NASDAQ And NYSE American Shareholder Approval Requirement – Equity Based Compensation

Posted by Securities Attorney Laura Anthony | May 7, 2019

Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants; (iii) a change of control (see HERE); and (iv) transactions other than public offerings (see HERE). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.

In this blog I am detailing the shareholder approval requirements related to equity-based compensation of officers, directors, employees or consultants. Other Exchange Rules interplay with the rules requiring shareholder approval for equity issuances and for equity compensation issuances in general. For example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to establishing or materially amending a stock option plan, purchase plan or other equity compensation arrangement pursuant to which stock may be acquired by officers, directors, employees, or consultants without shareholder approval.

Nasdaq Rule 5635(c)

Nasdaq Rule 5635(c) requires shareholder approval prior to the issuance of securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants, except for: (1) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan); (2) tax qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans (including foreign plans complying with applicable foreign tax law), provided such plans are approved by the company’s independent compensation committee or a majority of the company’s Independent Directors; or plans that merely provide a convenient way to purchase shares on the open market or from the company at market value; (3) plans or arrangements relating to an acquisition or merger as permitted under IM-5635-1; or (4) issuances to a person not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to the individual’s entering into employment with the company, provided such issuances are approved by either the company’s independent compensation committee or a majority of the company’s Independent Directors. Promptly following an issuance of any employment inducement grant in reliance on this exception, a company must disclose in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved.

NYSE American Company Guide Section 711

Substantially similar to Nasdaq, the NYSE American Company Guide Section 711 requires shareholder approval with respect to the establishment or material amendments to a stock option or purchase plan or other equity compensation arrangement pursuant to which options or stock may be acquired by officers, directors, employees, or consultants, except for: (1) issuances to an individual, not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to entering into employment with the company provided that such issuances are approved by the company’s independent compensation committee or a majority of the company’s independent directors, and, promptly following an issuance of any employment inducement grant in reliance on this exception, the company discloses in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved; or (2) tax-qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans, provided such plans are approved by the company’s independent compensation committee or a majority of the company’s independent directors; or plans that merely provide a convenient way to purchase shares in the open market or from the issuer at fair market value; or (3) a plan or arrangement relating to an acquisition or merger; or (4) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan).

The NYSE American requires a listed company to notify the exchange in writing if it intends to rely on any of the exemptions.

Interpretation and Guidance

Definition of Consultant

For purposes of this rule, a “consultant” is anyone for whom the company is eligible to use a Form S-8. Accordingly, shareholder approval would be required for stock awards, plans or arrangements for the issuance of equity to: (i) natural persons; (ii) that provide bona fide services to the company; and (iii) whose services are not in connection with the offer or sale of securities in a capital-raising transaction, and who does not directly or indirectly promote or maintain a market for the company’s securities.

Adoption of Plans

A company may adopt an equity plan or arrangement, and grant options (but not shares of stock) thereunder, prior to obtaining shareholder approval provided that: (i) no options can be exercised prior to obtaining shareholder approval, and (ii) the plan can be unwound, and the outstanding options cancelled, if shareholder approval is not obtained. Companies should be aware of any accounting issues that may arise under these circumstances.

A company that has a plan in place at the time of listing on an Exchange would not be required to obtain shareholder approval for that plan, but would be required to obtain approval for future amendments.

Material Amendments

For purposes of the rule, both Exchanges specifically indicate that a material amendment would include, but not be limited to: (i) any material increase in the number of shares to be issued under the plan, including sublimits (other than as a result of a reorganization, stock split, merger or spin-off); (ii) a material increase in benefits including repricing (such as lowering the strike price of an option) or extensions of duration (though a change in a vesting schedule without more is not material); (iii) a material expansion of the class of participants eligible for the plan; or (iv) an expansion of the types of options or awards under the plan, including value for value exchanges.

If a plan allows for the issuance of stock options, adding stock appreciation rights (SARs) to a plan would not be material as SARs are substantially similar to options. Similarly, if a plan allows for the issuance of restricted stock, adding restricted stock units (RSUs) would not be material.

An amendment to increase tax withholding associated with awards to satisfy tax obligations is not considered a material amendment. Likewise, allowing a recipient to surrender unissued shares to satisfy a tax obligation would not be considered a material amendment. Adding a cashless exercise feature is also not a material amendment.

Neither Exchange will require shareholder approval if the plan, by its own terms, allows for specific actions without further approval, including, for example, the re-pricing of options. In order to rely on the ability to amend, the plan must be specific in the terms and actions that are allowed. A general authority to amend will not obviate the need for shareholder approval for what would otherwise be considered a material amendment. Moreover, some pricing changes, such as changing the exercise price from the closing bid price on the day of grant to the average of the high and low market price on the same day, would not require a new approval.

However, if a plan has a formula that allows for automatic increases of the shares available under the plan (“evergreen plan”) or a formula for automatic grants, the plan cannot have a term in excess of ten years unless shareholder approval is obtained every ten years. Plans that do not contain a formula and do not impose a limit on the number of shares available for grant would require shareholder approval of each grant under the plan.

As the rule specifically only applies to equity grants, awards or compensation and not cash, a company could buy back outstanding awards for cash without first seeking shareholder approval.

Mergers

Plans or arrangements involving a merger or acquisition do not require shareholder approval in two situations. First, shareholder approval will not be required to convert, replace or adjust outstanding options or other equity compensation awards to reflect the merger transaction. Second, shares available under certain plans acquired in acquisitions and mergers may be used for certain post-transaction grants without further shareholder approval provided the plan had originally been approved by shareholders.

In particular, where a non-listed company is acquired by or merged with a listed company, the listed company may use shares for post-transaction grants of options and other equity awards without further shareholder approval, provided: (i) the time during which those shares are available for grants is not extended beyond the period when they would have been available under the pre-existing plan, absent the transaction, and (ii) such options and other awards are not granted to individuals who were employed by the granting company or its subsidiaries at the time the merger or acquisition was consummated.

Plans adopted in contemplation of a merger or acquisition will not be considered pre-existing for purposes of this exception. Where an evergreen plan is assumed in a merger, the ten-year period for shareholder approval is measured from the date the target company established the plan.

Any additional shares available for issuance under a plan or arrangement acquired in connection with a merger or acquisition would be counted in determining whether the transaction involved the issuance of 20% or more of the company’s outstanding common stock, thus triggering the shareholder approval requirements under Rule 5635(a) related to mergers and acquisitions.

Source of Shares

A requirement that grants be made out of treasury shares or repurchased shares will not alleviate shareholder approval requirements.

Inducement Exemption

The inducement exemption can only be used for employment, and not consulting, arrangements. However, in some circumstances the exemption may be relied upon to induce a consultant to enter into an employment arrangement. An exchange would consider all facts and circumstances related to the relationship. This exemption can only relied upon in connection with the initial inducement for employment. Accordingly, if an inducement award is materially amended, the amendment would require shareholder approval notwithstanding that the initial award did not.

Likewise, the determination of a “bona fide period of non-employment” requires a facts and circumstances analysis. Generally an exchange will consider: (i) whether there was a relationship between the company and former employee during the time of non-employment; (ii) whether the former employee received payments from the company during the period of non-employment; (iii) the reasons for ending the employment relationship; (iv) whether the former employee was employed elsewhere after leaving the company; and (v) whether there was an agreement or understanding that the employee would return to the company.

For purposes of the required press release disclosure, four days will generally satisfy the “promptly” requirement. A company can aggregate the disclosure of inducements where the inducements were made in connection with a merger or acquisition, or a company regularly offers such awards. In that regard, a company can adopt a plan that will be used solely for inducements, without the necessity of shareholder approval. However, inducement grants made to executive officers must always be individually disclosed.

Parallel Nonqualified Plan

A parallel nonqualified plan means a plan that is a “pension plan” within the meaning of the ERISA Act that is designed to work in parallel with a qualified tax plan to provide benefits that exceed IRS compensation limitations. A plan will not be considered a parallel nonqualified plan unless: (i) it covers all or substantially all employees of an employer who are participants in the related qualified plan whose annual compensation is in excess the compensation limits; (ii) its terms are substantially the same as the qualified plan that it parallels except for the elimination of the limitations; and, (iii) no participant receives employer equity contributions under the plan in excess of 25% of the participant’s cash compensation.

Below Market Sales

The private sale of securities to officers, directors, employees or consultants at a price less than market value is considered a form of “equity compensation” and, as such, requires shareholder approval. For purposes of this rule, market value is the consolidated closing bid price immediately preceding the time the company enters into a binding agreement to issue the securities. Shareholder approval would not be required if the officer, director, employee or consultant was purchasing securities from the company in a public offering.

Issuances to an entity controlled by an officer, director, employee, or consultant of the a company may also be considered equity compensation under certain circumstances, such as where the issuance would be accounted for under GAAP as equity compensation or result in the disclosure of compensation under Regulation S-K.

Broker Votes

Broker-dealers may not vote client proxies on equity compensation plans unless the beneficial owner of the shares has given voting instructions. That is, equity compensation plans are considered “non-routine” items prohibiting broker votes on behalf of their clients.

Foreign Private Issuers

Although the rule applies to foreign private issuers, if such issuer is otherwise following its home country practices in accordance with the Exchange rules, it can do so related to this shareholder approval requirement as well.

Consequences for Violation

This rule is strictly construed and, as such, all plans or material amendments to a plan, regardless of the number of shares under the plan or arrangement, require shareholder approval. Consequences for the violation of any of the Exchange’s rules, including shareholder approval rules, can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.

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Mergers And Acquisitions; Board Of Directors Responsibilities – Delaware

Posted by Securities Attorney Laura Anthony | April 30, 2019

Recently the Delaware Chancery Court rejected an interested executive’s defense of a breach of fiduciary duty claim, reminding us of the importance of making full and accurate disclosures when seeking shareholder approval for a merger or acquisition transaction. In particular, in the case of In re Xura, Inc. Stockholder Litigation the Delaware Chancery Court denied a motion to dismiss brought against a merger target company’s CEO, alleging that he had orchestrated the company’s sale to a particular bidder based on his self-interest in the outcome of the transaction.

The CEO argued that his actions should have been judged by the deferential business judgement rule and not a higher entire fairness standard because the transaction was approved by a majority of the disinterested shareholders. The CEO relied on the 2015 Delaware Supreme Court case of Corwin v. KKR Financing Holdings which held that a transaction that would be subject to enhanced scrutiny would instead be reviewed under the deferential business judgment rule after it was approved by a majority of fully informed stockholders. However, the Court found that the stockholder’s vote was not fully informed as the proxy statement failed to make numerous material disclosures and, as such, could not be used as the usual defense for officers and directors with a stake in the outcome of a transaction.

Board of Directors’ and Key Officers Fiduciary Duties in the Merger Process

State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Key executive officers have a similar duty. Generally a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).

However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from the Unocal and Revlon cases discussed below, both of which involved hostile takeovers.

A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders such as where directors are on both sides of the transaction.  Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms. The entire fairness standard is a difficult bar to reach and generally results in in a finding in favor of complaining shareholders.

In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation.  The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation. Where a director’s duty is to the shareholders, an executive officer can have duties to both the board of directors and the shareholders.

As with many aspects of securities law, and the law in general, a director’s or officer’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors or key executives is reduced and only the basic business judgment rule will apply.  For instance, in instances where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers who, in turn, will be able to exercise their business judgment in implementing the transactions.

Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective is maximizing the return to shareholders, though social interests and considerations (such as the loss of jobs) may also be considered in the process.

The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision.  The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for and review of documents and contracts.

In the performance of their obligations and fiduciary responsibilities, a board of directors and executive officers may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction.  Most investment banking houses that do M&A work also provide fairness opinions on transactions.  Furthermore, most firms will prepare a fairness opinion even if they are not otherwise engaged or involved in the transaction.  In addition to adding a layer of protection to the board of directors and executives, the fairness opinion is utilized by the accountant and auditor in determining or supporting valuations in a transaction, especially where a related party is involved.  This firm has relationships with many firms that provide such opinions and encourage our clients to utilize these services.

Delaware Case Law

As with all standards of corporate law, practitioners and state courts look to both Delaware statutes and court rulings to lead the way.

Stemming from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), once a board of directors has made the decision to sell or merge the company, it triggers additional duties and responsibilities, commonly referred to as the “Revlon Duties.” The Revlon Duties provide that once a board has made a decision to sell, it must consider all available alternatives and focus on obtaining the highest value and return for the shareholders. The Revlon case focuses on duties in a sale or breakup of a company rather than a forward growth acquisition.  A board of directors in a Revlon situation is, in essence, acting as an auctioneer seeking the best return. However, although the premise of Revlon remains, later decisions take into account the reality that the highest return for shareholders is not strictly limited to dollars received.

Company executives do not have to decide to sell just because an offer has been made. Prior to Revlon, in the case of Unocal vs. Mesa Petroleum, 493 A.2d 946 (Del. 1985), the court found that a board of directors may take defensive measures in the face of a hostile takeover attempt and may consider the preservation of corporate policy and effectiveness of business operations in defending against a takeover. However, once the board has made the decision that a sale or breakup is imminent, the Revlon Duties are invoked and preservation of corporate policy and operations is no longer a deciding factor.

In the case of Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985), the Court found that the board was grossly negligent where it approved the sale of the company after only a few hours of deliberation, failed to inform itself of the chairman’s role and benefits in the sale, and did not seek the advice of outside counsel.  Similarly in Cede & Co. vs. Technicolor, Inc., 634 A.2d 345 (Del. 1993), the court found that the board was negligent in approving the sale of a company where it did not search for real alternatives, did not attempt to find a better offer, and had insufficient knowledge of the terms of the proposed merger agreement.

On the other hand, the court in In re CompuCom Sys., Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS 145 (Del. Ch. Sept. 29, 2005), upheld the board of directors’ business judgment even though the transaction price per share was less than market value, as the board showed it was adequately informed, acted rationally and sought better deals.

In Family Dollar Stores, Inc. Stockholder Litigation, C.A. No. 9985-CB (Del. Ch. Dec. 19, 2014), the court continued to apply the Revlon Duties but supported Family Dollar Stores’ decision to reject Dollar General Corp.’s higher dollar offer in favor of seeking a shareholder vote on Dollar Tree, Inc.’s offer. The court found that the board properly considered all factors, including an evaluation of the relative antitrust risks of selling to either suitor. The court upheld the board’s process in determining maximum value for shareholders, and that such determination is not solely based on a price per share value.

Cleansing Through Shareholder Approval

In 2015 the Delaware Supreme Court case of Corwin v. KKR Financing Holdings held that a transaction that would be subject to enhanced scrutiny under Revlon would instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders. In addition to federal securities law requirements imposed on public companies, Delaware law requires disclosure of all material facts when stockholders are requested to vote on a merger. (For more on materiality and the duty to disclose, see HERE and HERE . Corwin provides a strong incentive for companies to ensure full disclosure and as discussed below, based on the new case of In re Xura, Inc. Stockholder Litigation the failure to provide such disclosure may nullify the otherwise strong Corwin defense.

Following the Corwin decision, several Delaware courts enhanced the ruling, finding that the business judgment rule becomes irrebuttable if invoked as a result of a stockholder vote; Corwin is not limited to one-step mergers and thus also applies where a majority of shares tender into a two-step transaction; the ability of plaintiffs to pursue a “waste” claim is exceedingly difficult; even interested officers and directors can rely on the business judgement rule following Corwin doctrine stockholder approval; and if directors are protected under Corwin, aiding and abetting claims against their advisors will also be dismissed.

Once the business judgment rule is invoked, a shareholder generally only has a claim for waste, which is a difficult claim to prove. Corwin makes it difficult for plaintiffs to pursue post-closing claims (including those that would have nuisance value) because defendants will frequently be able to dismiss the complaint at the pleading stage based on the stockholder vote. It is thought that Corwin will help reduce M&A-based litigation which has become increasingly abusive over the years and imposes costs on companies, its stockholders and the marketplace.

Corwin should also be considered in conjunction with the Delaware Supreme Court’s 2014 decision in Cornerstone Therapeutics Inc. Shareholder Litigation in which the Supreme Court held that directors can seek dismissal even in an entire fairness case unless the plaintiff sufficiently alleges that those directors engaged in non-exculpated conduct (i.e., disloyal conduct or bad faith). Cornerstone generally allows an outside, independent director to be dismissed from litigation challenging an interested transaction unless the plaintiff alleges a breach of the duty of loyalty against that director individually. The Corwin case goes further by providing that if there is an informed stockholder vote, then directors who are interested or lack independence can obtain dismissal without having to defend the fairness of the transaction.

Although following Corwin a string of cases strengthened and expanded its doctrine, the recent (December 2018) case of In re Xura, Inc. Stockholder Litigation reminded the marketplace that in order for Corwin to provide its protections, the stockholder approval must be fully informed. In Xura the court found that the disclosures made by the CEO to the board of directors and shareholders and that ultimately were included in the company’s proxy statement were so deficient as to preclude a fully informed, uncoerced decision. The takeaway from Xura is that despite growing officer/director protections in an M&A transaction, process and disclosure remain the bedrock of any defense.

Conflicts of Interest – the Entire Fairness Standard

The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or non-corporate purpose, including to preserve their job or position. Where a transaction is not cleansed using the Corwin doctrine, where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.

Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions.  Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.

The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director).  In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive.  The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.

To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive inform both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.

Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. As mentioned, many companies obtain third-party fairness opinions as to the transaction.

Exculpation and Indemnification

Many states’ corporate laws allow entities to include provisions in their corporate charters allowing for the exculpation and/or indemnification of directors. Exculpation refers to a complete elimination of liability, whereas indemnification allows for the reimbursement of expenses incurred by an officer or director. Delaware, for example, allows for the inclusion of a provision in the certificate of incorporation eliminating personal liability for directors in stockholder actions for breaches of fiduciary duty, except for breaches of the duty of loyalty that result in personal benefit for the director to the detriment of the shareholders. Indemnification generally is only available where the director has acted in good faith. Exculpation is generally only available to directors, whereas indemnification is available to both officers and directors.

To show that a director acted in good faith, the director must meet the same general test of showing that they met their duties of care, loyalty and disclosure. The best way to do this is to be fully informed and to participate in the process, whether that process involves a merger or acquisition or some other business transaction. As mentioned above, courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for, and review of, documents and contracts.

Conclusion

In advising the board of directors and executive officers, counsel should stress that the executive be actively involved in the business decision-making process, review the documents and files, ask questions and become fully informed. The higher the level of diligence, the greater the protection. Furthermore, an executive must fully and completely inform its fellow executives, board members and shareholders of all facts and circumstances and any potential self-interest.

Significantly, it is not important whether the decision ultimately turns out to be good or bad. Hindsight is 20/20. The important factor in seeking protection (via the business judgment rule, and through exculpation and indemnification) is that best efforts are made.

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NYSE American Compliance Guidance MEMO

Posted by Securities Attorney Laura Anthony | February 26, 2019 Tags: NYSE, NYSE American Compliance Guidance MEMO

In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies. The annual letter updates companies on any rule changes from the year and reminds companies of items the NYSE deems important enough to warrant such a reminder.

The only new item in this year’s letter relates to advance notice of stock dividends and distributions. Effective February 1, 2018, the NYSE requires listed companies to provide ten minutes’ advance notice to the exchange of any announcement with respect to a dividend or stock distribution, whether the announcement is during or outside exchange traded hours. This change is consistent with other NYSE and Nasdaq rules which generally require notifications of announcements, including press releases, that could impact trading, at least 10 minutes prior to such notification.

The NYSE letter also provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news. Part 4 of the Company Guide requires listed companies to promptly release to the public any news or information which might reasonably be expected to materially affect the market for its securities. Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FDcompliant method. Furthermore, for news being released between 7:00 a.m. and 4:00 p.m. Eastern time, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email. As noted above, where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement.

The NYSE includes examples of material news such as earnings, mergers/acquisitions, executive changes, redemptions/conversions, securities offerings and pricings related to these offerings, major product launches, regulatory rulings, new patent approvals and dividend or major repurchase announcements. Once notified, NYSE Marketwatch will determine if a temporary trading halt should be effected to allow the market time to fully absorb the news. Also, if the news is being released between 7:00 a.m. and 9:25 a.m., the company can request a temporary trading halt.

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

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

The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information. It is widely believed that insider trading rules are in need of an overhaul. Generally, insider trading refers to buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. For more information, see HERE.

The compliance letter also addresses the following matters:

Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 704 of the Company Guide, which requires that a company hold an annual meeting during each fiscal year.

Record Date Notification – Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date.  Record dates should be set for business days.

Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security.  The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards.

Annual Report Website Posting Requirement – Section 610(a) of the Company Guide requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC.

Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements.  The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC.

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

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

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

Shareholder Approval and Voting Rights Requirements – Sections 711 through 713 of the Company Guide outline the Exchange’s shareholder approval requirements including the 20% rules.  Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).

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

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The Treasury Department Report To The President On FinTech And Innovation

Posted by Securities Attorney Laura Anthony | January 22, 2019

This summer, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Nonbank Financials, Fintech and Innovation” (the “Treasury Report”). The Treasury Report was issued in response to an executive order dated February 3, 2017 which has resulted in a series of such reports. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports. For a summary of the Treasury Department Report on Capital Markets, see HERE.

The Core Principles identified in the executive order are:

1. Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
2. Prevent taxpayer-funded bailouts;
3. Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
4. Enable American companies to be competitive with foreign firms in domestic and foreign markets;
5. Advance American interests in international financial regulatory negotiations and meetings;
6. Make regulation efficient, effective, and appropriately tailored; and
7. Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

This blog will summarize key portions of the 222-page report; however, for those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken down by category.

Interestingly, the Treasury Report opts not to provide any detailed coverage on blockchain, distributed ledger technologies or digital assets, instead finding that topic to be significant enough to warrant stand-alone treatment. The Treasury Department is party of an interagency working group of the Financial Stability Oversight Council focused on this new area of technology and capital resources.

 Non-bank Financials, Fintech, and Innovation

A non-bank financial firm provides financial services, including extending credit; providing investment advice; executive retail investment transactions; processing payments; facilitating back-end check processing; enabling card issuance, processing, and network activities; and providing customer-facing digital payments software. As such, non-bank financial firms play an important role in the U.S. economy.

During the financial crisis, the government wrote far-reaching laws that mandated the adoption of hundreds of new regulations, many of which either limited certain services by banks or made them unprofitable. As a result, the financial service sector grew rapidly. Importantly, capital is available for companies in the financial services and fintech sectors. The financing of financial services firms has reached in excess of $22 billion globally, and such firms now make up more than 36% of all U.S. personal loans, up from less than 1% in 2010.

In addition, at the same time, the rapid development of financial technology enabled financial services firms to improve operational efficiencies and lower regulatory compliance costs. The Treasury Report succinctly notes, “[S]ince the financial crisis, there has been a proliferation in technological capabilities and processes at increasing levels of cost effectiveness and speed. The use of data, the speed of communication, the proliferation of mobile devices and applications, and the expansion of information flow all have broken down barriers to entry for a wide range of startups and other technology-based firms that are now competing or partnering with traditional providers in nearly every aspect of the financial services industry.”

There are abundant examples of significant changes in the world economy. Digital advice platforms make financial planning and wealth management tools available to all households regardless of income level. Technology provides options for the unbanked and underbanked population through mobile-based applications. Consumer and mortgage lending are all available online in a shorter process than ever before. Payment processors allow for quick and easy transactions between businesses and consumers and person-to-person among friends sharing a bill. Cloud computing, machine learning, artificial intelligence, blockchain and distributed ledger technologies are likewise revolutionizing the financial service sectors.

Issues and Recommendations

The Treasury Report groups its recommendations into four categories: (i) adapting regulatory approaches to changes in the aggregation, sharing and use of consumer financial data and support competitive technologies; (ii) aligning the regulatory framework to eliminate regulatory fragmentation and support new business models; (iii) updating activity-specific regulations, especially those that are outdated by technological advances; and (iv) advocating an approach that supports responsible experimentation in the financial sector and helps America be competitive internationally.

Specific recommendations include:

Consumer Financial Data

The Treasury Report recommendations focus on improving consumers’ access to data and its use by third parties to support better delivery of services. In particular, there are numerous regulations and regulatory uncertainties that act as impediments for financial service companies and data aggregators desiring to establish data sharing agreements. The Treasury Report also recommends that Congress enact a federal data security and breach notification law to protect consumer financial data and ensures that consumers are notified of breaches in a timely manner.

Eliminating Regulatory Fragmentation and Supporting New Business Models

Treasury makes numerous recommendations for removing regulatory burdens and fragmentation and for new regulations that will support cloud technologies, machine learning, and artificial intelligence into financial services. Treasury also recommends a more unified state law system, including the drafting of model laws and unifying licensing processes across states. Treasury supports Vision 2020, an effort by the Conference of State Bank Supervisors that includes establishing a Fintech Industry Advisory Panel to help improve state regulation, harmonizing multi-state supervisory processes, and redesigning the Nationwide Multistate Licensing System.

Further at the federal level, Treasury encourages the development of a special-purpose national bank charter for non-bank financial service providers.  Interestingly, on the same day as the release of the Treasury Report, the Office of the Comptroller of the Currency announced that it would begin accepting applications for special-purpose national bank charters from financial technology companies that don’t take deposits.  As of the date of this blog, no such charters have yet been issued. Moreover, the Conference of State Bank Supervisors (CSBS) has filed a federal lawsuit claiming the program is illegal.

The Treasury Report also encourages banking regulators to clarify guidance regarding bank partnerships with non-bank financial firms, encouraging such partnerships, especially those that promote innovation. Furthermore, Treasury makes recommendations regarding changes to permissible activities, including bank activities related to acquiring or investing in non-bank platforms.

 Updating Activity-specific Regulations

Specific areas with recommendations for regulatory reform include:

• Marketplace lending – The Treasury Report recommends eliminating constraints on relationships between non-bank and bank lenders, codifying the “valid when made” doctrine and the role of the bank as the “true lender” of loans it makes.
• Mortgage Lending and Servicing – Non-bank financial firms now originate approximately half of all new mortgages. Regulatory changes should encourage broad primary market participation and the adoption of technological developments, shorten origination timelines, facilitate efficient loss mitigation and generally help deliver a more reliable, lower-cost mortgage product.
• Student Lending and Servicing – The federal student loan program represents more than 90% of outstanding student loans and is managed by a network of non-banks for servicing and collection. The Treasury Report recommends that the U.S. Department of Education establish minimum effective servicing standards and the increased use of technology for communication with borrowers, monitoring and management.
• Short-Term, Small Dollar Lending – Treasury recommends that the Bureau of Consumer Financial Protection rescind its Payday Rule as state regulations are adequate. The goal is to encourage access to short-term, small-dollar installment lending by both non-bank and bank financial institutions.
• Debt Collection – Treasury recommends that the Bureau establish minimum effective federal standards for third-party debt collectors, including standards for the information that must be transferred with the debt for purposes of third-party collection or sale.
• New Credit Models and Data – Regulators should provide regulatory clarity for the use of new data and modeling approaches that are generally recognized as providing predictive value.
• Credit Bureaus – Credit bureaus are not routinely monitored for the privacy provisions and data security requirements under the federal Gramm-Leach-Bliley Act and as such, the Treasury Report recommends that processes be put into place for such monitoring. Treasury also recommends that Congress amend the Credit Repair Organizations Act to exclude national credit bureaus and national credit scorers in order to allow these entities to provide credit education and counseling services to consumers to prospectively improve their credit scores.
• IRS Income Verification – The Internal Revenue Service (IRS) system that lenders and vendors use to obtain borrower tax transcripts is outdated and should be modernized in order to minimize delays in accessing tax information, which would facilitate the consumer and small business credit origination process.
• Payments – Treasury recommends that the states work to harmonize money transmitter requirements for licensing and supervisory examinations, and urges the Bureau to provide more flexibility regarding the issuance of remittance disclosures. Treasury encourages the Federal Reserve to move quickly in facilitating a faster retail payments system, such as through the development of a real-time settlement service that would allow for more efficient and widespread access to innovative payment capabilities.
• Wealth Management and Digital Financial Planning – Under the current regulatory structure, financial planners may be regulated at both the federal and state levels. Although many financial planners are regulated by the SEC or state securities regulators, they may also be subject to regulation by the Department of Labor, the Bureau, federal or state banking regulators, state insurance commissioners, state boards of accountancy, and state bars. This patchwork of regulatory authority increases costs and potentially presents unnecessary barriers to the development of digital financial planning services. Treasury recommends that an appropriate existing regulator of a financial planner be tasked with primary oversight of that financial planner and other regulators defer to that regulator.

Supporting Experimentation in the Financial Sector

The theme of the Treasury Report is to support innovation and permit experimentation and changes in the financial services industry. Many other countries have created innovation facilitators and other groups to test new technologies in the financial sector. Unfortunately the fragmentation of the U.S. regulatory system makes it more difficult for the U.S. to maintain global competitiveness. The Treasury Report recommendations focus on defragmenting the regulatory system and supporting innovative changes.

 

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SEC Updates CDI Related to Smaller Reporting Company Definition

Posted by Securities Attorney Laura Anthony | January 8, 2019 Tags: SEC Updates CDI Related to Smaller Reporting Company Definition

On June 28, 2018, the SEC adopted the much-anticipated amendments to 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.  For more information on the new rules, see HERE

Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.

As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float. Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.

The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.” As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that 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. However, Chair Clayton has directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.  On November 7, 2018, the SEC made conforming changes to its Compliance and Disclosure Interpretations (C&DI).

In particular, the SEC issued four new C&DI to reflect the impact of the larger size threshold for SRC status and withdrew four C&DI addressing transition issues for SRCs and two additional obsolete C&DI which still referred to the old Regulation S-B.

New C&DI 102.01 illustrates that, under the new amendments, companies can now be both accelerated filers and SRCs, which means that, as SRCs, they can use the scaled disclosure rules but, as accelerated filers, their periodic reports are due under the time frames for accelerated filers and they must provide Sarbanes-Oxley Section 404(b) auditor attestation reports in their 10-Ks. In an example, a company was an accelerated filer with respect to filings due in 2018 and had a public float of $80 million on the last business day of its second fiscal quarter of 2018. Because its public float at that measurement date was below $250 million, the company would qualify as an SRC for filings due in 2019; however, it would also need to file its 10-K within 75 days as an accelerated filer and would need to comply with Section 404(b).  Since the company was an accelerated filer with respect to filings due in 2018, it would be required to have less than $50 million in public float on the last business day of its second fiscal quarter in 2018 to exit accelerated filer status for filings due in 2019.

New C&DI 102.02 recaps the circumstances under which a reporting company that fails to qualify as an SRCcan later re-qualify if its revenues or public float decreases. Once a reporting company determines that it does not qualify as a smaller reporting company, it will remain unqualified unless, when making a subsequent annual determination, either:

• It determines that its public float is less than $200 million; or
• It determines that:

(i) for any threshold that it previously exceeded, it is below the subsequent annual determination threshold (public float of less than $560 million and annual revenues of less than $80 million); and

(ii) for any threshold that it previously met, it remains below the initial determination threshold (public float of less than $700 million or no public float and annual revenues of less than $100 million).

The C&DI provides an example where the company had exceeded one of the caps, but not the other: “A company has a December 31 fiscal year end. Its public float as of June 28, 2019 was $710 million and its annual revenues for the fiscal year ended December 31, 2018 were $90 million. It therefore does not qualify as a smaller reporting company. At the next determination date, June 30, 2020, it will remain unqualified unless it determines that its public float as of June 30, 2020 was less than $560 million and its annual revenues for the fiscal year ended December 31, 2019 remained less than $100 million.”

New C&DI 202.01 provides that in calculating annual revenues to determine whether a company qualifies as a SRC as defined in Regulation S-K, the company should include all annual revenues on a consolidated basis.  As such, a holding company with no public float as of the last business day of its second fiscal quarter would qualify as a smaller reporting company only if it had less than $100 million in consolidated annual revenues in the most recently completed fiscal year for which audited financial statements are available.

New C&DI 104.13 confirms that a company that is transitioning from an SRC (in the example, the company qualifies as an SRC in 2019 but will no longer qualify in 2020 based on its public float on the last day of its 2019 second quarter) may still rely on General Instruction G(3) to incorporate by reference executive compensation and other disclosure required by Part III of Form 10-K into the 2019 Form 10-K from its definitive proxy statement to be filed not later than 120 days after its 2019 fiscal year-end.

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The SEC Has Issued New Guidance On Cybersecurity Disclosures

Posted by Securities Attorney Laura Anthony | March 27, 2018 Tags: The SEC Has Issued New Guidance On Cybersecurity Disclosures

On February 20, 2018, the SEC issued new interpretative guidance on public company disclosures related to cybersecurity risks and incidents. In addition to addressing public company disclosures, the new guidance reminds companies of the importance of maintaining disclosure controls and procedures to address cyber-risks and incidents and reminds insiders that trading while having non-public information related to cyber-matters could violate federal insider-trading laws.

The prior SEC guidance on the topic was dated, having been issued on October 13, 2011. For a review of this prior guidance, see HERE. The new guidance is not dramatically different from the 2011 guidance.

Introduction

The topic of cybersecurity has been in the forefront in recent years, with the SEC issuing a series of statements and creating two new cyber-based enforcement initiatives targeting the protection of retail investors, including protection related to distributed ledger technology (DLT) and initial coin or cryptocurrency offerings (ICO’s). Moreover, the SEC has asked the House Committee on Financial Services to increase the SEC’s budget by $100 million to enhance the SEC’s cybersecurity efforts. See my two-part blog series, including a summary of the recent speeches and initiatives, HERE and HERE.

The SEC incorporates cybersecurity considerations in its disclosure and supervisory programs, including in the context of its review of public company disclosures, its oversight of critical market technology infrastructure, and its oversight of other regulated entities, including broker-dealers, investment advisors and investment companies. Considering rapidly changing technology and the proliferation of cybersecurity incidents affecting both private and public companies (including a hacking of the SEC’s own EDGAR system and a hacking of Equifax causing a loss of $5 billion in market cap upon disclosure), threats and risks, public companies have been anticipating a needed update on the SEC disclosure-related guidance.

SEC Commissioner Kara Stein’s statement on the new guidance is grim on the subject, pointing out that the risks and costs of cyberattacks have been growing and could result in devastating and long-lasting collateral affects. Commissioner Stein cites a Forbes article estimating that cyber-crime will cost businesses approximately $6 trillion per year on average through 2021 and an Accenture article citing a 62% increase in such costs over the last five years.

Commissioner Stein also discusses the inadequacy of the 2011 guidance in practice and her pessimism that the new guidance will properly fix the issue.  She notes that most disclosures are boilerplate and do not provide meaningful information to investors despite the large increase in the number and sophistication of, and damaged caused by, cyberattacks on public companies in recent years. Commissioner Stein includes a list of requirements that she would have liked to see in the new guidance, including, for example, a discussion of the value to investors of disclosing whether any member of a company’s board of directors has experience, education, expertise or familiarity with cybersecurity matters or risks.

I have read numerous media articles and blogs related to the disclosure of cyber-matters in SEC reports. One such blog was written by Kevin LaCroix and published in the D&O Diary. Mr. LaCroix’s blog points out that according to a September 19, 2016, Wall Street Journalarticle, cyber-attacks are occurring more frequently than ever but are rarely reported. The article cites a report that reviewed the filings of 9,000 public companies from 2010 to the present and found that only 95 of these companies had informed the SEC of a data breach.

As reported in a blog published by Debevoise and Plimpton, dated September 12, 2016, (thank you, thecorporatecounsel.net), a review of Fortune 100 cyber-reporting practices revealed that most disclosures are contained in the risk-factor section of regular periodic reports such as Forms 10-Q and 10-K, as opposed to interim disclosures in a Form 8-K. Moreover, only 20 incidents were reported at all in the period from January 2013 through the third quarter of 2015.

However, as Commissioner Stein notes, the SEC only has so much authority or power through guidance, as opposed to rulemaking.  Commissioner Stein strongly advocates for new rulemaking in this regard. I do not think in the current environment advocating for fewer rules, that rulemaking related to cybersecurity disclosure will be made a priority. Moreover, I would not advocate for in-depth or robust further rules.  Disclosure is based on materiality, and a company has an ongoing obligation to disclose any material information, including that which is related to cybersecurity matters. I think the SEC can question principals-based specific disclosures, and whether they are robust enough, through review and comment on public company filings.  Certainly, the SEC staff, who reviews thousands of filings, has the knowledge of a lack of cybersecurity disclosure and can comment. In fact, if the SEC wrote a few standard cybersecurity-related disclosure comments and included them in a lot of comment letters, the marketplace would respond accordingly and beef up disclosure to avoid the comments.

Although I do not generally advocate for additional rules, Commissioner Stein makes one suggestion that I would support and that is adding the disclosure of cybersecurity event to the Form 8-K filing requirements. Although the new SEC guidance does not specifically require a Form 8-K, in light of the importance of these events, it seems it would be appropriate and the guidance itself requires “timely disclosure.”  However, without a specific requirement, a company could elect to disclose via a press release and/or the filing of a Form 8-K under Item 7.01 Regulation FD disclosure. When disclosing using a press release and Regulation FD item in a Form 8-K, a company may elect for the information to be “furnished, not filed.” Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The antifraud provisions under Rule 10b-5 would still apply to the disclosure, but the stricter Section 18 liability would not.

New Guidance on Public Company Cybersecurity Disclosures

The new guidance begins with an introduction describing the importance of cybersecurity in today’s business world, driving the point home by comparing it to the importance of electricity. 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.

The purpose of a cyber-attack can vary as much as the methodology used, including for financial gain such as the theft of financial assets, intellectual property or sensitive personal information on the one hand, to a vengeful or terrorist motive through business disruption on the other hand. Perpetrators may be insiders and affiliates, or third parties including cybercriminals, competitors, nation-states and “hacktivists.”

When victim to a cyber-attack or incident, a company will have direct financial and indirect negative consequences, including but not limited to:

• Remediation costs, including liability for stolen assets, costs of repairing system damage, and incentives or other costs associated with repairing customer and business relationships;
• Increased cybersecurity protection costs to prevent both future attacks and the potential damage caused by same. These costs include organizational changes, employee training and engaging third-party experts and consultants;
• Lost revenues from unauthorized use of proprietary information and lost customers;
• Litigation;
• Increased insurance premiums;
• Damage to the company’s competitiveness, stock price and long-term shareholder value; and
• Reputational damage.

Whereas the 2011 disclosure guidance was conservative in its tone, trying to strike a balance between satisfying the disclosure mandates of providing material information related to risks to the investing community with a company’s need to refrain from providing disclosure that could, in and of itself, provide a road map to the very breaches a company attempts to prevent, the new guidance is more blunt in the critical need to inform investors about material cybersecurity risks and incidents when they occur.

A company’s ability to timely and properly make any required disclosure of cybersecurity risks and incidents requires the company to implement and maintain disclosure controls and procedures that provide an appropriate method of discerning the impact that such matters may have on the company and its business, financial condition, and results of operations, as well as a protocol to determine the potential materiality of such risks and incidents.

Insider Trading

It is also important that public company officers, directors and other insiders respect the importance and materiality of cybersecurity risk and incident knowledge and not trade a company’s security when in possession of non-public information related to cybersecurity matters.  In that regard, companies should include cybersecurity matters in their insider trading policies and procedures. These insider trading policies should (i) guard against trading in the period between when a company learns of a cybersecurity incident and the time it is made public; and (ii) require the timely disclosure of such non-public information.

Guidance

Public companies have many disclosure requirements, including through periodic reports on Forms 10-K, 10-Q and 8-K, through Securities Act registration statements such as on Forms S-1 and S-3 and generally through the antifraud provisions of both the Exchange Act and Securities Act, which requires a company to disclose “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” The SEC considers omitted information to be material if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or that disclosure of the omitted information would have been viewed by the reasonable investor as having significantly altered the total mix of information available.

As with all disclosure requirements, the disclosure of cybersecurity risk and incidents requires a materiality analysis. Although there continues to be no specific disclosure requirement or rule under either Regulation S-K or S-X that addresses cybersecurity risks, attacks or other incidents, many of the disclosure rules encompass these disclosures indirectly, such as risk factors, internal control assessments, management discussion and analysis, legal proceedings, disclosure controls and procedures, corporate governance and financial statements. As mentioned, as with all other disclosure requirements, an obligation to disclose cybersecurity risks, attacks or other incidents may be triggered to make other required disclosures not misleading considering the circumstances.

A company has two levels of cybersecurity disclosure to consider. The first is its controls and procedures and corporate governance to both address cybersecurity matters themselves and to address the timely and thorough reporting of same. The second is the reporting of actual incidents.  In determining the materiality of a particular cybersecurity incident, a company should consider (i) the importance of any compromised information; (ii) the impact of an incident on company operations; (iii) the nature, extent and potential magnitude of the event; and (iv) the range of harm such incident can cause, including to reputation, financial performance, customer and vendor relationships, litigation or regulatory investigations.

Of course, the new guidance is also clear that a company would not need to disclose the depth of information that could, in and of itself, provide information necessary to breach cyber-defenses. A company would not need to disclose specific technical information about cybersecurity systems, related networks or devices or specific devices and networks that may be more susceptible to attack due to weaker systems.

The new guidance also reminds companies that they have a duty to correct prior disclosures that the company determines were untrue at the time material information was made or omitted, and to update disclosures that become inaccurate after the fact.

Like the prior guidance, the new guidance provides specific input into areas of disclosure.

Risk Factors

Obviously, where appropriate, cybersecurity risks need to be included in risk factor disclosures. The SEC guidance in this regard is very common-sense. Companies should evaluate their cybersecurity risks and take into account all available relevant information, including prior cyber-incidents and the severity and frequency of those incidents. Companies should consider the probability of an incident and the quantitative and qualitative magnitude of the risk, including potential costs and other consequences of an attack or other incident.  Consideration should be given to the potential impact of the misappropriation of assets or sensitive information, corruption of data or operational disruptions. A company should also consider the adequacy of preventative processes and plans in place should an attack occur.  Actual threatened attacks may be material and require disclosure.

As with all risk-factor disclosures, the company must adequately describe the nature of the material risks and how such risks affect the company. Likewise, generic risk factors that could apply to all companies should not be included. Risk factor disclosure may include:

• Discussion of the company’s business operations that give rise to material cybersecurity risks and the potential costs and consequences, including industry specific risks and third-party and service-provider risks;
• The costs associated with maintaining cybersecurity protections, including insurance coverage;
• The probability of an occurrence and its potential magnitude;
• Potential for reputational harm;
• Description of past incidents, including their severity and frequency;
• The adequacy of preventative actions taken to reduce cybersecurity risks and the associated costs, including any limits on the company’s ability to prevent or mitigate risks;
• Existing and pending laws and regulations that may affect the companies cybersecurity requirements and the associated costs; and
• Litigation, regulatory investigation and remediation costs associated with cybersecurity incidents.

Management Discussion and Analysis (MD&A)

In MD&A a company should consider all the same factors that it would consider in its risk factors.  A company would need to include discussion of cybersecurity risks and incidents in its MD&A if the costs or other consequences associated with one or more known incidents or the risk of potential future incidents result in a material event, trend or uncertainty that is reasonably likely to have a material effect on the company’s results of operations, liquidity or financial condition, or could impact previously reported financial statements. The discussion should include any material realized or potential reduction in revenues, loss of intellectual property, remediation efforts, maintaining insurance, increase in cybersecurity protection costs, addressing harm to reputation and litigation and regulatory investigations.  Furthermore, even if an attack did not result in direct losses, such as in the case of a failed attempted attack, but does result in other consequences, such as a material increase in cybersecurity expenses, disclosure would be appropriate.

Business Description; Legal Proceedings

Disclosure of cyber-related matters may be required in a company’s business description where they affect a company’s products, services, relationships with customers and suppliers or competitive conditions. Likewise, material litigation would need to be included in the “legal proceedings” section of a periodic report or registration statement. The litigation disclosure should include any proceedings that relate to cybersecurity issues.

Financial Statements

Cyber-matters may need to be included in a company’s financial statements prior to, during and/or after an incident. Costs to prevent cyber-incidents are generally capitalized and included on the balance sheet as an asset. GAAP provides for specific recognition, measurement and classification treatment for the payment of incentives to customers or business relations, including after a cyber-attack.  Cyber-incidents can also result in direct losses or the necessity to account for loss contingencies, including those related to warranties, direct loss of revenue, providing customers with incentives, breach of contract, product recall and replacement, indemnification or remediation. Incidents can result in loss of, and therefore accounting impairment to, goodwill, intangible assets, trademarks, patents, capitalized software and even inventory.  Financial statement disclosure may also include expenses related to investigation, breach notification, remediation and litigation, including the costs of legal and other professional service providers.

Broad Risk Oversight

A company must disclose the extent of its board of directors’ role in the risk oversight of the company, such as how the board administers its oversight function and the effect this has on the board’s leadership structure. To the extent cybersecurity risks are material to a company’s business, this discussion should include the nature of the board’s role in overseeing the management of that risk. Information should also be included on how the board engages with management on cybersecurity risk management.

Controls and Procedures

The new guidance clearly provides that companies should adopt comprehensive policies and procedures related to cybersecurity and to assess their compliance regularly, including policy/procedure compliance related to the sufficiency of disclosure controls and procedures.  Procedures must address a company’s ability to record, process, summarize and report financial and other information in SEC filings.  Additionally, any deficiency in these controls and procedures should be reported.

The SEC reminds companies that their principal executive officer and principal financial officer must make individual certifications regarding the design and effectiveness of disclosure controls and procedures. These certifications should take into account cybersecurity-related controls and procedures.

Furthermore, as discussed above, a company should have proper policies and procedures preventing officers, directors and other insiders from trading on material nonpublic information related to cybersecurity risks and incidents.

Regulation FD and Selective Disclosure

Companies may have disclosure obligations under Regulation FD related to cybersecurity matters. Under Regulation FD, “when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons it must make public disclosure of that information.” The SEC reminds companies that these requirements also relate to cybersecurity matters and that, along with all the other disclosure requirements, policies and procedures should specifically address any disclosures of material non-public information related to cybersecurity.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

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The Senate Banking Committee’s Hearing On Cryptocurrencies

Posted by Securities Attorney Laura Anthony | March 6, 2018 Tags: The Senate Banking Committee’s Hearing On Cryptocurrencies

On February 6, 2018, the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”) held a hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.” Both SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo testified and provided written testimony. The marketplace as a whole had a positive reaction to the testimony, with Bitcoin prices immediately jumping up by over $1600. This blog reviews the testimony and provides my usual commentary.

The SEC and CFTC Share Joint Regulatory Oversight

The Banking Committee hearing follows SEC and CFTC joint statements on January 19, 2018 and a joint op-ed piece in the Wall Street Journal published on January 25, 2018 (see HERE). As with other areas in capital markets, such as swaps, the SEC and CFTC have joint regulatory oversight over cryptocurrencies. Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets.

Bitcoin has been determined to be a commodity and as such, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Nevertheless, the CFTC does NOT have regulatory jurisdiction over markets or platforms conducting cash or “spot” transactions in virtual currencies or other commodities or over participants on such platforms. These spot virtual currency or cash markets often self-certify or are subject to state regulatory oversight. However, the CFTC does have enforcement jurisdiction to investigate fraud and manipulation in virtual currency derivatives markets and in underlying virtual currency spot markets.

The SEC does not have jurisdiction over currencies, including true virtual currencies. However, many, if not all, token offerings have been for the purpose of raising capital and have involved speculative investment contracts, thus implicating the jurisdiction of the SEC, in the offering and secondary trading markets.

Chair Clayton repeated that “every ICO I’ve seen is a security,” and added, “[T]hose who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement division.” Chair Clayton is very concerned that Main Street investors are getting caught up in the hype and investing money they cannot afford to lose, without proper (if any) disclosure, and without understanding the risks.  He also reiterates previous messaging that to date no ICO has been registered with the SEC and that ICO’s are international in nature such that the SEC may not be able to recover lost funds or effectively pursue bad actors. Cybersecurity is also a big risk associated with ICO investments and the cryptocurrency market as a whole. Chair Clayton cites a study that more than 10% of total ICO proceeds, estimated at over $400 million, has been lost to hackers and cyberattacks.

It is becoming increasingly certain that the U.S. will impose a new regulatory regime over those tokens that are not a true cryptocurrency, which would likely include all tokens issued on the Ethereum blockchain for capital raising purposes. Clayton made the distinction between Bitcoin, which is decentralized, on a public Blockchain and mined or produced by the public and other “securities tokens” which are the cryptocurrencies that developed by an organization and created and issued primarily for capital formation and secondary trading.

Many tokens are being fashioned that outright and purposefully resemble equity in an enterprise as a new way to represent equity and capital ownership. Clearly this falls directly within the SEC jurisdiction, and state corporate regulatory oversight as well. Furthermore, there are instances where a token is issued in a capital-raising securities offering and later becomes a commodity, or instances where a token securities offering is bundled to include options or futures contracts, implicating both SEC and CFTC compliance requirements.

In the Banking Committee testimony, the SEC and CFTC presented a united front, confirming that they are cooperating and working together to ensure effective oversight. Both agencies have established virtual currency task forces and their respective enforcement divisions are cooperating and sharing information. Also, both agencies have launched efforts to educate the public on virtual currencies, with the CFTC publishing numerous articles and creating a dedicated “Bitcoin” webpage.

In addition to cooperating with each other, they are also cooperating and communicating with the NASAA, the Consumer Financial Protection Bureau, FinCen, the IRS, state regulators and others.

The Technology

Consistent with all statements by the regulators, both the SEC and CFTC agree that that blockchain technology is disruptive and has the potential to, and likely will, change the capital markets. Moreover, both agencies consistently reiterate their support of these changes and desire to foster innovation.  In fact, the new technology has the potential to help regulators better monitor transactions, holdings and obligations and other market activities.

Chair Giancarlo’s testimony states that “DLT is likely to have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis. When tied to virtual currencies, this technology aims to serve as a new store of value, facilitate secure payments, enable asset transfers, and power new applications.” In addition, smart contracts have the ability to value themselves in real time and report information to data repositories.

However, regulation and oversight need to be fashioned that properly address the new technology and business operations. Both agencies are engaging in discussions with industry participants at all levels. A few of the key issues that will need to be resolved include custody, liquidation, valuation, cybersecurity at all levels, governance, clearing and settlement, and anti-money laundering and know-your-customer matters.

Overall, Chair Giancarlo seemed more positive and excited about blockchain and Bitcoin, pointing out current uses including a recent transaction where 66 million tons of American soybeans were handled in a blockchain transaction to China. Chair Clayton, while likely also very enthusiastic about the technology, is currently more focused on the fraud and misuse that has consumed this space recently.

Current Regulations and Needed Change

While the agencies investigate and review needed changes to the regulatory environment, both maintain that current regulations can be relied upon to address the current state of the market. On the SEC side, Chair Clayton walked the Banking Committee through previous SEC statements and the DAO Section 21(a) report issued in July 2017. He again confirmed that the Howey Test remains the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. The current registration and exemption requirements are also appropriate for ICO offerings. An issuer can either register an offering, or rely on exemptions such as Regulation D for any capital-raising transaction, including those involving tokens.

Conversely, the current regulatory framework related to exchange traded fund products (ETF’s) needs some work before a virtual currency product could be approved. Issues remain surrounding liquidity, valuation, custody of holdings, creation, redemption and arbitrage. In that regard, in a coming blog, I will review an SEC letter dated January 18, 2018 entitled “Engaging on Fund Innovation and Cryptocurrency-related Holdings” outlining why a crypto-related ETF would not be approved at this time.  Senator Mark Warner was quick to point out that there seems to be a regulatory disconnect where an SEC governed ETF is not approved, but a CFTC-governed Bitcoin future is allowed.

The current federal broker-dealer registration requirements remain the best test to determine if an exchange or other offering participant is required to be registered and a member of FINRA. Chair Clayton repeats his warning shot to gatekeepers such as attorneys and accountants that are involved in ICO’s and the crypto marketplace as a whole. Chair Clayton expresses concern that crypto markets often look similar to regulated securities markets and even are called “exchanges”; however, “investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems (ATSs), such as best execution, prohibitions on front running, short sale restrictions, and custody and capital requirements.”

CFTC Chair Giancarlo reiterated that current regulations related to futures, options, and derivatives contracts, and the registration (or lack thereof through self-certification) of spot currency exchanges are being utilized in the virtual currency market. However, the part of the regulatory system that completely defers to state law may need change. In particular, check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC, and both agencies expressed concern about this jurisdictional gap.

Giancarlo was especially critical of this state-by-state approach and suggested new federal legislation, including legislation related to data reporting, capital requirements, cybersecurity standards, measures to prevent fraud, price manipulation, anti-money laundering, and “know your customer” protections. “To be clear, the CFTC does not regulate the dozens of virtual currency trading platforms here and abroad,” Giancarlo said, clarifying that the CFTC can’t require cyber-protections, platform safeguards and other things that consumers might expect from traditional marketplaces.

Chair Clayton expressed the same concerns, especially the lack of protections for Main Street investors. Chair Clayton stated, “I think our Main Street investors look at these virtual currency platforms and assume they are regulated in the same way that a stock is regulated and, as I said, it’s far from that and I think we should address that.”

I am always an advocate of federal oversight of capital markets matters that cross state lines. A state-by-state approach is always inconsistent, expensive, and inefficient for market participants.

Both agencies are clear that regardless of the technology and nomenclature, they are and will continue to actively pursue cases of fraud and misconduct. Current regulations or questions related to needed changes do not affect this role. However, Chair Clayton did impress upon the Banking Committee that the current hiring freeze and budgetary restraints are an impediment. The SEC specifically needs more attorneys in their enforcement and trading and markets divisions.

Further Reading on DLT/Blockchain and ICO’s

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 ICO’s, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s 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 op-ed article and information on the International Organization of Securities Commissions statement and warning on ICO’s, see HERE.

For a review of the CFTC role and position on cryptocurrencies, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

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Financial Choice Act 2.0 Has Made Progress

Posted by Securities Attorney Laura Anthony | June 13, 2017 Tags: Financial Choice Act 2.0, The Financial Choice Act, Volcker Rule

On June 8, 2017, the U.S. House of Representative passed the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (the “Financial Choice Act 2.0” or the “Act”) by a vote of 283-186 along party lines. Only one Republican did not vote in favor of the Act. On May 4, 2017, the House Financial Services Committee voted to approve the Act. A prior version of the Act was adopted by the Financial Services Committee in September 2016 but never proceeded to the House for a vote.

The Financial Choice Act 2.0 is an extensive, extreme piece of legislation that would dismantle a large amount of the power of the SEC and strip the Dodd-Frank Act of many of its key provisions. The future of the Act is uncertain as it is unlikely to get through the Senate, although a rollback of Dodd-Frank remains a priority to the current administration. It is also possible that parts of the lengthy Act could be bifurcated out and included in other Acts that ultimately are passed into law.

Introduction

The Executive Summary for the Financial Choice Act 2.0 as presented to the House lists the following seven key principles of the Act:

1. Taxpayer bailouts of financial institutions must end and no company can remain “too big to fail”;
2. Both Wall Street and Washington must be held accountable;
3. Simplicity must replace complexity, because complexity can be gamed by the well-connected and abused by the Washington powerful;
4. Economic growth must be revitalized through competitive, transparent, and innovative capital markets;
5. Every American, regardless of their circumstances, must have the opportunity to achieve financial independence;
6. Consumers must be vigorously protected from fraud and deception as well as the loss of economic liberty; and
7. Systemic risk must be managed in a market with profit and loss.

The Act focuses on dismantling Dodd-Frank, including the controversial Volcker Rule, which prohibits banks from engaging in proprietary trading; the U.S. Department of Labor fiduciary rule, which went into effect on June 9, 2017; and the “too big to fail” provisions allowing for federal government bailouts. Among many provisions directly impacting the authority of the SEC, the Act would strip the SEC of the power to use administrative proceedings as an enforcement tool.

Summary of Key Provisions

Executive Compensation

Many of the changes would repeal provisions related to executive compensation.  Related to executive compensation, the Financial Choice Act would include:

1. Pay Ratio. The Act would repeal the section of Dodd-Frank which requires companies to disclose the pay ratio between CEO’s and the median employees. For a summary of the pay ratio rule, see my blog HERE. This rule is under scrutiny and attack separately and apart from the Financial Choice Act as well.  On February 6, 2017, acting SEC Chair Michael Piwowar called for the SEC to conduct an expedited review of the rule for the purpose of reconsidering its implementation.  It is highly likely that this rule will not be implemented as written, if at all.
2. Incentive-based Compensation. The Act would repeal provisions of Dodd-Frank that require enhanced disclosure related to incentive-based compensation by certain institutions.
3. Hedging. Proposal to repeal the section of Dodd-Frank which requires companies to disclose whether employees or directors can offset any increase in market value of the company’s equity grants as compensation.
4. Say on Pay. The Act will amend the Say on Pay rules such that the current advisory vote would only be necessary in years when there has been a material change to compensation arrangements, as opposed to the current requirement that a vote be held at least once every 3 years.  For more information on the Say on Pay rules, see my blog HERE.
5. Clawback Rules. The Clawback rules would prohibit companies from listing on an exchange unless such company has policies allowing for the clawback of executive compensation under certain circumstances. This would be in the form of additional corporate governance requirements. For more information on the clawback rules, see my blog HERE. The Act will amend the clawback rules such that they will only apply to current and former executives that had “control or authority” over the company’s financial statements.

On the bank-specific side, the Act would eliminate bank prohibitions on capital distributions and limitations on mergers, consolidations, or acquisitions of assets or control to the extent that these limitations relate to capital or liquidity standards or concentrations of deposits or assets.

Key Provisions on Securities Laws

Key provisions directly impacting the federal securities laws and potentially my client base:

1. An increase in the Sarbanes-Oxley Act (“SOX”) Rule 404(b) compliance threshold from $250 million public float to $500 million. Currently smaller reporting companies and emerging-growth companies are exempted from compliance with Rule 404(b).  A “smaller reporting company” is currently defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K, as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

Interestingly, when the SEC proposed an increase in the threshold definition of “smaller reporting company” in June of last year from $75 million to $250 million, it specifically chose to concurrently amend the definition of an “accelerated filer” to eliminate the benefit of an exclusion from the SOX 404(b) requirements for companies with a float over $75 million. In particular, the SEC proposed to amend the definition of “accelerated filer” to eliminate an exclusion for smaller reporting companies such that a company could be a smaller reporting company but also an accelerated filer. The SEC noted in its rule release that it intended to be sure that companies with a float over $75 million, whether a smaller reporting company or not, would have to comply with SOX 404(b) and the accelerated filing schedule for quarterly and annual reports. See my blog HERE.  If passed, the Financial Choice Act 2.0 would override the SEC’s current proposal on this point.

2. The Financial Choice Act 2.0 would increase the registration threshold requirements under Section 12(g) of the Securities Exchange Act for smaller companies. The Act 2.0 would also index the thresholds for inflation moving forward. In addition, the Act would eliminate the requirement to obtain ongoing accredited investor verifications for determining the Section 12(g) registration requirements.  On May 1, 2016, the SEC amended Exchange Act Rules 12g-1 through 12g-4 and 12h-3 related to the procedures for termination of registration under Section 12(g) through the filing of a Form 15 and for suspension of reporting obligations under Section 15(d), to reflect the higher thresholds set by the JOBS Act. The SEC also made clarifying amendments to: (i) cross-reference the definition of “accredited investor” found in rule 501 of Regulation D, with the Section 12(g) registration requirements; (ii) add the date for making the registration determination (last day of fiscal year-end); and (iii) amend the definition of “held of record” to exclude persons who received shares under certain employee compensation plans. Under the rules, a company that is not a bank, bank holding company or savings-and-loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. As I discussed in this blog on the subject HERE identifying accredited investors for purposes of the registration, and deregistration, requirements could be problematic. Investors are not necessarily responsive to inquiries from a company and may balk at providing personal information, especially those that have purchased in the open market but then subsequently, for whatever reason, converted such ownership to certificate/book entry or otherwise “record ownership.”
3. The Financial Choice Act 2.0 would expand the coverage under Title 1 of the JOBS Act to allow all companies to engage in certain test-the-waters communications in an IPO process and to file registration statements on a confidential basis. Title 1 of the JOBS Act specifically only applies to emerging-growth companies (EGC’s). In particular, Section 105(c) of the JOBS Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIB’s”) and institutional accredited investors (“IAI’s”) in order to gauge their interest in a proposed offering, whether prior to (irrespective of the 30-day safe harbor) or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus.  Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.  For more information on test-the-waters communications by EGC’s, see my blog HERE.

The Financial Choice Act 2.0 will also expand the ability to file a registration statement on a confidential basis to all companies and not just EGC’s.  Currently, an EGC may initiate the “initial public offering” (“IPO”) process by submitting its IPO registration statements confidentially to the SEC for nonpublic review by the SEC staff. A confidentially submitted registration statement is not deemed filed under the Securities Act and accordingly is not required to be signed by an officer or director of the issuer or include auditor consent.  Signatures and auditor consent are required no later than 15 days prior to commencing a “road show.”  If the EGC does not conduct a traditional road show, then the registration statements and confidential submissions must be publicly filed no later than 15 days prior to the anticipated effectiveness date of the registration statement. I note that the JOBS Act had originally set the number of days for submission of all information at 21 days and the FAST Act shortened that time period to 15 days.

4. A requirement that the SEC Chair conduct a study and issue a report on self-regulatory organizations, including recommendations to eliminate duplications and inefficiencies amongst the various organizations.
5. The Financial Choice Act 2.0 would increase the allowable offering amount for Tier 2 of Regulation A (i.e., Regulation A+) from $50 million to $75 million in any 12-month period. I often write about Regulation A/A+.  For the most recent comprehensive article on the subject, see my blog HERE.
6. The Financial Choice Act 2.0 would prohibit the SEC from requiring the use of “universal proxies” in contested elections of directors. Pre-change in administration, on October 16, 2016, the SEC proposed a rule requiring the use of the use of universal proxy cards in connection with contested elections of directors.  The proposed card would include the names of both the company and opposed nominees.  The SEC also proposed amendments to the rules related to the disclosure of voting options and standards for the election of directors.  My blog on the proposed rule can be read HERE.
7. An inflation update to the minimum thresholds for shareholders to be able to submit proposals for annual meetings. Currently Rule 14a-8 permits qualifying shareholders to submit matters for inclusion in the company’s proxy statement for consideration by the shareholders at the company’s annual meetings. Procedurally to submit a matter, among other qualifications, a shareholder must have continuously held a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal is submitted and through the date of the annual meeting.  For further reading on this rule, see HERE.  The Financial Choice Act 2.0 would update the ownership requirement thresholds for inflation.
8. Delay the repeal of the Chevron doctrine for two years. Under the Chevron doctrine, a court must defer to an agency’s interpretation of statutes and rules.  The Financial Choice Act called for the immediate repeal of this doctrine.  The Act 2.0 would delay such repeal for two years.
9. Increase the limits on disclosure requirements for employee-issued securities under Rule 701 from $10 million as set forth in version 1.0 to $20 million with an inflation adjustment. Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.  Currently, additional disclosures are required for issuance valued at $5 million or more in any 12-month period.  For more information on Rule 701, see my blog HERE.
10. The Act seeks to shift enforcement and penalties away from companies and towards individual officers, directors and other offenders. The SEC would be required to conduct an economic analysis before enforcing civil penalties against a company, to ensure that the company itself benefited from the alleged wrongdoing.  The intent is to prevent harm to innocent shareholders by penalizing a company for the wrongdoing of individuals.  Likewise, the Act will increase the penalties that can be imposed against individuals by two and in some cases three times the current amounts where the penalties are tied to the defendant’s illegal profits.  The Act would give the SEC new authority to impose sanctions equal to investor losses in cases involving “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement” and increase the stakes for repeat offenders.  Moreover, the Act will increase the maximum criminal fines for persons that engage in insider trading or other corrupt practices.
11. The Act would strip the SEC of the power to use administrative proceedings as an enforcement tool. The new law would permit a respondent to remove any administrative proceeding to a federal district court. Moreover, the Act would raise the SEC’s standard of proof in administrative proceedings from “preponderance of evidence” to the higher “clear and convincing” evidence of wrongdoing.   For more on this topic, see HERE.
12. The Act would reduce the SEC’s enforcement power in other areas as well. The duration of both the SEC’s and CFTC’s subpoena power would be reduced.  All investigations would be subject to a process for timely conclusion.  Respondents would also be guaranteed access to commissioners at the Wells process stage (before a formal complaint). In addition, the Act would restrict the SEC’s ability to leverage settlement by threatening the company or individual with automatic disqualification from regulated activities. Instead, disqualification would now require a formal hearing. The SEC would also have to publish its enforcement manual, providing further transparency into filing decisions.
13. The Act would require that all fines collected by the PCAOB and Municipal Securities Rulemaking Board be remitted to the Treasury for deficit reduction.

Too Big to Fail Bailouts

Related to bailouts, the Financial Choice Act 2.0 would, in summary:

1. Repeal the authority of the Financial Stability Oversight Council to designate firms as systematically important financial institutions (i.e., “too big to fail”);
2. Repeal Title II of Dodd-Frank and replace it with new bankruptcy code provisions specifically designed to accommodate large, complex financial institutions. Title II of Dodd-Frank is the orderly liquidation authority, granting authority to the federal government to obtain receivership control over large financial institutions;
3. Repeal Title VIII of Dodd-Frank, which gives the Financial Stability Oversight Council access to the Federal Reserve discount window for systematically important financial institutions (i.e., gives the federal government the money to bail out financial institutions) as well as the authority to conduct examinations and enforcement related to risk management;
4. Restrict the Federal Reserve’s discount window lending to Bagehot’s dictum; and
5. Prohibit the use of the Exchange Stabilization fund to bail out financial firms or creditors.

Financial Regulator Accountability

Related to accountability from financial regulators, the Act would:

1. Make all financial regulatory agencies subject to the REINS Act related to appropriations and place all such agencies on an appropriations process subject to congressional control and oversight;
2. Require all financial regulators to conduct a detailed cost-benefit analysis for all proposed regulations to ensure that benefits outweigh costs (provisions analogous to this are already required, but this would be more extreme);
3. Increase transparency of financial regulations’ costs to state and local governments and private-sector entities;
4. Reauthorize the SEC for a period of 5 years with funding, structural and enforcement reforms (i.e., dismantle the current SEC and replace it with a watered-down version);
5. “Institute significant due-process reforms for every American who feels that they have been the victim of a government shakedown”;
6. Repeal the Chevron Deference doctrine.  Under this doctrine, a court must defer to an agency’s interpretation of statues and rules;
7. Demand greater accountability and transparency from the Federal Reserve, both in its conduct of monetary policy and its prudential regulatory activity, by including the House-passed Fed Oversight Reform and Modernization Act;
8. Abolish the Office of Financial Research;
9. Require public notice and comment for any international standard-setting negotiation;
10. Prohibit the financial regulators and DOJ from using settlement agreements to require donations to non-victims;
11. Increase transparency and accountability in the Federal Reserve’s conduct of the supervisory stress tests while streamlining duplicative and overly burdensome components; and
12. Institute criminal penalties for leaks of sensitive, market-moving information related to the Federal Reserve’s stress-test and living-will processes.

Financial Institutions

The Act intends to create strongly capitalized, well-managed financial institutions by:

1. Providing an “off-ramp” from the post-Dodd-Frank supervisory regime and Basel III capital and liquidity standards for banking organizations that choose to maintain high levels of capital.  Any banking organization that makes a qualifying capital election but fails to maintain the specified non-risk-weighted leverage ratio will lose its regulatory relief;
2. Exempting banking organizations that have made a qualifying capital election from any federal law, rule or regulation that provides limitations on mergers, consolidations, or acquisitions of assets or control, to the extent that the limitations relate to capital or liquidity standards or concentrations of deposits or assets; and
3. Exempting banking organizations that have made a qualifying capital election from any federal rule, law or regulation that permits a banking agency to consider risk “to the stability of the US banking or financial system” which was added to various federal banking laws by Section 604 of Dodd-Frank, when reviewing an application to consummate a transaction or commence an activity.

Miscellaneous Provisions

Under the heading “[U]leash opportunities for small businesses, innovators, and job creators by facilitating capital formation,” the Act would:

1. Repeal multiple sections of Dodd-Frank, including the Volker Rule (which restricts U.S. banks from making speculative investments, including proprietary trading, venture capital and merchant bank activities);
2. Repeal the SEC’s authority to either prospectively or retroactively eliminate or restrict securities arbitration;
3. Repeal Dodd-Frank’s non-material specialized disclosure; and
4. Incorporate more than two dozen committee- or House-passed capital formation bills, including H.R. 1090 – Retail Investor Protection Act (prohibiting certain restrictions on investment advisors), H.R. 1312 – Small Business Capital Formation Enhancement Act (requiring prompt SEC action on finding of the annual SEC government business forum), H.R. 79 – Helping Angels Lead Our Startups Act (directing the SEC to amend Regulation D, expanding the allowable use of solicitation and advertising), and H.R. 910 – Fair Access to Investment Research Act (expanding exclusion of research reports from the definition of an offer for or to sell securities under the Securities Act).

The Act also contains numerous provisions related to small community financial institutions, as well as many provisions fundamentally changing the Consumer Financial Protection Bureau.

Dodd-Frank Budget Cuts

A few articles have indicated that President Trump’s fiscal 2018 budget proposal would include a restructure of the U.S. Consumer Financial Protection Bureau (CFPB), which was created by the Dodd-Frank Act. The purpose of the CFPB is to protect borrowers from predatory lending. The restructure would reduce the federal deficit by $145 million in the 2018 fiscal year.  The CFPB has been under attack by the administration. Last year, a U.S. appeals court found that the CFPB structure violated the Constitution, a decision that is currently being appealed.

The SEC reserve fund, which was also created under Dodd-Frank, would also be eliminated.  Currently the reserve fund is $50 million a year and is used by the SEC to overhaul its information technology, including upgrades to the EDGAR filing system and initiatives to police fraud and track equities trading patterns.

The remainder of the SEC budget would remain unchanged as it is considered deficit-neutral because the fees it collects from enforcement are matched by congressional funding.

Thoughts

In recent years we have seen the most dramatic changes in capital formation regulations and technological developments in the past 30 years, if not longer. Significant capital-formation changes include: (i) the creation of Rule 506(c), which came into effect on September 23, 2013, and allows for general solicitation and advertising in private offerings where the purchasers are limited to accredited investors; (ii) the overhaul of Regulation A, creating two tiers of offerings which came into effect on June 19, 2015, and allows for both pre-filing and post-filing marketing of an offering, called “testing the waters”; (iii) the addition of Section 5(d) of the Securities Act, which came into effect in April 2012, permitting emerging-growth companies to test the waters by engaging in pre- and post-filing communications with qualified institutional buyers or institutions that are accredited investors; and (iv) Title III crowdfunding, which came into effect on May 19, 2016, and allows for the use of Internet-based marketing and sales of securities offerings.

At the same time, we faced economic stagnation since the recession, a 7-year period of near-zero U.S. interest rates and negative interest rates in some foreign nations, nominal inflation and a near elimination of traditional bank financing for start-ups and emerging companies. If bank credit were available for small and emerging-growth companies, it would be inexpensive financing, but it is not and I do believe that Dodd-Frank and over-regulation are directly responsible for this particular problem.

In my practice, optimism and growth remain the buzzwords. My clients are universally enthusiastic about the state of the economy and business prospects as a whole. The consistent mantra of decreasing regulations is universally welcomed with a sense of relief. The SEC will not be immune to these changes, and we are just beginning to see what I believe will be an avalanche of positive change for small businesses and capital formation.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2017

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« FINRA Proposes Amendments To The Corporate Financing Rules SEC Issues Additional Guidance on Regulation A+ »

FINRA Proposes Amendments To The Corporate Financing Rules

Posted by Securities Attorney Laura Anthony | June 6, 2017 Tags: FINRA Corporate Financing Rules, FINRA Proposes Amendments To The Corporate Financing Rules

On April 11, 2017, the Financial Industry Regulatory Authority (FINRA) released three regulatory notices requesting comment on rules related to corporate financing and capital formation. In particular, the regulatory notices propose changes to Rule 5110, which regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities; Rules 2241 and 2242, which regulate equity and debt research analysts and research reports; and Rule 2310, which relates to public offerings of direct participation programs and unlisted REIT’s.

The proposed changes come as part of the FINRA360 initiative announced several months ago. Under the 360 initiative, FINRA has committed to a complete self-evaluation and improvement. As part of FINRA360, the regulator has requested public comment on the effectiveness and efficiency of its rules, operations and administrative processes governing broker-dealer activities related to the capital-raising process and their impact on capital formation.

Regulatory Notice 17-14 – Request for Comment on Rules Impacting Capital Formation

Regulatory Notice 17-14 is a request for comment on FINRA rules impacting capital formation. In its opening FINRA notes that the ability of small and large businesses to raise capital efficiently is critical to job creation and economic growth and that broker-dealers play a vital role in assisting in that process. FINRA members act as underwriters for public offerings, advisors on capital raising and corporate restructuring, placement agents for private offerings, funding portals and research analysts. Furthermore, there have been significant changes in the capital-raising processes, such as securities-based crowdfunding and Regulation A+ both initiated from the JOBS Act.

FINRA itself has made changes to modernize its regulations such as through the creation of the new Capital Acquisition Broker (CAB) and funding portal rules for brokers engaged in a limited range of fundraising activities. For more information on the CAB rules, see HERE. FINRA also seeks comments on changes that may be helpful in both the CAB and funding portal rules.

Below is a brief summary of some, but not all, the rules highlighted in FINRA Regulatory Notice 17-14.

Rules 2241 and 2242

The Regulatory Notice seeks comment on any FINRA rules that may impact capital formation, but highlights and summarizes certain rules that have significant impact on the process. For example, FINRA highlights Rule 2241 (Research Analysts and Research Reports) and Rule 2242 (Debt Research Analysts and Debt Research Reports), both of which are subject to a separate Regulatory Notice discussed in this blog.

Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. In Regulatory Notice 17-16, FINRA proposes a safe harbor from Rule 2241 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report.

Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

Rule 2310

Rule 2310 addresses underwriting terms and arrangements in public offerings of direct participation programs (DPP’s) and unlisted real estate investment trusts (REIT’s). These investments tend to be complex and as such, the Rule regulates underwriter and placement agent compensation, requires due diligence and contains suitability guidelines.

The 5100 Series of Rules

The 5100 series of rules govern underwriting compensation and terms, underwriter conduct, conflicts of interest and related matters.  Although there are nine rules in the 5100 Series, a few in particular most often affect the capital formation process.

Rule 5110 – Corporate Financing Rule – Underwriting Terms and Arrangements; Rule 5121 – Public Offerings of Securities with Conflicts of Interest

Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities.  The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA. The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest. In addition, the Rule limits certain compensation such as termination or tail fees and rights of first refusal and imposes lock-up restrictions related to the sale or transfer of securities received as compensation. The lock-up restrictions apply to a period beginning six months prior to the initial filing of a registration statement with the SEC and end 90 days following the effectiveness of the registration statement.

Where Rule 5110 requires the disclosure of affiliations, Rule 5121 goes further and prevents member firms from participating in offerings where certain conflicts of interest exist. Member firms are prohibited from participating in a public offering where certain conflicts exist, including where the issuer is controlled by or under common control with the FINRA member firm or its associated persons.

For more information on Rules 5110 and 5121, see HERE.

Rule 5122 – Private Placement of Securities Issued by Members; Rule 5123 – Private Placement of Securities

Subject to certain exceptions, such as where an offering is limited to accredited investors, Rule 5123 requires member firms to file a copy of the private placement memorandum, term sheet or other disclosure document with FINRA, for all offerings in which they sell securities, within 15 calendar days of the first sale. FINRA enacted the rule in an effort to further police the private placement market and to ensure that members participating in these private offerings conduct sufficient due diligence on the securities and their issuers.

Rule 5122 requires members that offer or sell their own securities to file the private placement memorandum, term sheet or other offering document at or prior to the first time the documents are provided to any prospective investor. Rule 5122 also establishes standards on disclosure and the use of private placement proceeds.

Rule 6432 – Compliance with Rule 15c2-11

Rule 6432 generally requires that, prior to initiating or resuming quotations in a non-exchange-listed security in a quotation medium, such as OTC Markets, a member firm must demonstrate compliance with Rule 6432 which, in turn, requires that the member firm has the information set forth in Securities Act Rule 15c2-11. Under Rule 6432, a member complies by filing a FINRA Form 211 at least three business days before the member’s quotation is published or displayed in the quotation medium. In reality the processing of the Form 211 application takes much longer than three days, and often several months. Moreover, the information and review conducted by FINRA in this process can be arduous.

Regulatory 17-15 – Request for Comment on Amendments to the Corporate Financing Rule

As discussed above, Rule 5110 is the corporate financing rule regulating underwriting compensation and prohibiting unfair arrangements in connection with the public offerings of securities. Under Rule 5110, a member firm is required to submit its underwriting or other arrangements associated with a public offering and obtain a no-objection letter from FINRA before they can proceed. FINRA proposes substantial changes to modernize, simplify and clarify its provisions.

The proposed amendments will clarify what is included in determining underwriter compensation. The Rule will eliminate a limit that prevents a member and its affiliates from acquiring more than 25% of a company’s stock and increase the fraction of shares sold in a private placement that a syndicate of investors can buy from 20 percent to 40 percent.  Currently, underwriting compensation is defined to include a laundry list of items. The proposed amendment would define “underwriting compensation” to mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would also include “finder fees and underwriter’s counsel fees, including expense reimbursements and securities.” The proposal would continue to provide two non-exhaustive lists of examples of payments or benefits that would be and would not be considered underwriting compensation.

The Rule would also allow members to use formulas other than those dictated by FINRA to calculate their underwriting compensation, extend certain filing deadlines, and clarify circumstances in which stock sale restrictions don’t apply.

The proposed Rule increases the filing deadline from one business day to three business days after the filing of the offering with the SEC.  The Rule also reduces the number of documents that must be filed. Furthermore, if a member participating in the offering files with FINRA, other participating members will be not be required to do so.

The Rule governs all public offerings subject to exceptions. Moreover, certain offerings are not subject to the Rule, such as offerings exempt under Section 4(a)(1), 4(a)(2) or 4(a)(6) of the Securities Act.

Regulatory Notice 17-16 – Request for Comment on Proposed Safe Harbor from FINRA Equity and Debt Research Rules

As discussed above, Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

FINRA proposes a safe harbor from Rule 2241 and 2242 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report. In particular, the safe harbor would cover specified brief, written analysis distributed to eligible institutional investors that comes from sales and trading or principal trading personnel but that may rise to the level of a research report (i.e., desk commentary).

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2017

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« FINRA Proposes New Registration And Examination Rules Financial Choice Act 2.0 Has Made Progress »

Recommendations Of SEC Government-Business Forum On Small Business Capital Formation

Posted by Securities Attorney Laura Anthony | May 23, 2017 Tags: ATS Registration, Blue Sky Pre-Emption, Finra, Form S-3, NASAA, Non-GAAP Accounting Standards, OTC Markets, Regulation A, Regulation CF, Regulation S-K, Rule 144, Rule 147, Rule 147A, Rule 15C2-11, Rule 504, Rule 506(b) Offerings, SEC, SEC Advisory Committee, SEC Office of Small Business Policy, SEC Rule 15c2-11, Section 4(a)(2), Small Business Capital Formation, Smaller Reporting Companies

In early April, the SEC Office of Small Business Policy published the 2016 Final Report on the SEC Government-Business Forum on Small Business Capital Formation, a forum I had the honor of attending and participating in. As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation. The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation.

The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations. The forum began with short speeches by each of the SEC commissioners and a panel discussion, following which attendees, including myself, worked in breakout sessions to drill down on specific issues and suggest changes to rules and regulations to help support small business capital formation, as well as the related, secondary trading markets. In particular, the three breakout groups were on exempt securities offerings; smaller reporting companies; and the secondary market for securities of small businesses.

Each breakout group is given the opportunity to make recommendations. The recommendations were refined and voted upon by the forum participants in the few months following the forum and have now been released by the SEC in a report containing all 15 final recommendations. In the process, the participants ranked the recommendations by whether it is likely the SEC will give high, medium, low or no priority to each recommendation.

Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. Last year the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also last year the forum recommended changes to Rule 147 and 504, which recommendations were considered in the SEC’s rule changes that followed. See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

Forum Recommendations

The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

1. As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
2. The definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies. See my blog HERE for more information on the current proposed change to the definition of smaller reporting company and HERE related to the distinctions between a smaller reporting company and an emerging-growth company.
3. Lead a joint effort with NASAA and FINRA to implement a private placement broker category including developing a workable timeline and plan to regulate and allow for “finders” and limited intermediary registration, regulation and exemptions. I think this topic is vitally important. The issue of finders has been at the forefront of small business capital formation during the 20+ years I have been practicing securities law. The topic is often explored by regulators; see, for example, the SEC Advisory Committee on Small and Emerging Companies recommendations HERE and a more comprehensive review of the topic HERE which includes a summary of the American Bar Association’s recommendations.

Despite all these efforts, it has been very hard to gain any traction in this area. Part of the reason is that it would take a joint effort by FINRA, the NASAA and both the Divisions of Corporation Finance and Trading and Markets within the SEC. This area needs attention. The fact is that thousands of people act as unlicensed finders—an activity that, although it remains illegal, is commonplace in the industry. In other words, by failing to address and regulate finders in a workable and meaningful fashion, the SEC and regulators perpetuate an unregulated fringe industry that attracts bad actors equally with the good and results in improper activity such as misrepresentations in the fundraising process equally with the honest efforts. However, practitioners, including myself, remain committed to affecting changes, including by providing regulators with reasoned recommendations.

4. The SEC should adopt rules that pre-empt state registration for all primary and secondary trading of securities qualified under Regulation A/Tier 2, and all other securities registered with the SEC. I have been a vocal proponent of state blue sky pre-emption, including related to the secondary trading of securities. Currently, such secondary trading is usually achieved through the Manual’s Exemption, which is not recognized by all states. There is a lack of uniformity in the secondary trading market that continues to negatively impact small business issuers. For more on this topic, see my two-part blog HERE and HERE.
5. Regulation A should be amended to: (i) pre-empt state blue sky regulation for all secondary sales of Tier 2 securities (included in the 4th recommendation above); (ii) allow companies registered under the Exchange Act, including at least business development companies, emerging-growth companies and smaller reporting companies, to utilize Regulation A (see my blog on this topic, including a discussion of a proposed rule change submitted by OTC Markets, HERE ); and (iii) provide a clearer definition of what constitutes “testing-the-waters materials” and permissible media activities.
6. Simplify disclosure requirements and costs for smaller reporting companies and emerging-growth companies with a principles-based approach to Regulation S-K, eliminating information that is not material, reducing or eliminating non-securities-related disclosures with a political or social purpose (such as pay ratio, conflict minerals, etc.), making XBRL compliance optional and harmonizing rules for emerging-growth companies with smaller reporting companies. For more on the ongoing efforts to revise Regulation S-K, including in manners addressed in this recommendation, see HERE and for more information on the differences between emerging-growth companies and smaller reporting companies, see HERE.
7. Mandate comparable disclosure by short sellers or market makers holding short positions that apply to long investors, such as through the use of a short selling report on Schedule 13D.
8. The SEC should provide scaled public disclosure requirements, including the use of non-GAAP accounting standards that would constitute adequate current information for entities whose securities will be traded on secondary markets. This recommendation came from the secondary market for securities of small businesses breakout group. I was part of the smaller reporting companies breakout group, so I did not hear the specific discussion on this recommendation.  However, I do note that Rule 144 does provide for a definition of adequate current public information for companies that are not subject to the Exchange Act reporting requirements.  In particular, Rule 144 provides that adequate current public information would include the information required by SEC Rule 15c2-11 and OTC Markets specifically models its alternative reporting disclosure requirements to satisfy the disclosures required by Rule 15c2-11.
9. The eligibility requirements for the use of Form S-3 should be revised to include all reporting companies. For more on the use of Form S-3, see my blog HERE. 
10. The SEC should clarify the relationship of exempt offerings in which general solicitation is not permitted, such as in Section 4(a)(2) and Rule 506(b) offerings, with Rule 506(c) offerings involving general solicitation in the following ways: (i) the facts and circumstances analysis regarding whether general solicitation is attributable to purchasers in an exempt offering should apply equally to offerings that allow general solicitation as to those that do not (such that even if an offering is labeled 506(c), if in fact no general solicitation is used, it can be treated as a 506(b); and (ii) to clarify that Rule 152 applies to Rule 506(c) so that an issuer using Rule 506(c) may subsequently engage in a registered public offering without adversely affecting the Rule 506(c) exemption. I note that within days of the forum, the SEC did indeed issue guidance on the use of Rule 152 as applies to Rule 506(c) offerings, at least as relates to an lternative trading systemintegration analysis between 506(b) and 506(c) offerings. See my blog HERE.
11. The SEC should amend Regulation ATS to allow for the resale of unregistered securities including those traded pursuant to Rule 144 and 144A and issued pursuant to Sections 4(a)(2), 4(a)(6) and 4(a)(7) and Rules 504 and 506.
12. The SEC should permit an ATS to file a 15c2-11 with FINRA and review the FINRA process to make sure that there is no undue burden on applicants and issuers. An ATS is an “alternative trading system.” The OTC Markets’ trading platform is an ATS. This recommendation would allow OTC Markets to directly file 15c2-11 applications on behalf of companies. A 15c2-11 application is the application submitted to FINRA to obtain a trading symbol and allow market makers to quote the securities of companies that trade on an ATS, such as the OTC Markets. Today, only market makers seeking to quote the trading in securities can submit the application. Also today, the application process can be difficult and lack clear guidance or timelines for the market makers and companies involved. This process definitely needs attention and this recommendation would be an excellent start.
13. Regulation CF should be amended to (i) permit the usage of special-purpose vehicles so that many small investors may be grouped together into one entity which then makes a single investment in a company raising capital under Regulation CF; and (ii) harmonize the Regulation CF advertising rules to avoid traps in situations where an issuer advertises or engages in general solicitations under Regulation A or Rule 506(c) and then converts to or from a Regulation CF offering.
14. The SEC should provide greater clarity on when trading activities require ATS registration, and when an entity or technology platform needs to a funding portal, broker-dealer, ATS and/or exchange in order to “be engaged in the business” of secondary trading transactions.
15. Reduce the Rule 144 holding period to 3 months for reporting companies. I fully support this recommendation.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC 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 OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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