (and thus that compliance had substantial gaps); (ii) a former executive filed a lawsuit until seal in federal court alleging illegal activity and although the lawsuit was disclosed in the 10-K’s signed by the directors, they did not take any remedial action; and (iii) the subsidiary received a subpoena from federal prosecutors related to illegal activity and the board still did not take action.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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« SEC Final Rule Changes For Exempt Offerings – Part 4 SEC Final Rule Changes For Exempt Offerings – Part 5 »
SEC Final Rule Changes For Exempt Offerings – Part 2
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters. The first blog in the series discussed the new integration rules (see HERE).
Background
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.
Effective September 2013, in accordance with the JOBS Act, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) and new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly, in the Rule 506 context, determining whether solicitation or advertising has been utilized is extremely important.
Other private offerings also allow for solicitation and advertising. In particular, Regulation A, Regulation Crowdfunding, Rule 147 and 147A, and Rule 504 all allow for solicitation and advertising. For more information on Rule 504, Rule 147 and 147A, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. Part 1 of this blog series talked about issues with integration, including between offerings that allow and don’t allow solicitation, but equally important is determining what constitutes solicitation in the first place.
Prior to the JOBS Act, general solicitation and advertising was prohibited in most exempt offerings and “testing the waters” was not yet a mainstream term of art in the capital markets. Following the JOBS Act creation of Rule 506(c), Regulation Crowdfunding and the new Regulation A/A+ structure, offering solicitation and pre-offering testing the waters became the norm. Recognizing the benefits of additional offering communications, and testing the waters prior to launching an offering, the SEC has included expanded offering communications and testing the waters provision in its modernized exempt offering rules.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
The Securities Act defines the term “offer” very broadly and includes any publication of information or communication in advance of a financing that would have the effect of arousing interest in the securities being offered. Likewise, general solicitation and advertising have been interpreted very broadly. Although Rule 502(c) lists some examples, the SEC has expanded upon those examples over the years, including information posted on an unrestricted website as a general solicitation.
Rule 502(c) lists the following examples of solicitation or advertising:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; provided, however,that publication by a company of a notice in accordance with Rule 135c or filing with the SEC of a Form D shall not be deemed to constitute general solicitation or general advertising; and provided further that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the U.S., to meetings with companies or selling security holder representatives conducted outside of the U.S., or to written press-related materials released outside the U.S., at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising.
Generally, testing the waters through contacting potential investors in advance of an exempt offering to gauge interest in the future offering, could be deemed solicitation. In 2015 the SEC issued several C&DI to address when communications would be deemed a solicitation or advertisement, including factual business communications in advance of an offering and demo days or venture fairs.
At that time, the SEC indicated that participation in a demo day or venture fair does not automatically constitute general solicitation or advertising under Regulation D. If a company’s presentation does not involve the offer of securities at all, no solicitation is involved. If the attendees of the event are limited to persons with whom either the company or the event organizer have a pre-existing, substantive relationship, or have been contacted through a pre-screened group of accredited, sophisticated investors (such as an angel group), it will not be deemed a general solicitation. However, if invitations to the event are sent out via general solicitation to individuals and groups with no established relationship and no pre-screening as to accreditation, any presentation involving the offer of securities would be deemed to involve a general solicitation under Regulation D. For more on a pre-existing substantive relationship, see HERE.
The amended rules specifically exempt “demo days” from the definition of general solicitation and advertising for all offerings; allow companies to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue; and add test-the-waters provisions to Regulation Crowdfunding.
Demo Days; New Rule 148
“Demo days” and similar events are generally organized by a group or entity that invites issuers to present their businesses to potential investors, with the aim of securing an investment.
New Rule 148 provides that certain demo day communications will not be deemed to be a general solicitation or advertising. Specifically, a company will not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting sponsored by a college, university, or other institution of higher education, a local government, a state government, instrumentalities of state and local governments, a nonprofit organization, or an angel investor group, incubator, or accelerator and in which more than one company participates. Rule 148 excludes broker-dealers and investment advisors from the scope of the exemption.
Rule 148 requires that “angel investor groups” maintain defined processes and procedures for making investment decisions, though the rule does not require that the processes be memorialized in writing.
Sponsors of events are not permitted to: (i) make investment recommendations or provide investment advice to attendees of the event; (ii) engage in any investment negotiations between the company and investors attending the event; (iii) charge attendees fees beyond a reasonable administrative fee; (iv) receive compensation for making introductions; or (v) receive any compensation with respect to the event that would require registration as a broker-dealer or investment advisor.
Advertising for the event is also limited and may not reference any specific offering of securities by a participating company. To address concerns that communications for demo day events will encompass a large number of non-accredited investors especially in light of the increase in virtual events, the new rule limits online participation for an event to: (i) individuals who are members of, or otherwise associated with the sponsor organization; (b) individuals that the sponsor reasonably believes are accredited investors; or (iii) individuals who have been invited to the event by the sponsor based on industry or investment related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.
Rule 148 also regulates the information a presenting company can convey to: (i) notification that the company is in the process of an offering or planning an offering of securities; (ii) the type and amount of securities being offered; (iii) use of proceeds; and (iv) the remaining unsubscribed amount of an offering.
Rule 148 is a non-exclusive method of communicating with potential investors. Companies may continue to rely on previously issued guidance to attend events where the participation is limited to individuals or groups of individuals with whom the company or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals. In those events, the information provided by the company is not limited.
Solicitations of Interest; New Rule 241
Prior to the JOBS Act, almost no exempt offerings (except intrastate offerings when allowed by the state) allowed for advertising or soliciting, including solicitations of interest or testing the waters. The JOBS Act created the current Regulation A, which allows for testing the waters subject to certain SEC filing requirements and the inclusion of specific legends on the offering materials. For a discussion on Regulation A test-the-waters provisions, see HERE.
The SEC recognizes the benefits of testing the waters prior to incurring the costs associated with an offering. As such, the SEC is adopting new Rule 241, which exempts companies from the registration requirements for generic pre-offering communications that are made in compliance with the rule. Rule 241 allows companies to solicit indications of interest in an exempt offering, either orally or in writing, prior to determining which exemption they will rely upon, even if the ultimate exemption does not allow for general solicitation or advertising. Rule 241 is an exemption from the registration requirements for “offers” but not “sales,” but since communications under the rule are considered “offers,” they are subject to the antifraud provisions under the federal securities laws.
Rule 241 is similar to existing Rule 255 of Regulation A. Rule 241 communications require a legend or disclaimer stating that: (i) the company is considering an exempt offering but has not determined the specific exemption it will rely on; (ii) no money or other consideration is being solicited, and if sent, will not be accepted; (iii) no sales will be made or commitments to purchase accepted until the company determines the exemption to be relied upon and where the exemption includes filing, disclosure, or qualification requirements, all such requirements are met; and (iv) a prospective purchaser’s indication of interest is non-binding.
Once a company determines which type of offering it intends to pursue, it would no longer be able to rely on Rule 241 but would need to comply with the rules associated with that particular offering type, including its solicitation of interest and advertising rules. Moreover, since the solicitation of interest would likely be a general solicitation, if the chosen offering does not allow general solicitation or advertising, the company would need to conduct an integration analysis to make sure that there would be no integration between the solicitation of interest and the offering. Under the new rules, that would generally require the company to wait 30 days between the solicitation of interest and the offering (see Part 1 of this blog series HERE). I say “would likely be a general solicitation” because a company may still indicate interest from persons that it has a prior business relationship with, without triggering a general solicitation, as they can now under the current rules.
If a company elects to proceed with a Regulation A or Regulation Crowdfunding offering, it will need to file the Rule 241 test-the-waters materials if the Rule 241 solicitation is within 30 days of the ultimate offering, as such solicitation of interest would integrate with the following offering. If more than 30 days pass, the Rule 241 communications would not need to be filed, but any Rule 255 communication would need to be filed in a Regulation A offering and new Rule 206 communications would need to be filed in a Regulation Crowdfunding offering.
Although new Rule 241 does not limit the type of investor that can be solicited (accredited or non-accredited), under the new rules, if a company determines to proceed with a Rule 506(b) offering within 30 days of obtaining indications of interest, it must provide the non-accredited investors, if any, with a copy of any written solicitation of interest materials that were used.
New Rule 241 does not pre-empt state securities laws. Accordingly, if a company ultimately proceeds with an offering that does not pre-empt state law, it will need to consider whether it has met the state law requirements, including whether each state allows for solicitations of interest prior to an offering. This provision will likely be a large impediment to a company that is considering an offering that does not pre-empt state law.
Regulation Crowdfunding; New Rule 206; Amended Rule 204
Prior to the amendments, a company could not solicit potential investors until their Form C is filed with the SEC. New Rule 206 will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. Under Rule 206, companies are permitted to test the waters with all potential investors.
The testing-the-waters materials will be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test-the-waters communications will need to contain a legend including: (i) no money or other consideration is being solicited, and if sent, will not be accepted; (ii) no sales will be made or commitments to purchase accepted until the Form C is filed with the SEC and only through an intermediary’s platform; and (iii) a prospective purchaser’s indication of interest is non-binding. Any test-the-waters materials will need to be filed with the SEC as an exhibit to the Form C.
Unlike Regulation A, Rule 206 only allows for testing the waters prior to the filing of a Form C with the SEC. Once the Form C is filed, any offering communications are required to comply with the terms of Regulation Crowdfunding, including the Rule 204 advertising restrictions.
However, the SEC has also amended Rule 204 to permit oral communications with prospective investors once the Form C is filed. The SEC has also expanded upon the allowed categories of advertised information that can be provided under Rule 204. Rule 204 generally allows a company to advertise a Regulation Crowdfunding offering by directing potential investors to the intermediary’s platform. Rule 204 allows such advertisements to include limited information about the offering. The SEC has added: (i) a brief description of the planned use of proceeds of the offering; and (ii) information on the company’s progress towards meeting its funding goals, to the already allowable: (a) statement that the company is conducting an offering under Regulation Crowdfunding; (b) the name of the intermediary and a link to the intermediary’s platform; (c) the terms of the offering; and (d) factual information about the legal identity and business location of the company including its full name, address, phone number, web site address, email of a representative and a brief description of the business.
The SEC has further amended Rule 204 to specify that a company may provide information about the terms of an offering under Regulation Crowdfunding in the offering materials for a concurrent offering, such as in an offering statement on Form 1-A for a concurrent Regulation A offering or a Securities Act registration statement filed with the SEC, without violating Rule 204. To do so, the information provided about the Regulation Crowdfunding offering must be in compliance with Rule 204, including the requirement to include a link directing the potential investor to the intermediary’s platform. However, since SEC rules prohibit live links to locations outside the EDGAR system, the link in such a filing could not be a live hyperlink.
Further Background Reading
Prior to the rule changes, the SEC issued a concept release and request for public comment on the subject in June 2019 (see HERE). Also, for my five-part blog series on the proposed rules, see HERE, HERE , HERE, HERE, and HERE.
« SEC Final Rule Changes For Exempt Offerings – Part 1 SEC Final Rule Changes For Exempt Offerings – Part 3 »
SEC Final Rule Changes For Exempt Offerings – Part 1
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). For my five-part blog series on the proposed rules, see HERE, HERE, HERE, HERE and HERE. The new rules go into effect on March 14, 2021.
The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I will break it down over a series of blogs, with this first blog focusing on integration.
Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they can make informed investment and voting decisions.
In recent years, the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors. The Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and to Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Section 4(a)(2) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the offering exemptions, incorporating the new rule changes.
Rule Changes
The rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; set clear and consistent rules that increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Integration; new Rule 152
Current Integration Structure
Prior to the amendments, the Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. That is, where two or more offerings are integrated, there is a danger that the exemptions for one or both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
Prior to the amendments, Securities Act Rule 502(a) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis. The five-factor test has been completely eliminated in the new regulatory structure.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, considering whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
New Rule 152(a) – General Integration Principal
The amended rules completely overhaul the integration concept, creating a new Rule 152(a) setting forth a general integration concept and new Rule 152(b) containing four safe harbors applicable to all securities offerings whether registered or exempt. Where a safe harbor exists under Rule 152(b), that safe harbor may be relied upon.
Where a safe harbor does not exist, offers and sales will not be integrated if, based on the particular facts and circumstances, the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Where solicitation is prohibited, the company must have a reasonable belief that each purchaser in the offering that does not allow for solicitation, was either not solicited or that such investor had a pre-existing substantive relationship with the company prior to commencement of the offering.
A “pre-existing” relationship is one that the company has formed with an offeree prior to the commencement of the offering or, that was established through another person, such as a registered broker-dealer or investment adviser, prior to that person’s participation in the offering. A substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication, and has established accreditation. A substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
In a huge change from the prior structure, under the new integration principle in Rule 152(a), a company may conduct concurrent Rule 506(c) and Rule 506(b) offerings, or any other combination of concurrent offerings, involving an offering prohibiting general solicitation and another offering permitting general solicitation, without integration concerns, so long as the provisions of Rule 152(a)(1) and all other conditions of the applicable exemptions are satisfied. That is, if the company can establish that the purchasers in the 506(b) offering were not solicited using general solicitation or that there was a substantive relationship with that purchaser prior to the commencement of the 506(b) offering, the exemption would survive.
Rule 152(a) specifically provides that where two or more concurrent offerings are being completed which allow general solicitation, care must be given to ensuring that all offerings comply with each of the exemptions including any disclosures or regulatory legends required for such offering. For example, if a company is conducting a concurrent Rule 506(c) and Regulation A offering and discusses the terms of the Regulation A offering in its Rule 506(c) general solicitation material, all of the requirements in Regulation A must be met.
New Rule 152(a) contains introductory language that the provisions of either Rule 152(a) or (b) will not have the effect of avoiding integration for any transaction or series of transactions that, although in technical compliance with the rule, is part of a plan or scheme to evade the registration requirements of the Securities Act.
New Rule 152(b) – Statutory Safe Harbors
New Rule 152(b) sets forth four new non-exclusive safe harbors from integration, including:
(i) Any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation applying the principals in Rule 152(a) (this 30-day test would replace the six-month test across the board);
(ii) Offerings under Rule 701, pursuant to an employee benefit plan, or in compliance with Regulation S will not integrate with other offerings;
(iii) A registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering for which general solicitation is permitted that terminated or completed more than 30 calendar days prior to the commencement of the registered offering; and
(iv) Offers and sales that allow for general solicitation will not integrate with a prior completed or terminated offering. In particular, offerings under Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504, Rule 506(b), Rule 506(c), Section 4(a)(2) and registered offerings will not integrate with a subsequent Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504 or Rule 506(c) offering.
New Rules 152(c) and 152(d) – Commencement, Termination and Completion of Offerings
New Rules 152(c) and 152(d) provide a non-exclusive set of factors to consider when determining when an offer has commenced, terminated or been completed. New Rule 152(c) provides a non-exclusive list of factors to consider in determining when an offering will be deemed to be commenced. Regardless of the type of offering, it will be commenced at the time of the first offer of securities in the offering by the issuer or its agents. The Rule also includes a list of factors that should be considered in determining when an offering is commenced, including:
(i) On the date the company first makes a generic offer soliciting interest in a contemplated offering where the company has not yet determined the exemption it will rely upon (new Rule 241 covering generic solicitations of interest will be discussed in Part 2 of this blog series);
(ii) For Section 4(a)(2), Regulation D or Rule 147 or 147A, on the date the company first made an offer of its securities in reliance on these exemptions;
(iii) For Regulation A, on the earlier of the first day of testing the waters or the public filing of a Form 1-A;
(iv) For Regulation Crowdfunding, on the earlier of the first day of testing the waters or the public filing of a Form C;
(v) For registered offerings – for a continuous offering on the date of the initial filing with the SEC or for a delayed offering, on the earliest of which the company or its agents commence public efforts to offer and sell which could be evidenced by the earlier of the filing of a prospectus supplement or use of public disclosure such as a press release.
New Rule 152(d) provides a non-exclusive list of factors to consider in determining whether an offering is terminated or completed. Regardless of the type of offering, termination or completion of an offering is likely to occur when the company and its agents cease efforts to make further offers to sell the issuer’s securities under such offering. The Rule also includes a list of factors that should be considered including:
(i) For a Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering, the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities;
(ii) For a Regulation A offering, when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering;
(iii) For Regulation Crowdfunding, upon the deadline of the offering set forth in the offering materials or as indicated in any notice to investors by the intermediary;
(iv) For registered offerings, on the date of withdrawal of the registration statement, the filing of a prospectus supplement or amendment disclosing the offering termination, a declaration of abandonment is made by the SEC, the third anniversary after effectiveness of the initial registration statement, or any other evidence of abandonment or termination of the offering such as the filing of a Form 8-K or a press release.
An offering may also be effectively terminated. For example, if a company commences a Rule 506(b) offering and then begins to solicit under Rule 506(c) and relies exclusively on Rule 506(c) once it commences solicitation, the Rule 506(b) offering will be deemed to be terminated.
As will be discussed in this blog series, Rule 506(b) has been amended such that a company may sell to 35 unaccredited investors within any 90 calendar days. This provision alleviates concerns that a company would engage in consecutive 506(b) offerings every 30 days selling to 35 accredited investors each time.
Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions), and Rule 500(g) have been amended to cross reference the new Rule 152. Other rules including Rules 255(e), 147(h), 147A(h) and Rule 155 (related to abandoned offerings) have been eliminated as the provisions are covered in Rule 152.
Exemption Overview Chart
The following chart is includes the most commonly used offering exemptions as updated by the amended rules:
| Type of Offering | Offering Limit within 12- month Period | General Solicitation/Manner of Offering | Issuer Requirements | Offeree and Investor Requirements | SEC Filing and Information Requirements | Restrictions on Resale | Preemption of State Registration and Qualification |
| Section 4(a)(2) | None | No general solicitation. | None | Transactions by an issuer not involving any public offering. See SEC v. Ralston Purina Co.Offerees and purchasers must be sophisticated and be given access to information. | None | Yes. Restricted securities | No preemption. Must qualify in each state |
| Rule 506(b) of Regulation D | None | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors
Up to 35 sophisticated but non-accredited investors in any 90 day period but must provide certain financial and non-financial disclosures |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement for accredited investor except disclosure of resale restrictions and investors must be given access to information if requested.
For any non-accredited investors: (A) if 1934 Act reporting company, certain reports or filings or (B) if non-reporting company, (1) Regulation A narrative information for eligible issuers and otherwise narrative information required by Part I of applicable registration form and (2) Regulation A financials that may be unaudited if offering $20,000,000 or less and audited if more |
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Rule 506(c) of Regulation D | None | General solicitation permitted if all purchasers are verified accredited investors. Non-exclusive safe harbors available for verification of natural persons and previous investors who self-certify within 5 years. | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors. No non-accredited investors.
Issuer must take reasonable steps to verify that all purchasers are accredited investors |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement except disclosure of resale restrictions and investors must be given access to information if requested.
|
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Regulation A: Tier 1 | $20 million but no more than $6,000,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Reg A offering and any Reg A offerings in 12 months | Permitted; before qualification, testing the waters permitted before and after the offering statement is filed.
No sales or direct or indirect commitments for sales until after qualified with SEC.
General solicitation permitted after qualified with SEC. |
U.S. or Canadian issuersExcludes blank check companies, registered investment companies, business development companies, issuers of certain securities, and certain issuers subject to a Section 12(j) order; and Regulation A Exchange Act reporting companies that have failed to file certain required reports
“Bad actor” disqualifications apply No asset-backed securities. |
None | Form 1-A, including two years of unaudited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Exit report on Form 1-Z within 30 days of offering completion. |
No | No preemption. Must qualify in each state. |
| Regulation A: Tier 2 | $75 million but no more than $22,500,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Tier 2 offering and any Reg A offerings in 12 months | Non-accredited investors are subject to investment limits of 10% of the greater of annual income and net worth, unless securities will be listed on a national securities exchange | Form 1-A, including two years of audited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Annual, semi-annual, current, and exit reports |
No | Exempt as “covered security,” subject to state fees and notice filings. | ||
| Rule 504 of Regulation D | $10 million including all Section 3(b)(1) sales and sales in violation of Section 5 | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually. Generic testing the waters permitted.General solicitation permitted if registered in state requiring use of substantive disclosure document or under exemption in state for sales to accredited investors | Excludes blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | None | Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.
Can register in a state based on state disclosure requirements for issuance of unrestricted securities. |
Yes. Restricted securities unless registered in a state requiring use of a substantive disclosure document or sold under state exemption for sale to accredited investors with general solicitation | Need to comply with state blue sky law by registration (Form U-7 may be available) or state exemption. State crowdfunding may be available |
| Intrastate: Section 3(a)(11) | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult. | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Securities must come to rest with in-state residents.Generally states require a one year hold. | No preemption. Must qualify in state. |
| Intrastate: Rule 147 | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult.Testing the waters is permitted | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Intrastate: Rule 147A | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all purchasers must be in- state residents.
Testing the waters is permitted |
In-state residents and “doing business” in-state; excludes registered investment companies | Offerees and Purchasers must be in- state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Regulation Crowdfunding; Section 4(a)(6) | $5 million | Testing the waters permitted before Form C is filed.Solicitation permitted with limits on advertising after Form C is filed
Offering must be conducted on an internet platform through a registered intermediary |
Excludes non-U.S. issuers, blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | No investment limits for accredited investors.Non-accredited investors investment limits in any 12-month period through crowdfunding of (i) the greater of $2,200 or 5% of the greater of annual income or net worth if either is less than $107,000, or (ii) 10% of the greater of annual income or net worth, but not more than $107,000, if both are at least $107,000. | Form C, including two years of financial statements that are certified, reviewed or audited, as required based on offering amount. Must file test the waters materials with Form C.Up to $107,000 – latest tax return and financials certified by officers; from $107,000 to $535,000 – financials reviewed by public accountant; above $535,000, audited financials but may be reviewed for first-time issuer up to $1,070,000.
Progress and annual reports |
12-month resale limitations | Exempt as “covered security,” subject to state notice filing with primary state. State antifraud rules apply. |
It is extremely difficult for small and emerging companies to raise capital, and any changes to the rules that will assist these companies is a positive step. Small businesses are job creators, generators of economic opportunity, and fundamental to the growth of the country. Small businesses account for the majority of net new jobs since the recession ended and are critical to the health and vitality of our country. In the absence of access to funding, small businesses cannot create new jobs, foster innovation, and develop into the next generation of publicly traded companies whose growth fuels capital markets investors’ retirement accounts.
I am very interested to see the new administration’s regulatory and general policies and agendas that impact small business capital raising efforts.
« Audit Committees – NYSE American SEC Final Rule Changes For Exempt Offerings – Part 2 »
Finders – Part 2
Following the SEC’s proposed conditional exemption for finders (see HERE), the topic of finders has been front and center. New York has recently adopted a new finder’s exemption, joining California and Texas, who were early in creating exemptions for intra-state offerings. Also, a question that has arisen several times recently is whether an unregistered person can assist a U.S. company in capital raising transactions outside the U.S. under Regulation S. This blog, the second in a three-part series, will discuss finders in the Regulation S context.
Regulation S
It is very clear that a person residing in the U.S. must be licensed to act as a finder and receive transaction-based compensation, regardless of where the investor is located. The SEC sent a poignant reminder of that when, in December 2015, it filed a series of enforcement proceedings against U.S. immigration lawyers for violating the broker-dealer registration rules by accepting commissions in connection with introducing investors to projects relying on the EB-5 Immigrant Investor Program. From a securities law perspective, EB-5 investments are generally completed by relying on the registration exemption found in Regulation S. For more on Regulation S, see HERE.
In a typical EB-5 investment, a company goes through a process of having their project approved by the United States Citizenship and Immigration Services (USCIS) after which they prepare private placement offering documents and solicit investors in qualifying foreign countries, including China. Due to language and cultural barriers, the U.S. company generally employs the services of marketing agents or finders in the foreign country to help locate and communicate with potential investors. Those finders are generally paid a success-based transaction fee. In addition, U.S. companies often establish a relationship with a U.S.-based immigration attorney that speaks the same language as the potential investors. The enforcement actions were part of a larger SEC investigation into securities law violations, including unregistered broker-dealer activity and sometimes fraud, in connection with the EB-5 program. It is interesting to note that no off-shore or non-U.S. finders were, or have since been, charged with unlicensed broker activity unless the action involved fraud.
Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 15(a)(1) of the Exchange Act, in turn, makes it unlawful for any broker to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker is registered with the SEC.
However, the Exchange Act generally does not apply to transactions outside the U.S. In particular, Section 30(b) of the Exchange Act specifically states that “The provisions of this chapter or of any rule or regulation thereunder shall not apply to any person insofar as he transacts a business in securities without the jurisdiction of the United States, unless he transacts such business in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate to prevent the evasion of this chapter.” Although this provision seems very broad, case law has narrowed the exemption such that the U.S. would still have jurisdiction, and the broker-dealer registration requirements in the Exchange Act would still apply, where (i) transactions occur in a U.S. securities market (such as Nasdaq or the NYSE); (ii) offers and sales were made abroad to U.S. persons (such as U.S. armed forces stationed abroad); or (iii) if the U.S. was used as a base for securities fraud perpetrated on foreigners.
Regulation S itself is a jurisdictional exemption. Rule 901 of Regulation S provides: “[F]or the purposes only of section 5 of the Act (15 U.S.C. §77e), the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed to include offers and sales that occur within the United States and shall be deemed not to include offers and sales that occur outside the United States.” Regulation S then continues to create a framework defining when an offer or sale is within the U.S. and preserves jurisdiction to protect foreign investors from offering fraud by U.S. persons.
Although not directly on point, SEC Rule 15a-6 provides a conditional exemption from the broker-dealer registration requirements for foreign broker-dealers that engage in certain specified activities involving U.S. investors. Rule 15a-6(b)(3) defines foreign broker-dealer to include “any non‑U.S. resident person (including any U.S. person engaged in business as a broker or dealer entirely outside the United States, except as otherwise permitted by this rule) that is not an office or branch of, or a natural person associated with, a registered broker or dealer, whose securities activities, if conducted in the United States, would be described by the definition of ‘broker’ or ‘dealer’ in sections 3(a)(4) or 3(a)(5) of the [Exchange] Act.” Notably, Rule 15a-6 does not include a requirement that a broker be licensed or registered in its foreign jurisdiction. Rather, the Rule only requires that the foreign broker be operating legally in its country of jurisdiction.
Rule 15a-6 allows certain transactions by foreign brokers with U.S. investors without registration. Regulation S, on the other hand, would only involve transactions with non-U.S. investors. Further in the Rule 15a-6 release, the SEC indicated that the exception in Rule 15a-6(a)(1) for unsolicited trades was designed to reflect the view that “U.S. persons seeking out unregistered foreign broker-dealers outside the U.S. cannot expect the protection of U.S. broker-dealer standards.” Again, in a Regulation S transaction, both the foreign finder and the investor would be outside the U.S.
Both Regulation S and Rule 15a-6 are based on the investors or brokers being outside the U.S. In determining whether such person is outside the U.S., the SEC will consider factors like whether the person physically visits the U.S., where a business has offices, where it has employees, where business is conducted and where bank accounts are located. Regulation S is very strict in its requirements that investors, and therefore finders, not have a connection to the U.S. at the time of an offer or sale of securities.
The bottom line is that I am comfortable that a foreign finder, operating exclusively outside the U.S. and exclusively soliciting non-U.S. investors, would be able to collect a transaction-based success fee without running afoul of the U.S. broker-dealer registration requirements.
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SEC Proposes Amendments To Rule 144
I’ve been at this for a long time and although some things do not change, the securities industry has been a roller coaster of change from rule amendments to guidance, to interpretation, and nuances big and small that can have tidal wave effects for market participants. On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. The proposed rule also updates the Form 144 filing requirements to mandate electronic filings, eliminate the requirement to file a Form 144 with respect to sales of securities issued by companies that are not subject to Exchange Act reporting, and amend the Form 144 filing deadline to coincide with the Form 4 filing deadline.
The last amendments to Rule 144 were in 2008 reducing the holding periods to six months for reporting issuers and one year for non-reporting issuers respectively, adding current information requirements and eliminating the use of the rule for shell companies and former shell companies unless certain preconditions were satisfied. For a summary of the current Rule 144, see HERE.
Currently, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. Under the amendments, the holding period for the underlying securities acquired upon conversion or exchange of “market-adjustable securities” would not begin until the conversion or exchange. Market adjustable securities usually take the form of convertible notes which had become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so – that is, until the SEC went on the attack starting a few years ago recently intensifying those efforts.
In a standard convertible note structure, an investor lends money in the form of a convertible promissory note. Generally the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer. As Rule 144 allows for tacking of the holding period, as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion. The notes generally convert at a discount to market price so if the converted securities are sold quickly, a profit is built in. The selling pressure from the converted shares has a tendency to push down the stock price of the issuer.
The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16 see HERE). As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock. Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a very large increase in the number of outstanding shares and a drastic decrease in the share price. Over the years this type of financing has often been referred to as “toxic” or “death spiral.”
Extreme dilution is really only possible in companies that do not trade on a national securities exchange. Both the NYSE and Nasdaq have provisions that prohibit the private issuance of more than 20% of total outstanding, of discounted securities without prior shareholder approval. For more on the 20% Rule, see HERE. In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed rule change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. The SEC also notes, correctly, that the exchanges do not look favorably on transactions involving market adjustable securities and as such, it is more difficult for an issuer to satisfy the listing criteria if they are or have been engaged in such transactions.
Although on first look it sounds like these transactions are risk-free for the investor, they are not. First, Rule 144 itself creates some hurdles. In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations. Also, if the company was formerly a shell company, it must always be current in its reporting obligations to rely on Rule 144. If a company becomes delinquent, the investor can no longer convert its debt and oftentimes such a company does not have the cash to pay back the obligation. Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers. Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.
The SEC recognizes these risks noting that a holder of market adjustable securities is subject to risk in the period from the issuance of the securities until the holding period is satisfied (such as a company going dark) but are not exposed to market risk associated with the underlying securities after conversion. In these circumstances, holders that convert and promptly resell the underlying security in order to secure a profit on the sale based on the built-in discount have not assumed the economic risks of investment of the underlying security. The SEC sees this as inconsistent with the purpose of Rule 144 to provide a safe harbor for transactions that are not distributions of securities.
The potential for profit attracted some unscrupulous market participants (especially in the early years), which together with the fact that the financing is expensive for companies, made the entire industry one that certain players in the small-cap world love to hate. From my viewpoint, the two sides of the coin became as polarized as partisan politics. An almost evangelical faction arose determined to stop these “predatory lenders,” likening them to the leg-breaking loan sharks of the 1960’s. On the other side, there are also higher-quality lenders that seek out a better-quality company to invest in and work to become long-term financial partners making multiple investments over the years mounting to millions of dollars helping companies grow. For many micro-cap companies, these lenders have become an indispensable source of capital where few or no other options exist.
I applaud every regulatory step in the direction of cleaning up the micro-cap space and giving OTC Markets respect as the venture marketplace it is, but in some cases the proverbial baby gets thrown out with the bath water. This isn’t the first time that the SEC has taken action to limit market adjusted financing. Back in 2006 the SEC altered its interpretation of Rule 415 limiting the amount of securities that could be registered as resale to 30% of a company’s public float (see HERE. Prior to that, big players like Cornell Capital and Dutchess Capital wrote ELOC’s for every micro-cap company in town.
Market adjusted investments dissipated for a little while but then the Rule 144 changes in 2008 (coupled with the allowance of tacking from 1997) brought it back to life. The 1997 Rule 144 proposing rule release proposed codifying the Division of Corporation Finance’s position that, if the securities to be sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms. However, investors still thought a two-year hold was too long. Then the 2008 rule changes shortened the holding period for restricted securities to six months for reporting companies and one year for non-reporting companies and overnight, the convertible note lending business blossomed.
The SEC certainly had visibility on the business as most of the issuers were publicly reporting and had to not only file an 8-K upon entering into a transaction but are required to report derivative liabilities on their balance sheets for the convertible overhang and to detail the transactions in the notes to financial statements. Back on September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. See HERE for my blog at the time.
At the time the SEC did not take aim at the investors and the only enforcement actions against investors’ involved fraud or market manipulation. Then in November 2017, the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act. Since that time the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer.
The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question. So far the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes. Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded.
Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly. Although the SEC has had some wins in the litigations, the issue is far from settled.
In that regard, the new Rule 144 proposal provides comfort in some respects. First, it is a step in regulating through rules and guidance as opposed to enforcement. Second, it seems to indicate that the SEC enforcement proceedings alleging unregistered dealer activities have specifically targeted market adjusted investment instruments that are not exchange traded as opposed to all private traders and investors.
After this long introduction, I’ll turn to the proposed rule.
Elimination of Tacking for Market Adjustable Securities
All offers and sales of securities in the US must either be registered or there must be an available exemption from registration. The Securities Act of 1933 (“Securities Act”) Rule 144 sets forth certain requirements for the use of the Section 4(a)(1) exemption for the resale of securities. Rule 144 is a non-exclusive safe harbor for reliance on Section 4(a)(1). Section 4(a)(1) of the Securities Act provides an exemption for a transaction “by a person other than an issuer, underwriter, or dealer.” Section 2(a)(11) in turn defines an underwriter as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security or participates or has a direct or indirect participation in any such undertaking.
Rule 144 sets forth objective criteria, including holding periods, public information, manner of sale, etc. on which selling security holders may rely to avoid being deemed to be engaged in a distribution and, therefore, to avoid acting as an underwriter under Section 2(a)(11) of the Securities Act. The holding period requirement is meant to ensure that the holder has assumed the economic risks of the investment and is not just acting as a conduit for the sale of unregistered securities to the public. When all of the conditions of Rule 144 are complied with, the purchaser of securities receives freely tradeable, unrestricted securities. Rule 144 only addresses the resale of restricted or control securities. Unrestricted securities (such as securities that have been registered under the Securities Act) may be sold without reference or regard to the Rule.
As discussed above, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. As a result, holders of market adjustable securities, such as a convertible note, may convert the note into common stock and immediately resell that common stock into the public marketplace, as long as the note has been held for the requisite Rule 144 holding period. Since the note is converted at a price below the market price, there is a built-in profit. Multiple conversions and sales can dramatically increase the amount of outstanding stock. This can be seen as a loophole in the rule’s structure resulting in distributions of securities, despite the compliance with Rule 144. The proposed rule change is intended to close this hole.
Currently Rule 144(d) sets out the holding period requirements to satisfy Rule 144. Rule 144(d)(3)(ii) provides “Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.” The proposed rule change would amend Rule 144(d)(3)(ii) to eliminate “tacking” for securities acquired upon the conversion or exchange of the market-adjustable securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. As noted above, the rule change would not capture exchange traded securities as the exchanges already have rules to prevent distributions without prior shareholder approval (see the 20% rule – HERE.
The new proposed Rule 144(d)(3)(ii) language is as follows:
(ii) Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms, unless:
(A) the newly acquired securities were acquired from an issuer that, at the time of conversion or exchange, does not have a class of securities listed, or approved for listing, on a national securities exchange registered pursuant to Section 6 of the Exchange Act (15 U.S.C. 78f); and
(B) the convertible or exchangeable security contains terms, such as conversion rate or price adjustments, that offset, in whole or in part, declines in the market value of the underlying securities occurring prior to conversion or exchange, other than terms that adjust for stock splits, dividends or other issuer-initiated changes in its capitalization.
As a result, the holding period for the underlying securities, either six months for securities issued by a reporting company or one year for securities issued by a non-reporting company, would not begin until the conversion or exchange of the market-adjustable securities. The proposed rule change would not include convertible securities that have provisions for adjustments for splits, dividends, or other issuer initiated changes in capitalization but were not otherwise market adjustable.
Forms 4, 5, and 144 Filing Requirements
The rule proposal would: (i) mandate the electronic filing of Form 144; (ii) eliminate the Form 144 filing requirement related to the sale of securities of issuers that are not subject to the reporting requirements of the Exchange Act; (iii) amend the Form 144 filing deadline so that Form 144 may be filed concurrently with Form 4 by persons subject to both filing requirements; and (iv) amend Forms 4 and 5 to add an optional check box to indicate that a reported transaction was intended to satisfy Rule 10b5-1(c), which provides an affirmative defense for trading on the basis of material non-public information in insider trading cases.
The SEC plans to make an online fillable Form 144 available to simplify electronic filing and to streamline the electronic filing of Forms 4 and 144 reporting the same sale of securities.
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