Intellectual Property And Technology Risks – International Business Operations
In December 2019, the SEC Division of Corporation Finance issued CF Disclosure Guidance: Topic No. 8 providing guidance related to the disclosure of intellectual property and technology risks associated with international business operations.
The global and technologically interconnected nature of today’s business environment exposes companies to a wide array of evolving risks, which they must individually examine to determine proper disclosures using a principles-based approach. A company is required to conduct a continuing analysis on the materiality of risks in the ever-changing technological landscape to ensure proper reporting of risks. To assist management in making these determinations, the SEC has issued additional guidance.
The guidance, which is grounded in materiality and a principles-based approach, is meant to supplement prior guidance on technology and cybersecurity matters including the February 2018 SEC statement on public company cybersecurity disclosures (see my blog HERE); Director Hinman’s speech at the 18th Annual Institute on Securities Regulation in Europe in March, 2019; the SEC statement on LIBOR Transition in July 2019; and Chair Clayton’s remarks on LIBOR transition and cybersecurity risks from December 2018. The new guidance concentrates on risks resulting from conducting business outside the U.S. and particularly in jurisdictions that do not have comparable protections for corporate proprietary information.
Although there is no specific line-item requirement under the federal securities laws to disclose information related to the compromise or potential compromise of technology, data or intellectual property, the SEC has made clear that its disclosure requirements apply to a broad range of evolving business risks regardless of the absence of specific requirements. Also, the actual material theft or compromise of technology or intellectual property assets would generally require disclosure, including potentially in management’s discussion and analysis, the business section, legal proceedings, internal controls and procedures and/or financial statements.
The newest guidance is broken down by sources of risk associated with potential theft of technology and intellectual property and assessing and disclosing risks related to potential theft or compromise of technology and intellectual property.
Sources of Risk Associated with Potential Theft of Technology and Intellectual Property
There are many cybersecurity risks associated with technology and intellectual property. Cyber-incidents can take many forms, both intentional and unintentional, and commonly include the unauthorized access of information, including personal information related to customers’ accounts or credit information, data corruption, misappropriating assets or sensitive information or causing operational disruption. Attacks use increasingly complex methods, including malware, ransomware, phishing, structured query language injections and distributed denial-of-service attacks. A cyber-attack can be in the form of unauthorized access or a blocking of authorized access.
In the global context, the risk of theft includes through a direct intrusion by private parties or foreign actors, including those affiliated with or controlled by sovereign entities such as foreign states. The SEC guidance also warns of corporate espionage including the infiltration of moles and insiders.
In addition to direct intrusions, a theft or compromise can be accomplished using indirect attacks such as reverse engineering of technology and intellectual property. Patents together with reverse engineering can be used to assist in obtaining trade secrets and know-how.
Some foreign nations take a very direct route to obtain technology and intellectual property information by requiring companies to yield rights in order to conduct business in or access markets in their jurisdiction, either through formal written agreements or legal or administrative requirements. Companies need to be cognizant of the risks associated with these types of agreements or laws, including unintended consequences. Examples which require cautious risk assessment include: (i) patent license agreements which allow the foreign licensee to retain rights on improvements, including the ability to sever the improvements and receive a separate patent; (ii) patent license agreements which allow the foreign licensee to continue to use the technology or intellectual property after the patent or license term expires; (iii) foreign ownership and investment restrictions which can result in a loss of control over the foreign assets or entity holding the foreign assets; (iv) the use of unusual or idiosyncratic terms favoring foreign persons; (v) regulatory requirements which restrict the ability to conduct business in a foreign jurisdiction unless technology or data is stored locally; (vi) regulatory requirements which require the use of local service providers or technology in connection with international operations; and (vii) local licensing or administrative approvals that involve the sharing of intellectual property.
Assessing and Disclosing Risks Related to Potential Theft or Compromise of Technology and Intellectual Property
In addition to assessing the risks of a potential theft or compromise of technology, data or intellectual property in connection with international operations, companies must conduct an analysis as to how the realization of these risks may impact their business, including financial condition and results of operations, and any effects on their reputation, stock price and long-term value. As always, where the risks are material, they must be disclosed.
Where a company’s technology, data or intellectual property is being or previously was materially compromised, stolen or otherwise illicitly accessed, hypothetical disclosure of potential risks is not sufficient to satisfy a company’s reporting obligations.
The SEC guidance provides a list of questions for management to consider when assessing risks and related disclosure requirements involving international technology, data and intellectual property, including:
(i) Is there a heightened risk by virtue of conducting business, maintaining assets or earning revenue abroad;
(ii) Does the company have operations in a jurisdiction that is particularly susceptible to heightened risk;
(iii) Does the company have operations in a jurisdiction that requires entering into contracts related to technology as a condition to conducting business;
(iv) Has the company’s products been, or may they be, subject to counterfeit and sale through e-commerce;
(v) Has the company directly or indirectly transferred or licensed technology or intellectual property to a foreign entity or government, such as through the creation of a joint venture with a foreign entity;
(vi) Does the company store technology abroad;
(vii) Is the company required to use equipment or service providers in a foreign jurisdiction;
(viii) Has the company entered into a patent or technology license agreement with a foreign entity or government that provides such entity with rights to improvements on the underlying technology and/or rights to continued use of the technology following the licensing term, including in connection with a joint venture;
(ix) Is the company subject to foreign jurisdiction requirements which limit foreign ownership or investment and, in that vein, does the company have foreign subsidiaries where the majority ownership is held by governments or entities in that foreign jurisdiction;
(x) Has the company provided access to your technology or intellectual property to a state actor or regulator in connection with foreign regulatory or licensing procedures, including but not limited to local licensing and administrative procedures;
(xi) Has the company been required to yield rights to technology or intellectual property as a condition to conducting business in or accessing markets located in a foreign jurisdiction;
(xii) Does the company operate in a jurisdiction where the ability to enforce rights over intellectual property is limited as a statutory or practical matter;
(xiii) Does the company conduct business with local laws that limit or prohibit the export of data or financial documentation;
(xiv) Is the company readily able to produce data or other information that is housed internationally in response to regulatory requirements or inquiries;
(xv) Have conditions in a foreign jurisdiction caused the company to relocate or consider relocating operations to a different host nation and, if so, what are the related costs including material costs, training new employees, establishing new facilities and supply chains and the impact on import and export;
(xvi) Does the company have adequate controls and procedures in place to protect technology, data and intellectual property, and do these procedures include the ability to adequately respond to an actual or potential threat;
(xvii) Does the company have adequate controls and procedures in place to detect: (a) malfeasance by employees and others; (b) industrial or corporate espionage; (c) unauthorized intrusions into computer networks; and (d) other forms of cyber-theft and breaches; and
(xviii) What level of risk oversight and management does the board of directors and executive officers have with regard to the company’s data, technology and intellectual property and how these assets may be impacted by operations in foreign jurisdictions where they may be subject to additional risks.
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The SEC Has Adopted Final Amendments To Rule 15C2-11; Major Change For OTC Markets Companies
Despite an unusual abundance of comments and push-back, on September 16, 2020, one year after issuing proposed rules (see HERE), the SEC has adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11. The primary purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities. The SEC believes the final amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors. From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealer to rely on that confirmation. Importantly the new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer. The final rule release contains an in-depth discussion of the numerous comments received (I was one of the many comment writers), especially related to the piggyback exception. As part of the comment process, the OTC Markets, and many of its supporters, suggested the creation of a new “expert market” which would allow the trading of securities with no or limited information, by institutions and other qualified individual traders. In rejecting the proposal, the SEC indicated that there was not enough detail and information around how such a market would operate, but that it was open to considering such a segregated expert qualified marketplace in the future following the appropriate groundwork. The final rules entail a complete overhaul of the current rule structure and as such will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system. I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks. The final rule release contains a section on guidance related to the rules implementation and use. The guidance includes information on determining the reliability of information sources, conducting information reviews, and red flags that may heighten a review requirement. The effective date of the rule is 60 days following publication in the federal register. The rule will be published any day now. Compliance with the majority of the rule is required nine months after the effective date. However, compliance with the provision requiring a catch-all category of company to have current information for the preceding two years in order to qualify for the piggyback exception is not until two years from the effective date. As discussed more fully below, a catch-all company is generally an alternatively reporting company on OTC Markets. Background Rule 15c2-11 was enacted in 1971 to ensure that proper information was available to a broker and its clients prior to quoting a security in an effort to prevent micro-cap fraud. The last substantive amendment was in 1991. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA. The specific information required to be maintained by the broker-dealer when it initiates a quotation is delineated in Exchange Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or Regulation A under wand quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv). In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. This reasonable basis requirement has altered the initial quotation process dramatically over the last ten years. In particular, FINRA uses this requirement to conduct a deep dive into the due diligence and background of a company when processing a 211 Application. As discussed below, although the amended rule continues to require that a broker-dealer have a reasonable basis to believe information is accurate and from a reliable source, the revamped structure itself may help shift the burden back to the broker-dealer, where it belongs, and reduce FINRA’s overlapping merit review. Importantly as discussed, OTC Markets will not be required to submit a Form 211 but rather its determination of compliance with the rules will be self-effectuating, and a broker-dealer relying on OTC Markets review, will also not be required to submit a Form 211 to FINRA. This alone will make a tremendous difference in the process. The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed by a market maker and approved by FINRA and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. The disparity is so extreme that a quotation can take on a life of its own and continue long after a company has ceased to exist or closed operations. The SEC’s rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies. However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity). Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company. The final rules: (i) require that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allow OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamline the rule and eliminate obsolete provisions. The final rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA. However, if new IDQS platforms or national securities associations develop, they would also be covered by the rule. Final Amendments OTC Markets Review The new rule allows a qualified IDQS to comply with the information review requirements. As mentioned, in reality, the qualified IDQS is OTC Markets. In complying with the information review requirements under Rule 15c2-11, OTC Markets will be subject to the same review, responsibility and record keeping requirements of a broker-dealer and must have reasonably designed written policies and procedures associated with the rule’s compliance. OTC Markets would then “make known” to the public that it has completed a review and that a broker-dealer can quote or resume quoting the securities, and be in compliance with Rule 15c2-11. Likewise, OTC Markets can make a determination that a company qualifies for an exception to the 211 rule requirements and a broker-dealer can rely on that determination. A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review. Keeping the rule’s current 3 business day requirement, a broker-dealer’s quotation must be published or submitted within three business days after the qualified IDQS (OTC Markets) makes a publicly available determination. Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies, to file Forms 211 with FINRA. I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews. Current Public Information Requirements; Location of Information The final rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed. In addition, the amendment will restructure and renumber paragraphs and subparagraphs. To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation. The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation. The catch-all category encompasses companies that alternatively report on OTC Markets (see HERE for more information), as well as companies that are delinquent in their SEC reporting obligations. Provided however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggy-back exception. For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence. The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet. Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied. In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension. The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggy-back exception, for continued quotations. Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications. I’ve included a brief discussion of red flags in the section titled guidance below. The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties. Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements. Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer . The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information. Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security. The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation. A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet. The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors. In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder. As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10% or greater shareholders unless the company has current publicly available information. The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security. Exceptions in General The final rule amendments add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception; and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met. Piggyback and Unsolicited Quote Exception Changes The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. As discussed, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme. There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception. The final rule, which contains a 60 page discussion on the piggyback exception, will amend the exception to: (i) require that information be current and publicly available (see below chart); (ii) require at least a one-way priced quotation (either bid or ask) – which is a modification from the proposal which would have required a two-way quotation; (iii) eliminate the current 30 calendar day window before the exception can be relied upon but retain the requirement that that no more than 4 days in succession can elapse without a quotation; (iv) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (v) allow a period in which the exception can be relied upon for quotations of shell companies (modified from the rule proposal); and (vi) provide a conditional 15 day grace period to continue quotations when current information is no longer available (this provision was not in the rule proposal); and (vi) revise the frequency of quotation requirement. Notably, the SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggy-back exception, rather, the amended rule provides a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations. In particular, a broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period. Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter end. Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility. Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility. The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:| Category of Company | 15c2-11 Current Information |
| Exchange Act reporting company | Filed within 180 days following end of the reporting period |
| Regulation A reporting company | Filed within 120 days of fiscal year end and 90 days of semi-annual period end |
| Regulation Crowdfunding filer | Filed within 120 days of fiscal year end |
| Foreign Private Issuer | Since first day of most recent completed fiscal year, information required to be filed by the laws of home country or principal exchange traded on |
| Catch-all company | Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet. Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e. approximately 2 years and 2 months). A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date – i.e. 9 months after the effective date. |
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Proposed 2021 U.S. Budget
In February, the Office of Management and Budget released the proposed fiscal 2021 United States government budget. The beginning of the Budget contains a message from President Trump delineating a list of key priorities of the administration including better trade deals, preserving peace through strength, overcoming the opioid crisis, regulation relief and American energy independence. The budget has some notable aspects that directly relate to the capital markets and its participants.
SEC
As the federal government has been doing for all agencies, the 2021 Budget seeks to eliminate agency reserve funds. Specifically regarding the SEC, the Budget cuts the SEC reserve by $50 million. The reduction in reserve fund is thought to increase overall accountability as the SEC would need to go to Congress to ask for additional funds if needed, with an explanation, instead of just accessing a reserve account. Reserve fund cuts are sent to the U.S. Treasury for deficit reduction.
However, the Budget also increases the overall SEC financing by 5.6% for a total of $1.9 billion including allowing for a 2.9% increase in workforce. The budget also increases the SEC’s annual funding for cybersecurity from $41.8 million to $46.6 million.
PCAOB
One of the overarching stated principals in the Budget is to reduce overlapping and duplication and in particular, “when multiple agencies or programs have similar goas, engage in similar activities or strategies, or target similar beneficiaries” they should be consolidated or the duplicated functions eliminated. In that regard, the 2021 budget proposed moving the now autonomous PCAOB under the SEC with a mandate that the SEC and PCAOB start to consolidate their duplicative functions. “Consolidating these functions within SEC will reduce regulatory ambiguity and duplicative statutory authorities,” the proposed Budget states.
The PCAOB was originally created by the Sarbanes-Oxley Act of 2002 in response to a series of accounting frauds including involving Enron Corp. However, the SEC is also tasked with investigation, oversight and enforcement against the same accounting firms that must be members of the PCAOB. The PCAOB has faced a series of controversies in recent years.
In December 2017, following a scandal involving the leak of confidential information about future inspections of KPMG LLP to auditors at the accounting firm, the SEC replaced the PCAOB’s entire board. A month later criminal charges were unsealed for three former PCAOB employees and three former KPMG executives.
In May 2018, five key division and office heads departed the regulator. Also in 2018, the number of settled disciplinary proceedings made public by the PCAOB dropped by 63%. In May 2019, a group of current and former PCAOB employees filed a whistleblower complaint alleging infighting, a hostile work environment and retaliatory conduct.
To top off the issues, in September 2019,a nonpartisan government oversight report found that over its full 16-year life, the PCAOB had only brought 18 enforcement actions against the big four accounting firms despite having found 808 instances of defective audits by those same firms. The report found that the PCAOB had only collected a total of $6.5 million in fines despite having the authority to demand as much as $15 million per violation. Finally, the report found an incestuous relationship between the PCAOB and the big four accounting firms with a frequent interchange of employees. In short, the PCAOB has not proved itself worth its expense nor effective in its mission.
Like other savings, the savings from folding in the PCAOB with the SEC would be used to reduce the federal deficit. It is expected that the joining of the two would result in a savings of $57 million in 2022 and a total of $580 million over ten years.
Financial Crimes/Cryptocurrencies
It is widely acknowledged that the increase in digital assets and cryptocurrencies has increased the prevalence of money laundering and funding for criminal activities including cybercriminals and terrorist activities. As an example, in August of last year, the Treasury Department’s Office of Foreign Assets Control (“OFAC”) blacklisted the cryptocurrency addresses of Chinese nationals involved in trafficking and producing the drug fentanyl. It is believed that the perpetrators were laundering funds using cryptocurrency. At the time, FinCEN issued an advisory to financial institutions outlining some of the common schemes used to launder funds.
In a move to increase law enforcement in this sector, after nearly two decades of control under of the U.S. Department of Homeland Security, the 2021 Budget proposes moving the Secret Service to the Department of the Treasury. The Budget cites the need for increased efficiencies in combating threats stemming from financial technology, including cryptocurrencies. The Budget would also provide the Secret Service with $2.4 billion in funding and allow for an additional 119 Secret Service agents.
The budget also proposes funding $127 million to support the Financial Crimes Enforcement Network, which “links law enforcement and intelligence agencies with financial institutions and regulators.” The budget outlines that the funding would help support FinCEN’s actions under the Bank Secrecy Act and would “expand its efforts to combat emerging virtual currency and cybercrime threats.” FinCEN regulates and monitors anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA).
AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC. The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs). For more information, see HERE.
The Budget also allocated $173 million to the Department of Treasury’s Office of Terrorism and Financial Intelligence which combats terrorists, rogue regimes, proliferators of weapons of mass destruction, human rights abusers, and other illicit actors by denying their access to the financial system, disrupting their revenue streams, and degrading their ability to cause harm.
As an aside, in addition to the Secret Service, Budget will also move the Bureau of Alcohol, Tobacco, Firearms and Explosives and the Organized Crime and Drug Enforcement Task Force to the Department of Treasury. The ATF has historically been under the Department of Justice.
Small Business Administration (SBA)
The SBA was established to aid, counsel and assist small businesses. The Budget supports $43 billion in business lending to assist U.S. small business owners in accessing affordable capital to start, build, and grow their businesses though loans will have an up-front administrative fee to offset costs.
Other Points of Interest – Technology and Cybersecurity
The Administration is prioritizing technology and industries of the future across the board with an emphasis on artificial intelligence. The Department of Defense Budget invests over $14 billion in science and technology programs that support key investments in industries of the future, such as artificial intelligence, quantum information science, and biotechnology, as well as core Department of Defense modernization priorities such as hypersonic weapons, directed energy, 5G, space, autonomy, microelectronics, cybersecurity, and fully networked command, control, and communications.
The Department of Commerce provides $718 million for the National Institute of Standards and Technology (NIST) to advance U.S. innovation and technological development, as part of an all-government approach to ensure that the US leads the world in the areas of AI, quantum information science, advanced manufacturing, and next generation communications technologies such as 5G. The Budget doubles NIST’s AI funding in order to accelerate the development and adoption of AI technologies and help ensure AI-enabled systems are interoperable, secure and reliable.
The Department of Energy has a new Artificial Intelligence and Technology Office responsible for providing department wide guidance and oversight on AI technology development and application. The Budget provides $5 million for this new office to enhance AI R&D projects already underway. In addition, the Department of Energy is allocated $5.8 billion for the Office of Science to continue its mission of focusing on early-stage research. Within this amount: $475 million is requested for Exascale computing to help secure the United States as a global leader in supercomputing; $237 million is requested for quantum information science; $125 million is requested for AI and machine learning; and $45 million is requested to enhance materials and chemistry foundational research to support U.S.- based leadership in microelectronics. Moreover, to support broad, interagency cybersecurity efforts, the Budget provides funding in multiple programs, including $185 million for the Office of Cybersecurity, Energy Security, and Emergency Response.
The Department of Education Budget includes $2 billion for Career and Technical Education Grants to ensure that all high schools can offer high-quality technological educations.
« SEC Proposed Rule Changes For Exempt Offerings – Part 5 SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions »
SEC Proposed Rule Changes For Exempt Offerings – Part 4
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this fourth blog focusing on amendments to Regulation A other than integration and offering communications which affect all exempt offerings and were discussed in the first two blogs in this series. The final blog in this series will discuss changes to Regulation Crowdfunding.
To review the first blog in this series, which centered on the offering integration concept, see HERE. To review the second blog in the series, which focused on offering communications, the new demo day exemption, and testing-the-waters provisions, see HERE. To review the third blog in this series, which focused on Regulation D, Rule 504 and the bad actor rules, see HERE.
Background; 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 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). Currently, 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 background on the current exemption framework, including a chart summarizing the most often used exemptions and their requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
Regulation A
The current two tier Regulation A offering process went into effect on June 19, 2015, as part of the JOBS Act. Since its inception there has been one rule modification opening up the offering to SEC reporting companies (see HERE) and multiple SEC guidance publications including through C&DI on the Regulation A process. For a recent summary of Regulation A, see HERE.
Increase in Offering Limit
On March 15, 2018, the U.S. House of Representatives passed H.R. 4263, the Regulation A+ Improvement Act, increasing the Regulation A+ Tier 2 limit from $50 million to $75 million in a 12-month period. On June 8, 2017, the U.S. House of Representatives passed the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (the “Financial Choice Act 2.0”), which also included a provision increasing the Tier 2 offering limit to $75 million.
Following suit, the new proposed rule changes will increase the maximum Regulation A Tier 2 offering from $50 Million to $75 million in any 12-month period. As such, the 30% offering limit for secondary sales would increase from $15 million to $22.5 million. Tier 1 offering limits would remain unchanged.
Simplification
The SEC is also proposing to simplify the requirements for Regulation A and establish greater consistency between Regulation A and registered offerings by permitting Regulation A issuers to: (i) file certain redacted exhibits using the process previously adopted for registered offerings (see HERE); (ii) make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements; (iii) incorporate financial statement information by reference to other documents filed on EDGAR and generally allow incorporation by reference to the same degree as a registered offering (see HERE); and (iv) to have post-qualification amendments declared abandoned.
In March 2019, the SEC amended parts of Regulation S-K to allow companies to mark their exhibit index to indicate that portions of the exhibit or exhibits have been omitted, include a prominent statement on the first page of the redacted exhibit that certain identified information has been excluded from the exhibit because it is both not material and would be competitively harmful if publicly disclosed, and indicate with brackets where the information has been omitted from the filed version of the exhibit. At the time, the Regulation A rules were not changed such that Regulation A filers are still compelled to submit an application for confidential treatment in order to redact immaterial confidential information from material contracts and plans of acquisition, reorganization, arrangement, liquidation, or succession.
SEC staff would continue to review Forms 1-A filed in connection with Regulation A offerings and selectively assess whether redactions from exhibits appear to be limited to information that meets the appropriate standard. Upon request, companies would be expected to promptly provide supplemental materials to the SEC similar to those currently required, including an unredacted copy of the exhibit and an analysis of why the redacted information is both not material and the type of information that the company both customarily and actually treats as private and confidential.
Companies would also still be able to request confidentiality under Rule 83. For more on confidential treatment in SEC filings, see HERE
The SEC is also proposing to make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements. Currently confidential submittals must be filed as an exhibit to a public filing, which adds time and expense to the process. To the contrary, confidential registration statements filed under the Securities Act can simply be recoded to become publicly available. The proposed rules would add the same process for Regulation A filers.
The SEC is also proposing to allow previously filed financial statements to be incorporated by reference into a Regulation A offering circular. As proposed, companies that have a reporting obligation under Rule 257 or the Exchange Act must be current in their reporting obligations. In addition, companies would be required to make incorporated financial statements readily available and accessible on a website maintained by or for the company, and disclose in the offering statement that such financial statements will be provided upon request. Companies conducting ongoing offerings would still need to file an annual post-qualification amendment with updated financial statements.
Excluding Delinquent Reporting Companies
The proposed amendments would exclude reporting companies that are not current in periodic reports required under Section 13 or 15(d) of the Exchange Act from using Regulation A. Excluding companies that are subject to, but not current in, Exchange Act reporting obligations from eligibility under Regulation A may reduce the average level of information asymmetry about Regulation A issuers and incrementally increase investor interest in securities offered in this market.
« SPAC IPOs A Sign Of Impending M&A Opportunities SEC Proposed Rule Changes For Exempt Offerings – Part 5 »
SEC Proposed Rule Changes for Exempt Offerings – Part 3
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this third blog focusing on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D other than integration and offering communications which affect all exempt offerings and were discussed in the first two blogs in this series. In addition, this third blog will cover amendments to the bad-actor disqualification provisions. The final two blogs in this series will discuss changes to Regulation A and Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see HERE.
Background; 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 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). Currently, 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 background on the current exemption framework, including a chart summarizing the most often used exemptions and their requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
Rule 506(c) Verification Requirements
Rule 506(c) allows for general solicitation and advertising; however, all sales must be made to accredited investors and the company must take reasonable steps to verify that purchasers are accredited. It is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. For more on Rules 506(b) and 506(c), see HERE.
Rule 506(c) provides for a principles-based approach to determine whether an investor is accredited as well as providing a non-exclusive list of methods to determine accreditation. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.
Examples of the type of information that companies can review and rely upon include: (i) publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages); (ii) third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and (iii) third-party accredited investor verification service providers.
Moreover, non-exclusive methods of verification include:
- Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
- Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
- Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
- A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.
Related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property. The SEC has provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. However, if the evidence is at all questionable, further inquiry should be made.
In the new proposed rule release, the SEC realizes that the non-exclusive list may create some uncertainty and lead to some companies to believe that they must rely only on the methods in the list. The SEC is proposing to add a new item to the non-exclusive list that allows for a company to accept the written representation of an investor that they are accredited if the company has previously taken steps to verify accredited status and is not aware of any new information to the contrary.
The amended rule will also reiterate the principles-based approach of the rule, including reminding companies to consider (i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (ii) the amount and type of information that the company has about the purchaser; and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
Rule 506(b); Harmonization of Disclosure Requirements
Currently Rule 506(b) has scaled disclosure requirements based on the size of the offering, where unaccredited investors are included. The proposed rules update the information requirements for investors under Rule 506(b) where any unaccredited investors are solicited. The new information requirements would align with information required under Regulation A. For Rule 506(b) offerings up to $20 million, the same financial information that is required for Tier 1 Regulation A offerings will be required. For offerings greater than $20 million, the same financial information that is required for Tier 2 Regulation A offerings will be required.
The effect of the rule change would be to eliminate the ability for a company that has trouble getting financial statements to be able to only provide a balance sheet. Foreign private issuers would be able to provide the financial information in either U.S. GAAP or IFRS as would be permitted in a registration statement.
If the company is not subject to the Exchange Act reporting requirements, it must also furnish the non-financial statement information required by Part II of Form 1-A or Part I of a Securities Act registration statement on a form that the issuer would be eligible to use (usually Form S-1). If the company is subject to the Exchange Act reporting requirements, it must provide its definitive proxy with annual report, or its most recent Form 10-K. These information requirements only apply where non-accredited investors will be solicited to participate in the offering.
Finally, as mentioned in Part I of this blog series related to integration where an issuer conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
Rule 504
On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act and created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. At that time, the SEC also amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. For more on the 2016 rule amendments, see HERE.
Currently Rule 504 provides an exemption for offerings up to $5 million in any twelve-month period. Rule 504 is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Rule 504 does not have any specific investor qualification or limitations. However, Rule 504 does not pre-empt state law and as such, the law of each state in which an offering will be conducted must be reviewed and complied with.
The proposed rule changes will increase the maximum offering under Rule 504 from $5 million to $10 million in any 12-month period.
Bad-Actor Provisions
Rules 504, 506(b), 506(c), Regulation A and Regulation Crowdfunding all have bad-actor disqualification provisions. While the disqualification provisions are substantially similar, the look-back period for determining whether a covered person is disqualified differs between Regulation D and the other exemptions. The proposed rules will harmonize the bad-actor provisions among Regulations D, A and Crowdfunding by adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.
Under Regulation D, the disqualification event is measured as of the time of sale of the securities in the offering. Under Regulation A and Regulation Crowdfunding, the look-back period is measured from the time the company files an offering statement. However, the SEC believes that it is important to look to both the time of filing of the offering document and the time of the sale with respect to disqualifying bad actors from participating in an offering. The proposed rule change will add “or such sale” to any look back references in Regulation A and Regulation Crowdfunding.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
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.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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« NASDAQ Provides Additional Relief To Shareholder Approval Requirements For Companies Affected By Covid-19 Disclosures Related To Covid-19 – What Investors Want To Know »
SEC Enacts Temporary Expedited Crowdfunding Rules
Following the April 2, 2020 virtual meeting of the SEC Small Business Capital Formation Advisory Committee in which the Committee urged the SEC to ease crowdfunding restrictions to allow established small businesses to quickly access potential investors (see HERE), the SEC has provided temporary, conditional expedited crowdfunding access to small businesses. The temporary rules are intended to expedite the offering process for smaller, previously established companies directly or indirectly affected by Covid-19 that are seeking to meet their funding needs through the offer and sale of securities pursuant to Regulation Crowdfunding.
The temporary rules will provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief will apply to offerings launched between May 4, 2020 and August 31, 2020.
TEMPORARY RULES
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. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1,070,000 (as adjusted for inflation in 2017) 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 cannot 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. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
In March 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework including Regulation Crowdfunding. The proposed rules would increase the offering limit to $5 million; increase the investment limit by altering the formula to be based on the greater of, rather than lower of, an investor’s annual income or net worth; remove investment limits on accredited investors; allow the use of special purpose vehicles and reduce the types of securities that can be sold in a Regulation Crowdfunding offering. However, the timing for implementation of the proposed rules, either as proposed or with changes, is uncertain.
As noted, the temporary rules are intended to provide existing eligible smaller businesses with quick access to capital by reaching out to the “crowd” which may include local investors, customers, vendors, etc., that are willing to support small businesses. This table, which was included in the SEC press release announcing the temporary rules, and to which I have provided explanatory and further detailed information, is a very good summary of the temporary rules.
| Requirement | Existing Regulation Crowdfunding | Temporary Amendment |
| Eligibility | The exemption is not available to:
|
To rely on the temporary rules, issuers must meet the existing eligibility criteria PLUS:
|
| Offers permitted | After filing of offering statement (including financial statements) | After filing of offering statement, but financial statements may be initially omitted (if not otherwise available) |
| Investment commitments accepted | After filing of offering statement on Form C (including financial statements) | After filing of offering statement on Form C that includes financial statements or amended offering statement that includes financial statements.That is, the temporary rule allows a test-the-waters period by allowing the company to file a Form C and post offering information on a funding platform, gathering indications of interest, prior to filing financial statements. If the offering does not garner interest, the company may determine to abandon or delay the offering and would not have occurred the expense of financial statement preparation.
Certain disclosures will need to be added if no financial statements are included and no investment commitments can be accepted until the financial statements have been provided. |
| Financial statements required when issuer is offering more than $107,000 and not more than $250,000 in a 12-month period | Financial statements of the issuer reviewed by a public accountant that is independent of the issuer | Financial statements of the issuer and certain information from the issuer’s federal income tax returns, both certified by the principal executive officer.Must also provide a statement that financial information certified by the principal executive officer has been provided instead of financial statements reviewed by an independent public accountant. |
| Sales permitted | After the information in an offering statement is publicly available for at least 21 days | As soon as an issuer has received binding investment commitments covering the target offering amount (note: commitments are not binding until 48 hours after they are given) |
| Early closing permitted | Once target amount is reached if:
|
As soon as binding commitments are received reaching target amount if:
|
| Cancellations of investment commitments permitted | For any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. Thereafter, an investor is not able to cancel any investment commitments made within the final 48 hours of the offering (except in the event of a material change to the offering). | For any reason for 48 hours from the time of the investor’s investment commitment (or such later period as the issuer may designate). After such 48-hour period, an investment commitment may not be cancelled unless there is a material change to the offering. |
e Crowdfunding Professional Association (C
« SEC Proposed Rule Changes for Exempt Offerings – Part 2 SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements »
Conditional Relief For Persons Affected By Coronavirus
As the whole world faces unprecedented personal and business challenges, our duty to continue to run our businesses, meet regulatory filing obligations and support our capital markets continues unabated. While we stay inside and practice social distancing, we also need to work each day navigating the new normal. Thankfully many in the capital markets, including our firm, were already set up to continue without any interruption, working virtually in our homes relying on the same technology we have relied on for years.
We all need to remember that the panic selling frenzy will end. Emotions with even out and the daily good news that comes with the bad (for example, the number of cases in China is falling dramatically; some drugs are working to help and the FDA is speeding up review times for others; early signs China’s economy is starting to recover already; scientists around the world are making breakthroughs on a vaccine; etc.) will begin to quell the fear. No one knows what the economic damage will be but we do know that new opportunities will appear, the buying opportunity is already being hinted at for capital markets, and entrepreneurs will continue.
In the meantime, besides the economic stimulus packages that have already passed in some states and that are fighting their way through the federal partisan political system, regulators have provided some relief for our clients and the capital markets participants.
Extension in SEC Reporting Filing Deadlines
The SEC has issued an exemptive order providing public companies with an additional 45 days to file certain disclosure reports that would otherwise be due between March 1 and April 30, 2020. The extension is only available under certain conditions. In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough. In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis. For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines
The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.
If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.
For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report. For more on S-3 eligibility, see HERE.
Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.
The extension actually changes the due date for the filing of the report. Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.
Disclosures Regarding Covid-19 Impact
The SEC press release regarding the exemptive Order reminds companies of the obligations to disclose information related to the impact of Covid-19 on their businesses. SEC Chair Jay Clayton stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”
Furthermore, the combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading). The exemptive order reminds all companies of its obligations. If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.
Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made. Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate. Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).
Furnishing of Proxy and Information Statements
The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible. The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.
Virtual Annual Meetings
Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law. Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not. New York has historically been one of the states that does not have easy provisions for virtual meetings. Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings. Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.
Relief for Registered Transfer Agents
The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020. The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.
The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists. The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.
To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.
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Hester Peirce Proposal For Treatment Of Cryptocurrency
SEC Commissioner Hester M. Peirce, nicknamed “Crypto Mom,” has made a proposal for the temporary deregulation of digital assets to advance innovation and allow for unimpeded decentralization of blockchain networks. Ms. Peirce made the proposal in a speech on February 6, 2020.
The world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector with the SEC’s announcement that a cryptocurrency is a security in its Section 21(a) Report on the DAO investigation. Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
However, although capital raising seems clear, the breadth of the SEC’s jurisdiction and involvement are much less so. Not all token issuances and digital assets are used for capital raising, but rather these digital assets are fundamental to the operations of decentralized applications. Amazing new networks are being built and traditional applications are being disrupted at every turn. However, the ability to publicly issue the digital tokens that drive these networks continues to challenge the best practitioners, with all avenues leading back to some form of registration. The SEC’s temporary injunction against Telegram and its Grams digital token, the one token everyone firmly believed was a pure utility, together with the successful Regulation A offering of Blockstack’s token, has made Regulation A the clear choice for a public token issuance.
In theory, an S-1 would work as well, though to date no one has tried and likely will not do so in the short term. The issue with an S-1 is testing the waters and gun jumping (see HERE). Public communication in advance of an S-1 is strictly limited whereas most token offerings rely heavily on pre-marketing. Regulation A broadly allows pre-offering marketing, offers and communications (see HERE).
Currently, those who operate in the digital asset space must carefully navigate rough, uncharted waters while doing everything possible to comply with federal regulations. Although Regulation A+ works for the public issuance of a token, the issue of transitioning from a security to a utility a Hester Peirce Proposal For Treatment Oft this point requires a leap of faith. The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security. The question remains: how can a token that begins as a security, be utilized and traded freely in a network, in its utilitarian purpose, such to allow the network to grow in decentralization?
The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license (see, for example, HERE). Currently there is no active secondary trading market for digital asset securities in the U.S., though we are getting closer. However, secondary trading is different than use in a network for a token’s intended purpose.
Although there is no written guidance or pronouncement from the SEC Division of Trading and Markets, it appears that the SEC will allow a token that is a security to be used in a network without compliance with the registration or exemption provisions of the federal securities laws. The basis for this conclusion is the clearance of Blockstack’s Regulation A offering, which announces that the token can be used on the network and informal calls with FinHUB (see HERE) and digital asset legal practitioners. This does not provide the sort of comfort that a business investing millions of dollars into technology wants to rely upon.
That is one huge gap in the digital asset regulatory framework, but many more exist, leading Commissioner Peirce to throw out the first of what will probably be several proposals that hopefully bring us to a working structure.
Commissioner Peirce’s Proposal
Ms. Peirce begins by pointing out what I and every other practitioner have pointed out while trying to traverse the law’s application to digital assets, and that is that compliance with the law while furthering the meritorious digital asset technology is an unwinnable struggle. Ms. Peirce states, “[W]hether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin, providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, our securities laws stand in the way of innovation.”
Although the issues are widespread, Ms. Peirce focuses on the issue of getting tokens into the hands of potential network users without violating securities laws. Where a token is a security, the ability to grow a network and utilize a token within the network is unreasonably hampered.
Furthermore, although many tokens may be bundled in such a way as to create an investment contract under Howey, she thinks the SEC has gone too far in its analysis. The mere fact that a token is marketed as potentially increasing in value should not make it a security. If that were the case, quality handbags, designer sneakers, fine art and good wines would all be securities under the purview of the SEC.
The options available for digital asset technology innovators are limited. A network could simply open source the code and allow mining to create the initial tokens. A network could also take its chances and conclude that a token is not a security and proceed with the issuance, although that did not work out well for Telegram. The option most networks have chosen is to either avoid the U.S. altogether or rely on Regulation D and/or Regulation S for token issuances, and recently Regulation A for a more public issuance.
The safe harbor proposed by Commissioner Peirce is designed for projects looking to build a decentralized network. The safe harbor is admittedly in a draft form. Commissioner Peirce hopes for active public input as well as involvement within the SEC to help take her draft and formulate a workable plan that is either a rule or a no-action position, but that the market can rely on in moving forward.
The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempt from the federal securities laws as long as certain conditions are satisfied. In particular, (i) the offer and sale of tokens would be exempted from the provisions of the Securities Act of 1933 (“Securities Act”) other than the anti-fraud provisions; (ii) tokens would be exempt from registration under the Securities Exchange Act of 1934 (“Exchange Act”); and (iii) persons engaged in certain token transactions would be exempt from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.
In order to qualify for the safe harbor, several conditions must be met including: (i) the development team must intend the network to reach maturity, either through full decentralization or token functionality, within three years of the date of the first token sale, and act in good faith to meet that goal. I note that good faith is a hard standard to prove; (ii) the team must disclose key information on a freely accessible public website; (iii) the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network; (iv) the team must take reasonable efforts to create liquidity for users; and (v) the team would have to file a notice of reliance on the safe harbor on EDGAR within 15 days of the first token sale.
Determining decentralization requires an analysis of whether the network is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control. Functionality would be when holders can use the tokens for the transmission and storage of value or to participate in an application running on the network.
The key information that would need to be disclosed on a public website includes (i) the source code; (ii) transaction history; (iii) purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding); (iv) information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism; (v) the governance mechanisms for implementing changes to the protocol; (vi) the plan of development, including the current state and timeline for achieving maturity; (vii) financing plans, including prior token sales; (viii) the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team; (ix) the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future; (x) the sale by any member of 5% or more of his or her originally held tokens; and (xi) any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.
The requirement to make good-faith efforts to create liquidity for users could include a secondary trading market. In that case, the team would be required to utilize a trading platform that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection. Although I find this requirement perplexing, Commissioner Peirce believes it will help facilitate the distribution of the tokens such that they can flow back to a utility use on the network.
As mentioned, the safe harbor would not include the anti-fraud provisions of the securities laws. In addition, the safe harbor would be subject to the bad actor rules, such that it could not be used if any member of a team fell within the bad actor provisions (see HERE). The safe harbor would pre-empt state securities laws, but as with other pre-emptions, it would not include the state anti-fraud provisions.
The safe-harbor would be retroactive in that it would apply to tokens previously issued in registered or exempt offerings to allow for the free use of the token to build the network, and secondary sales.
Conclusion
Although as Commissioner Peirce notes, it has to start somewhere, it is a given in the industry that the proposal as written will not likely gain traction. It is simply too anti-regulation for any regulator’s and perhaps even industry participant’s liking. However, it does lay the framework to open the conversation and start towards a workable solution. Certainly, the current plan to let tokens registered as securities, be used as utilities, until we say otherwise, is not any better. The industry needs a workable solution, and I am glad an SEC Commissioner is taking a step forward.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.
For FinCEN’s most recent guidance related to cryptocurrency, see HERE.
For a discussion on the enforceability of smart contracts, see HERE.
For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.
For a review of the SEC, FinCEN and CFTC joint statement on digital assets, see HERE.
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SEC Issues Guidance On Proxy Advisory Firms
On August 29, 2019, the SEC issued anticipated guidance related to the application of the proxy rules to proxy advisory firms. Market participants have been very vocal over the years regarding the need for SEC intervention and guidance to rein in the astonishing power proxy advisor firms have over shareholder votes, and therefore public companies in general. The new SEC interpretation clarifies that advice provided by proxy advisory firms generally constitutes a “solicitation” under the proxy rules including the necessity to comply with such rules and the related anti-fraud provisions. On the same day, the SEC issued guidance on the proxy voting responsibilities of investment advisors, including when they use proxy advisory firms. This blog focuses on the guidance directly related to proxy advisory firms.
The SEC has been considering the role of proxy advisors for years. In 2010 it issued a concept release seeking public comment on the role and legal status of proxy advisory firms within the U.S. proxy system. In 2013, the SEC held a roundtable on the use of proxy advisory firm services by institutional investors and investment advisers and in 2014, it issued a Staff Legal Bulletin (SLB 20) to provide guidance about the availability and use of exemptions from the proxy rules by proxy advisory firms. Another roundtable was held in November 2018 on the subject. Although the current guidance is a good step in providing clarification, the SEC is also considering rule amendments directly related to proxy advisory firms.
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. Under Exchange Act Rule 14a-1(l), a solicitation includes, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. Under the SEC’s interpretation, proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation.
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. However, solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Rule 14a-1(l) – Solicitations
Exchange Act Section 14(a)9 applies to any solicitation for a proxy with respect to any security registered Section 12 and authorizes the SEC to establish rules and regulations governing such solicitations. As mentioned above, Exchange Act Rule 14a-1(I) defines a solicitation for purposes of compliance with the federal proxy rules. In particular, the terms “solicit” and “solicitation” include: (i) any request for a proxy whether or not accompanied by or included in a form of proxy; (ii) any request to execute or not to execute, or to revoke, a proxy; or (iii) the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.
The terms do not apply, however, to: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder who does not otherwise engage in a proxy solicitation stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
The new SEC guidance, which is in Q & A format, indicates that solicitations by proxy advisors are reasonably calculated to “result in the procurement, withholding or revocation of a proxy” and, as such, fall within the definition of a solicitation. Finding that proxy advisor solicitations are covered by the rules is consistent with the SEC’s interpretations over the years that the definition is meant to be very broad. The SEC has also consistently stated that the federal proxy rules apply to any person seeking to influence the voting of proxies, regardless of whether the person himself/herself is seeking authorization to act as a proxy. To me it is clear that proxy advisor communications related to a particular vote are clearly solicitations as they both describe the specific proposals and make a voting recommendation.
Proxy advisors can exert a great deal of influence. Many investment advisers retain and pay a fee to proxy advisory firms to provide detailed analyses of various issues, including advice regarding how the investment adviser should vote on the proposals at the registrant’s upcoming meeting. Further proxy advisory firms recommend particular investment advisors based, at least in part, on that investment advisor’s voting history and criteria.
The courts have likewise interpreted the definition of a solicitation expansively. For example, courts have held that a report provided by a broker-dealer to shareholders of the target company in a contested merger constituted a solicitation because it advised the shareholders that one bidder’s offer was “far more attractive” than the other and therefore was a communication reasonably calculated to affect the shareholders’ voting decisions. Similarly, a letter from a shareholder to other shareholders in connection with an annual meeting asking them not to sign any proxies for the company was found to be a solicitation.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition and in Rule 14a-2(b) discussed below and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the new SEC guidance specifically states that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination. On the other hand, I note that when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
Rule 14a-2(b) – Exemptions from filing requirements
Although a proxy advisory firm may be engaged in solicitations, they may be exempt from the information and filing requirements of the federal proxy rules under Rule 14a-2(b). Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” A proxy advisory firm does not seek to vote on behalf of those they solicit or advise.
As an aside I note that the exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a2-(b)(2) provides an exemption from the information and filing requirements of the federal proxy rules when the number of persons being solicited is under 10. This would rarely, if ever, apply to a proxy advisory firm. Rule 14a2-(b)(3) provides an exemption from the information and filing requirements for financial advisors who provide voting advice to their clients subject to certain disclosures such as related party relationships and subject to certain conditions such as the lack of special commissions or compensation for furnishing the voting advice.
Rule 14a2-(b)(4) provides an exemption for certain limited partnership roll-up transactions. Rule 14a2-(b)(5) exempts broker-dealer research reports. Subject to certain timing limitations, Rule 14a2-(b)(6) provides an exemption for “any solicitation by or on behalf of any person who does not seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a shareholder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent, or authorization in an electronic shareholder forum.” Finally, subject to certain conditions, Rule 14a2-(b)(7) provides an exemption for shareholders in connection with the formation of a nominating shareholder group.
Rule 14a-9 – Anti-fraud provisions
The SEC guidance affirms that solicitations that are exempt from the federal proxy rules’ information and filing requirements remain subject to Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact or omits to state any material fact necessary in order to make the statements therein not false or misleading.
Rule 14a-9 also extends to opinions, reasons, recommendations, or beliefs that are disclosed as part of a solicitation. To protect from Rule 14a-9 concerns, opinions and recommendations should disclose underlying facts, assumptions and limitations. The SEC guidance gives specific examples of information that proxy advisory firms should consider providing in respect to their recommendations, including:
- an explanation of the methodology used to formulate its voting advice on a particular matter (including any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters) where the omission of such information would render the voting advice materially false or misleading;
- to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company if such differences are material and the failure to disclose the differences would render the voting advice false or misleading; and
- disclosure about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of those conflicts.
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.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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SEC Proposes Amendments to Accelerated and Large Accelerated Filer Definitions
As promised by SEC Chair Jay Clayton almost a year ago when the SEC amended the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K (see HERE ), on May 9, 2019, the SEC proposed amendments to the definitions of an “accelerated filer” and “large accelerated filer.”
In June 2018, the SEC amended the definition of a smaller reporting company (SRC) to include companies with less than a $250 million public float or if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year. At that time the SEC did not amend the definitions an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRCs remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act (SOX).
Under the proposed amendments, smaller reporting companies with less than $100 million in revenues would not be required to obtain an attestation of their internal control over financial reporting (ICFR) from an independent outside auditor under Section 404 of SOX. In particular, the proposed amendments would exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
The proposed amendments also would increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new proposed amendments will assist with capital formation for smaller companies. The SEC also notes that the proposed amendments are targeted at companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets. Making a reference to a statement by SEC Commissioner Hester Peirce at the time of the amendment to the definition of an SRC expressing her disappointment that the definition of accelerated filer and large accelerated filer were not concurrently changed, in the press release announcing the new proposed rule changes Chair Clayton points out, “[I]nvestors in these lower-revenue companies will benefit from more tailored control requirements. Many of these smaller companies – including biotech and health care companies – will be able to redirect the savings into growing their companies by investing in research and human capital.”
Background
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been fairly constant over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and the introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
| Filer Category | Form 10-K | Form 10-Q |
| Large Accelerated Filer | 60 days after fiscal year-end | 40 days after quarter-end |
| Accelerated Filer | 75 days after fiscal year-end | 40 days after quarter-end |
| Non-Accelerated Filer | 90 days after fiscal year-end | 45 days after quarter-end |
| Smaller Reporting Company | 90 days after fiscal year-end | 45 days after quarter-end |
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and now lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues. I hope the proposed rule changes move quickly through the system.
Detail on Proposed Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million would be both an SRC and an accelerated filer.
The SEC is proposing to amend the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC under the SRC revenue test – i.e., one with less than $100 million in annual revenues during its most recently completed fiscal year. The effect of this proposal would be that such a company would not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement.
The proposed rule change would not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with a float of greater than $75 million but less than $700 million and less than $100 million in revenue would no longer qualify as either an accelerated or large accelerated filer. On the contrary, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the proposed amendments:
| Proposed Relationships between SRCs and Non-Accelerated and Accelerated Filers | ||
| Status | Public Float | Annual Revenue |
| SRC and Non-Accelerated Filer | Less than $75 million | N/A |
| $75 million to less than $700 million | Less than $100 million | |
| SRC and Accelerated Filer | $75 million to less than $250 million | $100 million or more |
| Accelerated Filer (not SRC) | $250 million to less than $700 million | $100 million or more |
The proposed amendments would revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million. Also, the proposed amendments would increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the proposed amendments would allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the proposed amendments on transition provisions:
| Proposed Amendments to the Public Float Thresholds | |||
| Initial Public Float Determination | Resulting Filer Status | Subsequent Public Float Determination | Resulting Filer Status |
| $700 million or more | Large Accelerated Filer | $560 million or more | Large Accelerated Filer |
| Less than $560 million but
$60 million or more |
Accelerated Filer | ||
| Less than $60 million | Non-Accelerated Filer | ||
| Less than $700 million but $75 million or more | Accelerated Filer | Less than $700 million but
$60 million or more |
Accelerated Filer |
| Less than $60 million | Non-Accelerated Filer | ||
Statements of Commissioners on Rule Amendment
SEC Chairman Jay Clayton and Commissioners Jackson, Peirce and Roisman all made statements on the proposed rule changes at an open meeting related to the amendment. Chair Clayton’s speech focuses on the fact that most aspects of ICFR remain unchanged as do the heightened requirements that SOX imposed generally. However, the proposed rules “are aimed at the subset of issuers where the added step of an ICFR auditor attestation is likely to add significant costs and is unlikely to enhance financial reporting or investor protection.” Of course, he is hopeful the change will encourage more companies to access public markets.
Commissioner Hester Peirce (may favorite Commissioner) is true to form, supporting the proposed amendments but wishing they had gone further. As she did when the SEC amended the definition of an SRC, Commissioner Peirce criticizes the fact that there now can be overlap between an SRC and accelerated or large accelerated filer, which can cause confusion. As Commissioner Peirce notes, “[T]he process of determining whether a company is an SRC and a non-accelerated filer, or an SRC and an accelerated filer, or outside of both categories is so complicated that even we at the SEC need diagrams to figure it out. The fact that we ourselves struggling to understand our own regime does not bode well for smaller companies trying to follow our rules without the benefit of a staff of seasoned securities attorneys.” The quote hit home; in writing my blog on the SRC rule change and now this rule change, I started creating a diagram for myself until I found that the SEC had published one as well – it was the only way to follow and understand the interactions. Commissioner Peirce would advocate for a fine line whereby all SRC’s would be non-accelerated filers and exempt from Section 404(b). I agree.
Commissioner Roisman supported the proposed rule changes and, like Commissioner Peirce, wondered whether it went far enough.
Commissioner Jackson, also true to form, does not support the proposed amendment at all as he believes that the risk of corporate management fraud is too high to allow the change. Commissioner Jackson uses WorldCom and Enron as his primary example of management without auditor oversight; however, I note that these companies were behemoths compared to the sector of business affected by the current proposal. Commissioner Jackson also questions the data and analysis used by the SEC to support the proposed amendments and instead gathered his own data. Unfortunately, there is often a disconnect between statistical data and real-world applications and as such, my views remain aligned with Commissioner Peirce.
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