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The Financial Choice Act 2.0

Posted by Securities Attorney Laura Anthony | March 28, 2017 Tags: Dodd-Frank, EGC, Financial Choice Act 2.0, Say on Pay Rules, Summary of Original Financial Choice Act, The Financial Choice Act 2.0, Tier 2 of Regulation A

On February 9, 2017, the Chair of the House Financial Services Committee issued a memo outlining changes to the Financial Choice Act, dubbing the newest version the Financial Choice Act 2.0. The memo was not intended for public distribution but found its way in any event, causing a great deal of anticipation as to the amended Act itself. The actual amended Act has not been released as of the date of this blog.

Introduction

As a reminder, the Financial Choice Act, which was passed by the House Financial Services Committee on September 13, 2016, 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. As first written, it would not be feasible for the Act to pass into law, but it certainly illustrates the extreme views of members of the House on the state of current over-regulation.

Moreover, the new administration continues that view and it is possible that the newer version will be in a form that could gain traction. 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.

Summary of Original Financial Choice Act

The Executive Summary for the original Financial Choice Act lists the following seven key principles of the Act:

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

The Act focuses on dismantling Dodd-Frank. Many of the changes would repeal provisions related to executive compensation (I note that the leaked memo on version 2.0 does not indicate any changes to these original provisions). Related to executive compensation, the Financial Choice Act would include:

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 separate and apart of 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.
Incentive-based Compensation. The Act would repeal provisions of Dodd-Frank that require enhanced disclosure related to incentive-based compensation by certain institutions.
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.
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.
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.

Related to bailouts, the Act would, in summary:

Repeal the authority of the Financial Stability Oversight Council to designate firms as systematically important financial institutions (i.e., too big to fail);
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; and
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;

Related to accountability from financial regulators, the Act would:

Make all financial regulatory agencies subject to the REINS Act related to appropriations and place all such agencies on an appropriations process subject to bipartisan control;
Require all financial regulators to conduct a detailed cost-benefit analysis for all proposed regulations (provisions analogous to this are already required, but this would be more extreme);
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);
“Institute significant due-process reforms for every American who feels that they have been the victim of a government shakedown”;
Repeal the Chevron Deference doctrine. Under this doctrine, a court must defer to an agency’s interpretation of statues and rules;
Demand greater accountability and transparency from the Federal Reserve; and
Abolish the Office of Financial Research.

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

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);
Repeal the SEC’s authority to either prospectively or retroactively eliminate or restrict securities arbitration;
Repeal non-material specialized disclosure; and
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. 4168 – Small Business Capital Formation Enhancement Act (requiring prompt SEC action on finding of the annual SEC government business forum), H.R. 4498 – Helping Angels Lead Our Startups Act (directing the SEC to amend Regulation D, expanding the allowable use of solicitation and advertising), and H.R. 5019 – 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).

Financial Choice Act 2.0

As mentioned, the described changes come from a leaked memo from the Chair of the House Financial Services Committee. The actual changes have not been made public as of yet. The vast majority of changes in the memo are related to banking provisions and the Consumer Financial Protection Bureau; however, below is a summary of those directly impacting the federal securities laws and potentially my client base.

Key provisions of the newer version of the Financial Choice Act include:

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.

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.”
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.

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.
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.
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.
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.
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.
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.

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 have 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 was 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.

I am extremely optimistic that this trend is changing. According to an article published by CNN on March 10, 2017, the U.S. economy added 235,000 jobs in Trump’s first full month in office. In the year prior, the average was about 190,000 jobs per month. In the same time period, the unemployment rate dropped from 4.8% to 4.7%. The same article reports that consumer and business confidence is high and as we all know, the stock market is at a record high. Wage growth continued to show signs of progress after persisting at a sluggish pace for years. Wages grew a solid 2.8% in February compared with a year ago.

In my practice, optimism and growth are 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.

Click Here To Print- PDF Printout The Financial Choice Act 2.0

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.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.

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SEC Announces Examination Priorities For 2017

Posted by Securities Attorney Laura Anthony | March 7, 2017

On January 12, 2017, the SEC announced its Office of Compliance Inspections and Examinations (OCIE) priorities for 2017. The OCIE examines and reviews a wide variety of financial institutions, including investment advisors, investment companies, broker-dealers, transfer agents, clearing agencies and national securities exchanges. The OCIE examination goals are to promote compliance, prevent fraud, identify risk and inform policy.

The priorities this year have a primary focus on (i) protecting retail investors, especially those saving for retirement; (ii) assessing market-wide risks; and (iii) new forms of technology, including automated investments advice.

The SEC shares its annual examination priorities as a heads-up and to encourage industry participants to conduct independent reviews and make efforts for increased compliance, prior to an SEC examination, investigation or potential enforcement proceeding. Moreover, the SEC chooses its priority list in conjunction with discussions with all divisions of the SEC and other market regulators and identifies what it believes are the areas that present heightened risk to investors and market integrity.

A. Retail Investors

Retail investors are being offered products and services that were formally only available to institutional investors. A wide range of products that have traditionally been alternative or institutional products, such as private funds, illiquid investments and structured products, are now available to the retail investor. In addition, as investors are more dependent than ever on their own investments for retirement, financial services firms have increased their services in the area of planning for retirement and the SEC intends to examine this area of service. The SEC will examine whether information, advice, products and services are being offered in a manner consistent with laws, rules and regulations.

The focus of examinations in this area will be on:

Electronic Investment Advice – Investors are increasingly able to obtain investment advice through automated or digital platforms. The SEC will examine registered investment advisors (RIA’s) and broker-dealers that offer these services, including “robo-advisors” that offer advice online or through other electronic platforms. The SEC will focus on the firms’ compliance programs, marketing, formulation of investment recommendations, data protection, and conflict of interest disclosures.

Wrap Fee Programs – The SEC will expand its review of RIA’s and broker-dealers that offer a single bundled fee for advisory and brokerage services, usually referred to as a “wrap fee program.” In particular, the SEC will review whether the RIA’s are meeting their fiduciary duties and contractual obligations to the clients. Areas of concern are wrap account suitability, effectiveness of disclosures, conflicts of interest, and brokerage practices, including best execution and trading away.

Exchange Traded Funds (“ETF’s”) – The SEC will examine ETF’s for compliance with securities laws, including exemptions under the Exchange Act of 1934 and Investment Company Act of 1940. The SEC will also focus on unit creation, redemption process, sales practices and disclosures and the suitability of broker-dealers’ recommendations to purchase ETF’s with a niche strategy.

Never-before-examined Investment Advisors – The SEC will expand its review of never-before-examined investment advisors and will, in particular, try to examine more newly registered advisors and advisors that have been registered for a long period of time without examination.

Recidivist Representatives and their Employers – The SEC will use analytics to track individuals with a history of misconduct and will also examine the firms that employ these people.

Multi-branch Advisors – The use of a multi-branch model provides unique challenges in fashioning compliance programs and oversight procedures.

Share Class Selection – The SEC will examine factors affecting recommendations to invest in or remain invested in a particular share class of a mutual fund, including conflict-of-interest issues. The SEC will examine whether recommendations are being improperly made for share classes with higher loads or distribution fees.

B.Focusing on Senior Investors and Retirement Investments

The SEC continues to focus on retirement accounts and senior investors. Specific areas of priority include:

ReTIRE – The SEC will continue to focus on its ReTIRE initiative, which focuses on investment advisors and broker-dealers that offer services to retirement accounts. The priority this year is on recommendations and sales of variable insurance products and the sales and management of target date funds.

Public Pension Advisors – The OCIE will examine investment advisors to state pension plans, municipalities and other government entities, including particular risks to these advisors such as pay to play and undisclosed gifts and entertainment practices.

Senior Investors – The OCIE will evaluate how firms manage interactions with senior investors, including the ability to identify financial exploitation. Examinations will focus on supervisory programs and controls related to products and services directed at senior investors.

C.Assessing Market-wide Risks

The SEC continues to review structural risks and trends that involve multiple firms and industries, including:

Money Market Funds – The SEC will review money market funds to ensure compliance with the new redemption rules and changes to Form PF which came into effect in October 2016.

Payment for Order Flow – The SEC will examine broker-dealers with a retail client base to ensure compliance with the duty of best execution when routing customer orders.

Clearing Agencies – The SEC will continue annual clearing agency reviews.

FINRA – The SEC intends to enhance its oversight of FINRA with respect to its goal of protecting investors and market integrity. The SEC will also review the quality of FINRA’s examination of broker-dealers.

Regulation Systems Compliance and Integrity (SCI) – The SEC will continue to review compliance with Regulation SCI. See my blog HERE.

Cybersecurity – The SEC will review cybersecurity compliance procedures and controls. See my blog HERE.

Anti-Money Laundering (“AML”) – The SEC will examine clearing and introducing firms’ AML programs and specifically those of firms that have not filed suspicious activity reports or have filed such reports late. The SEC will also examine programs that allow customers to deposit and withdraw cash and/or provide non-U.S. customers with direct access to the markets.

D.Other Areas of Examination

In addition to the primary focus discussed above, the SEC will prioritize the following additional areas for examination:

Transfer Agents – The SEC views transfer agents as an important gatekeeper to prevent Section 5 and other violations as well as preventing fraud. The SEC intends to allocate more resources to examine transfer agents and particularly those involved with microcap securities and private offerings.

Municipal Advisors – The SEC will conduct examinations of newly registered municipal advisors.

Private Fund Advisors – The SEC will examine private fund advisors, focusing on conflicts of interest and disclosure of conflicts.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

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SEC Proposes Shortening Trade Settlement

Posted by Securities Attorney Laura Anthony | December 27, 2016 Tags: DTC, DTC Process, SEC, SEC Proposes Shortening Trade Settlement

On September 28, 2016, the SEC proposed a rule amendment to shorten the standard broker-initiated trade settlement cycle from three business days from the trade date (T+3) to two business days (T+2). The change is designed to help reduce risks, including credit, market and liquidity risks, associated with unsettled transactions in the marketplace. Outgoing SEC Chair, Mary Jo White was quoted as saying that the change “is an important step to the SEC’s ongoing efforts to enhance the resiliency and efficiency of the U.S. clearance and settlement system.” I have previously written about the clearance and settlement process for U.S. capital markets, which can be reviewed HERE.

Background

DTC provides the depository and book entry settlement services for substantially all equity trading in the US. Over $600 billion in transactions are completed at DTC each day. Although all similar, the exact clearance and settlement process depends on the type of security being traded (stock, bond, etc.), the form the security takes (paper or electronic), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

All securities trades involve a legally binding contract. In general, the “clearing” of those trades involves implementing the terms of the contract, including ensuring processing to the correct buyer and seller in the correct security and correct amount and at the correct price and date. This process is effectuated electronically.

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In 1993, Exchange Act Rule 15c6-1 was adopted requiring that settlement occur three business days after the trade date, commonly referred to as “T+3.” Delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts. Technology, of course, plays an important role in the process and ability to efficiently manage settlements.

There may be two brokerage firms between DTC and the customer account holder. Brokerage firms that are direct members with DTC are referred to as “clearing brokers.” Many brokerage firms make arrangements with these DTC members (clearing brokers) to clear the securities on their behalf. Those firms are referred to as “introducing brokers.” A clearing broker will directly route an order through the national exchange or OTC Market, whereas an introducing broker will route the order to a clearing broker, who then routes the order through the exchange or OTC Market.

The Dodd-Frank Act added a definition of, and responsibilities associated with, a “financial market utility” or FMU. Clearing brokers are FMU’s. FMU’s provide the actual functions associated with clearing trades through the DTC system. As part of that process, a division of DTC, the National Securities Clearing Corporation (“NSCC”), becomes the buyer and seller of each contract, netting out and settling all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. When one of the counterparties in the process does not fulfill its settlement obligations by delivering the securities, there is a “failure to deliver.” Overall, failures to deliver are less than 1% of all transactions.

Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. These accounts can be in the billions. Clearing firms can either settle each day or carry their open account forward until the next business day. Because all transactions are netted out, 99% of all trade obligations do not require the exchange of money, which helps reduce some risk. NSCC’s role in this process is referred to as a central counterparty or CCP. This process is continuous.

Looking at the process from the top down, the CCP carries the risk that the clearing firm (or FMU) will not have the financial resources to perform its obligations. In turn, the clearing firms have risks from their customers, including introducing brokers, who in turn ultimately have risks from the individual account holders. The risks are compounded by changing values of the securities being traded, during the settlement process. The faster a trade settles, the lower the cumulative risk at each level of the process.

This is a very simplified high-level description of the process. Technically, the roles of DTC and its subsidiaries, CEDE and NSCC, as well as clearing agencies and introducing brokers involve a complex set of regulations, with different definitions, obligations and roles for the different hats the entities wear depending on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the form the security takes (paper or electronic), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved (retail or institutional). For those interested, the SEC rule release provides an excellent in-depth review of the settlement and clearing process.

Exchange Act Rule 15c6-1

Exchange Act Rule 15c6-1 prohibits a broker-dealer from effecting or entering into a contract for the purchase or sale of a security, subject to certain exemptions, that provides for the payment of the funds or delivery of the securities later than the third business day after the contract (i.e., trade) date unless expressly agreed upon by both parties at the time of the transaction. Exempted securities include government and municipal securities, commercial paper, limited partnership units that are not listed on an exchange or automated quotations system (OTC Markets), and sales in a firm commitment underwritten offering that are priced after market close.

Firm commitment offerings can rely on an extended T+4 settlement cycle. It is unclear what impact the proposed rule change will have on this exception. The SEC rule release has sought comment on the question.

One of the SEC’s roles is to enhance the resilience and efficiency of the clearance and settlement process such that the system itself does not add to, but rather subtracts from, the risks associated with trading in securities. The SEC is proposing to amend Rule 15a6-1(a) to shorten the settlement cycle to T+2. The SEC believes this change will reduce various risks in the marketplace, including: (i) the credit risk that one party will be unable to fulfill its delivery obligations (of either cash or the securities) on the settlement date; and (ii) the market risk that the value of the securities will change between the trade and settlement such as to result in a loss to one of the parties.

To drill down further on the summary of the settlement and clearing process described in the background section of this blog, the following is a high-level description of what happens following the execution of a trade. First, when the trade is submitted to an exchange or alternative trading system (such as OTC Markets), it is matched with a counterparty. That is, a buy order is electronically matched to a sell order. As long as there is a match, the trade is locked in and sent to NSCC.

On the trade date (T), NSCC validates the trade data and communicates receipt of the transaction. At that moment the parties are legally committed to complete the trade. At midnight on the first day (T+1), NSCC substitutes itself as the legal buyer and legal seller. Technically, the first buy/sell contract is replaced by two new contracts, one between NSCC and the buyer and the other between NSCC and the seller. On the second day (T+2), NSCC issues a trade summary report to its members which summarizes all securities and cash to be settled that day, and shows the net positions for each. NSCC also sends an electronic instruction to DTC to process the net security and cash settlements. Finally, on the third day (T+3), DTC process the electronic settlement by transferring cash and securities between the broker-dealer accounts and the broker-dealers, in turn, put the securities and/or cash in their customer accounts.

Although institutional trading is similar, there are unique aspects and there can be additional participants. For example, an institution may have a custodian of its securities in addition to its broker, may use a matching provider and may avail itself of different netting and settling processes within the brokerage and DTC systems. Although the detailed process may differ, ultimately both retail and institutional trades currently fully settle in the T+3 timeline.

As mentioned, the length of the settlement cycle impacts the exposure to credit, market and liquidity risks for the participants. The participants, including NSCC, take measures to reduce these risks, including by requiring funds to be kept on deposit by clearing and brokerage firms effecting such participants’ liquidity. Even then, however, all participants are exposed to market risk during the settlement process, including a decline in value of the traded securities and the risk that such decline could exceed the broker’s capital deposit or result in a failure to deliver.

A reduction in risks would reduce the necessity to mitigate such risk, including reducing the funds that must be kept on deposit by participants. It is undisputed that reducing the settlement cycle reduces these risks.

Also, obviously if funds are tied up for three days pending a settlement of a transaction, whether you are the retail investor or clearing agency, there is a lack of available liquidity to participate in other transactions during that time.

The reduction of the settlement cycle to T+2 will also assist in aligning global clearing of securities as many markets including the United Kingdom and many European countries are already on the T+2 schedule.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

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Yahoo Hacking Scandal And Obligations Related To Cybersecurity

Posted by Securities Attorney Laura Anthony | December 6, 2016 Tags: Obligations Related To Cybersecurity, Yahoo Hacking Scandal

On September 26, 2016, Senator Mark R. Warner (D-VA), a member of the Senate Intelligence and Banking Committees and cofounder of the bipartisan Senate Cybersecurity Caucus, wrote a letter to the SEC requesting that they investigate whether Yahoo, Inc., fulfilled its disclosure obligations under the federal securities laws related to a security breach that affected more than 500 million accounts. Senator Warner also requested that the SEC re-examine its guidance and requirements related to the disclosure of cybersecurity matters in general.

The letter was precipitated by a September 22, 2016, 8-K and press release issued by Yahoo disclosing the theft of certain user account information that occurred in late 2014. The press release referred to a “recent investigation” confirming the theft of user account information associated with at least 500 million accounts that was stolen in late 2014. Just 13 days prior to the 8-K and press release, on September 9, 2016, Yahoo filed a preliminary 14A filing with the SEC related to the sale of Yahoo’s operating business to Verizon Communications, Inc., in which it stated that it did not have any knowledge of “any incidents of, or third party claims alleging… unauthorized access” of personal data of its customers that could have a material effect on the Verizon-Yahoo transaction.

The September 22 filing was the first disclosure by Yahoo of the hack and has raised many questions as to when it knew about the 2014 cyberattack and what its duties were to make public disclosure of same. The hack has also raised questions related to the SEC’s current rules and thresholds for how and when companies need to report a material data breach.

This blog provides a summary of the current SEC guidelines related to disclosures of cybersecurity risks and incidents as well as a summary of current disclosure practices among reporting companies.

SEC Guidance on Disclosure of Cybersecurity Matters

Introduction

On October 13, 2011, the SEC issued a Disclosure Guidance related to cybersecurity risks and cyber incidents. The guidance attempts to find 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. In that regard, the SEC is clear that disclosure of actual detailed security measures is not required. As with the rules on disclosure in general, companies must consider their specific facts and circumstances in determining the required disclosure, if any.

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. 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. A primary example of the latter is the famous hacking of the Sony Pictures Entertainment email system in 2014.

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; and
Reputational damage.

Disclosure Guidance

Consistent with all disclosure guidance, the SEC begins its guideline with the basic premise that the disclosure requirements are meant to “elicit disclosure of timely, comprehensive, and accurate information about risks and events that a reasonable investor would consider important to an investment decision.” With that said, as of the date of the guidance, and as of today, there is no specific disclosure requirement or rule under either Regulation S-K or S-X that addresses cybersecurity risks, attacks or other incidents.

However, as discussed further in this blog, many of the disclosure rules encompass these disclosures indirectly, such as risk factors, internal control assessments, management discussion and analysis, legal proceedings and financial statement loss contingencies. Moreover, 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.

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. The SEC expects companies to “evaluate their cybersecurity risks and take into account all available relevant information, including prior cyber incidents and the severity and frequency of those incidents.” In addition, 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. Material 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;
Discussion of any outsourcing of functions that give rise to risks or preventative measures;
Description of past incidents, including their costs and consequences;
Risks of cyber-incidents that could remain undetected for a period of time; and
Description of insurance coverage.

Management Discussion and Analysis (MD&A)

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, increase in cybersecurity protection costs, and related litigation. 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 effect 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.

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, breach of contract, product recall and replacement, indemnification or remediation. Furthermore, incidents can result in loss of, and therefore accounting impairment to, goodwill, intangible assets, trademarks, patents, capitalized software and even inventory.

Controls and Procedures

To the extent that cyber-matters effect a company’s ability to record, process, summarize and report financial and other information in SEC filings, management will need to consider whether there is a reportable deficiency in disclosure controls and procedures.

Disclosure in Practice

The Yahoo hacking incident resulted in 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 Journal article, 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.

My opinion (which was also Mr. LaCroix’s opinion and that of most of the industry) is that companies are relying on the materiality standard to avoid disclosure of cyber-incidents. Most public-company hacking involves large organizations that can reasonably make the judgment call that the incident and its effects are not material to investment decisions. See HERE for a discussion on materiality.

Additional Information

In 2011, at the time of the SEC release, there was a noticeable increase in reliance on technology by all businesses resulting in the issuance of the guidance. Today, the prevalence of technological reliance and cyber-incidents has increased dramatically and as such, it is my view that it is time for the SEC to review and update their guidance.

The SEC focuses time and financial resources on the use of technology by the SEC itself and market participants. In November 2015, the SEC adopted Regulation Systems Compliance and Integrity, which requires key market participants to have comprehensive written policies and procedures to ensure the security and resilience of their technological systems, to ensure that systems operate in compliance with federal securities laws and to provide for maintenance and testing of such systems. For more information see my blog HERE.

Recap on Disclosure Effectiveness Initiative

The disclosure of cybersecurity risks, attacks or other incidents is ultimately just a disclosure. As I’ve been writing about often recently, disclosure has been and continues to be a topic of examination and regulatory change.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

Download our mobile app at iTunes.

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SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

Posted by Securities Attorney Laura Anthony | November 29, 2016 Tags: SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amend Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). In addition, the SEC has created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC has amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC has repealed the rarely used and now redundant Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A will take effect on April 20, 2017. Amended Rule 504 will take effect on January 20, 2017, and the repeal of Rule 505 will be effective May 20, 2017. The rule changes had initially been proposed in October 2015. My two-part blog on the proposed amendments can be read HERE and HERE.

Background on Rule 147 and Rationale for Amendments

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption.

Rule 147 was adopted as a safe harbor under Section 3(a)(11) to provide further details on the application of the Intrastate Exemption. Rule 147 was adopted in 1974 and until now had not been updated since that time. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.

Section 3(a)(11) and Rule 147 has limitations that simply do not comport to today’s world. For example, the Rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and, if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.

Also, Rule 147 required that an issuer be incorporated in the state in which the offering occurs. In today’s world many company’s incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be overly burdensome.

The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 made it difficult for issuers to take advantage of these new state crowdfunding provisions.

At the same time, many current state intrastate exemptions are modeled after the language in Section 3(a)(11) and the existing Rule 147. As a result, simply amending Rule 147 to allow changes to the manner of offering to include advertising through Internet, television, radio and other forms of media that could be seen by out-of-state residents, would have left a disparity between state and federal rules. Accordingly, the SEC determined to amend Rule 147 within the statutory constraints of Section 3(a)(11) and add new Rule 147 without such constraints.

Summary of the New Rules

Amended Rule 147 remains a safe harbor under Section 3(a)(11) of the Securities Act allowing companies to continue to rely on the rule for current state law exemptions. New Rule 147A is a stand-alone rule not attached to Section 3(a)(11) and therefore not constrained by the specific language in that Section. New Rule 147A is substantially similar to amended Rule 147 but eliminates the restrictions on offers such that the Internet and websites can be used for such offers, and eliminates the requirement that a company be incorporated in the state in which it is conducting the offering as long as certain conditions are met. Sales will still be limited to residents of the company’s state.

Other than provisions allowing out-of-state offers (such as by use of a website) and offerings by states incorporated out of state, amended Rule 147 and new Rule 147A are substantially the same.

Both amended Rule 147 and new Rule 147A include the following: (i) a requirement that the issuer has its “principal place of business” in-state and satisfy at least one in-state “doing business” requirement; (ii) a new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser; (iii) a requirement that issuers obtain a written representation regarding residency from each purchaser; (iv) determining residency of an entity purchaser using the “principal place of business” standard; (v) limiting resales to persons within the same state for a period of six months; (vi) an integration safe harbor for any other prior offering and some subsequent offerings; and (vii) legend requirements for offerees and purchasers related to resale limitations.

Both amended Rule 147 and new Rule 147A remain intrastate exemptions and must comply with all state laws regarding any offerings. States are free to impose additional disclosure requirements, bad-actor prohibitions and other state-specific investor protections. No notice or Form D filing is required to be made to the SEC.

Rule 504 of Regulation D is a registration exemption for small offerings available to companies that are not Exchange Act reporting, investment companies or blank-check companies. Generally Rule 504 requires that the issuing company comply with state law as to the particular offer and exemption requirements, including, where required, a state level registration. The new rule maintains the structure, and bows to state law requirements but increases the aggregate offering amount from $1 million to $5 million and adds bad-actor disqualifications from reliance on the rule.

The SEC has repealed Rule 505 of Regulation D.

Amended Rule 147 and New Rule 147A – Specifics

Manner of Offering

New Rule 147A will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon.

Amended Rule 147 will continue to prohibit offers to out-of-state residents. Both Rules 147 and 147A will require that all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state. To accommodate space-constrained social media, such as Twitter, the SEC will allow the use of hyperlinks. In particular, where offering materials or information is distributed through a medium with limitations on the number of characters or text that may be included, and the information with disclaimers would exceed such limitations, the company can satisfy its disclosure obligation by including an active hyperlink to the required disclosures. The communication must prominently indicate that the required language is provided through the hyperlink. Where an electronic communication is capable of including the required statements, along with the other information, without exceeding the applicable limit on number of characters or amount of text, a hyperlink should not be used.

Determining Whether an Issuer is a “Resident” of a Particular State

Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual. Amended Rule 147 maintains this basic requirement, but supplants “principal office” with “principal place of business,” a term that is also used in new Rule 147A. Under amended Rule 147 a company will be deemed a “resident” of a particular state in which it is both incorporated and has its principal place of business.

An issuer’s “principal place of business” is defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” The concept of principal office has been eliminated.

Under new Rule 147A residence will be determined solely using the “principal place of business” test without regard to state of incorporation. Under both amended Rule 147 and new Rule 147A, companies may only sell securities to purchasers in the same state in which such company has its principal place of residence. As noted above, Rule 147A does not so limit “offers.”

Where a company changes state of residence, under both rules, it will not be able to conduct another offering until the securities sold in the first offering have “come to rest.” That is, both rules provide that where an issuer completes an offering in one state, it would not be able to conduct an offering in another state until six months after the last sale in the prior state. This six-month period is also used for the resale limitation in both rules, which is an amendment from the prior nine-month rule under old Rule 147.

Other than the above manner of offering and determination of residence provisions, amended Rule 147 and new Rule 147A are identical. Accordingly, each of the following discussed provisions apply equally to both Rule 147 and new Rule 147A.

Determining Whether an Issuer is “Doing Business” in a Particular State

In addition to issuer residency, a company must satisfy at least one test establishing that such company is “doing business” in the state of the offering. Old Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Amended Rule 147 and new Rule 147A add a fourth test based on majority of employees, and only require that a company satisfy one of the four test to qualify for the use of the offering within that state.

In particular, an issuer shall be deemed to be doing business within a state if the issuer meets one of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state; or (iv) a majority of the issuer’s employees are located within the state.

Presumably a majority is satisfied by a greater than 50% determination. An employee would be located in a state if he or she is based in an office located in the state. A particular example provided in the rule release is one where an employee services the Virginia, Maryland and Washington, D.C., area for a company with an office in Maryland. In such case, the employee would be deemed based in Maryland.

Amended Rule 147 eliminates an exception from the 80% rule previously in place for companies with $5,000 or less in revenues.

As with all provisions of amended Rule 147 and new Rule 147A, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

Amended Rule 147 and new Rule 147A define the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. Again, “principal place of business” is defined as the location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.

Amended Rule 147 and new Rule 147A add a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state at the time of the purchase of securities, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. As with 506(c), the SEC is reluctant to provide a firm list of requirements that satisfy the reasonable belief standard but rather urges a company to consider all facts and circumstances. However, the rule release does contain some example considerations, including (i) a pre-existing relationship between the company and prospective purchaser that includes knowledge of residency; (ii) evidence such as the address on utility and house bills; (iii) pay stubs; (iv) tax returns; (v) documents issued by a federal or state governmental authority including a driver’s license; and (vi) public records.

In addition to the reasonable belief requirements, a company must obtain a written representation of residency from the investor. The representation of the investor can serve as evidence of residency but is not dispositive. A self-attestation from an investor, without more, is not enough to create a reasonable belief.

The SEC provides examples of proof of residency. For individuals proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the intrastate offering. Amended Rule 147 and new Rule 147A shorten this holding period to six months from the date of the sale. Market makers or dealers desiring to quote such securities after the six-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information.

Bona fide gifts are specifically not subject to the resale limitations. However, the donee would still be bound by the same limitation. Accordingly, if an issuer conducted an intrastate offering in Florida, for example, and a purchaser than made a bona fide gift to a charity in California, that charity would be limited to resales to purchasers in Florida until the six-month period had expired. In this case, the charity could tack onto the holding period of the original purchaser.

The resale limitation is confined to the state in which the issuer conducts the offering. If an issuer changes its principal place of business following an offering, the resale limitations would stay in the state where the offering had been conducted.

Moreover, Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. In the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence. Finally, persons reselling will need to consider whether they could be considered an underwriter if they purchase with a view to distribution. For purposes of determining underwriter status, a purchaser can rely on the guidance in Rule 144.

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Current Rule 147(b)(2) provides an integration safe harbor based on a hard six-month rule. Amended Rule 147 and new Rule 147A amend the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, offers and sales under Rule 147 and Rule 147A will not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering.

The Rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test. As part of an integration analysis, an issuer will need to consider the particular offering exemptions and requirements, including the use of general solicitation and advertising. For instance, a regulation crowdfunding, which by its nature solicits residents in all states, would not be consistent with a Rule 147 offering, but may work with a Rule 147A offering.

Moreover, an issuer will need to be mindful of gun-jumping issues where a registered offering is begun immediately after the conclusion of a Rule 147 or 147A offering that involved solicitation and advertising. In such cases, like testing the waters under Rule 105(c) of the JOBS Act, solicitations will need to be limited to qualified institutional buyers and institutional accredited investors for the 30 days prior to filing the registration statement. In practice, I suspect most issuers will simply wait for a 30-day period after completing an intrastate offering, prior to filing a registration statement.

Disclosure/Legend Requirements

Under amended Rule 147 and new Rule 147A, a disclosure about the limitations on resale needs to be given to each offeree and purchaser at the time of any offer or sale. The disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser. In addition, a written disclosure must be provided to all purchasers a reasonable period of time before the date of the sale.

Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Such legend must also identify the state in which the intrastate offering was completed for purposes of the resale restrictions.

State Law Requirements

Although the SEC had initial proposed limitations as to the availability of the offering to states that, in turn, had registration or exemptions with particular specified provisions including limits on investment amounts, the final rules do not contain such provisions. The SEC believes the states can regulate such offerings without particular federal requirements. The SEC notes that most state crowdfunding or intrastate offering protections already contain total offering limits and per-investor investment limitations.

Intrastate Broker-dealer Exemption

Section 15 of the Exchange Act exempts any broker whose business is exclusively intrastate and who does not use any facility for a national securities exchange, from broker-dealer registration requirements (the “intrastate broker-dealer exemption”). At the request of commenters, the SEC clarifies that a broker will not lose its ability to rely on the intrastate broker-dealer exemption merely because it maintains a website that can be viewed by out-of-state persons so long as such broker takes reasonable steps to ensure that its business remains exclusively intrastate. Such reasonable measures can include disclosures and disclaimers and taking measures to determine the state of residency of a potential client or lead.

Section 12(g) Registration

Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors to register such class of securities with the SEC. After consideration, including the fact that intrastate offerings do not impose any ongoing reporting requirements, the SEC determined not to exempt securities sold in Rule 147 and 147A offerings from the Section 12(g) registration requirements.

Exclusion of Investment Companies

Under Section 24(d) of the Investment Company Act of 1940, Section 3(a)(11) is not available to investment companies registered or required to be registered under the Investment Company Act. Accordingly, investment companies will remain excluded from Section 3(a)(11) and amended Rule 147. For consistency, the SEC specifically excludes investments companies from the use of new Rule 147A.

Amendments To Rules 504 And 505

Overview of Current Rule

Currently Rule 504 of Regulation D provides an exemption from registration for offers and sales up to $1 million in securities in any twelve-month period. Current Rule 504, like Regulation A/A+, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Moreover, current rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

Rules 504, 505 and 506 together comprise Regulation D. Rule 506 is promulgated under Section 4(a)(2) of the Securities Act and preempts state law. Rules 505 and 506 are promulgated under Section 3(b) of the Securities Act and do not preempt state law. Currently Rules 505 and 506 have bad-actor disqualification provisions but Rule 504 does not.

The vast majority of states require the registration of Rule 504 offerings. Rule 504 is similar to the offering exemption found in Section 3(a)(11) in that on the federal level it defers to state legislation and oversight. In fact, of the 34 states that have recently passed state-based crowdfunding exemptions, Maine specifically allows an issuer to rely on Rule 504 in utilizing its crowdfunding provisions.

As Rule 504 is, in essence, a deferral to the states for small offerings, the SEC is of the position that it does not warrant imposing extensive regulation on the federal level. I agree. As stated by the SEC, the purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions and general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Amendments

The SEC has increased the amount of securities that may be offered and sold in reliance on Rule 504 to $5 million in any 12-month period, and has added bad-actor disqualification provisions to the rule. The SEC believes the change will help facilitate capital formation and give states greater flexibility in developing state-coordinated review programs for multi-state registrations. The proposed rule also corrects the technical reference to Section 3(b) of the Securities Act in the Rules 504 to Section 3(b)(1), which change was made by the JOBS Act in 2012.

The proposed bad-actor disqualification provisions are substantially the same as those in place for Rule 506 offerings. For a review of the Rule 506 bad-actor disqualification provisions, see my blog HERE.

Repeal of Rule 505

The SEC has repealed the almost never used Rule 505 in its entirety.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

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SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | November 22, 2016 Tags: Application; Associated Person Registration; Supervision, CAB, CABs, Conduct Rules for CABs, Description of Capital Acquisition Broker (“CAB”), Financial and Operational Rules for CABs, FINRA Rule 2121, FINRA Rule 3110, FINRA rules, M&A deals

On August 18, 2016, the SEC approved FINRA’s rules implementing a new category of broker-dealer called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. FINRA first published proposed rules on CABs in December 2015. My blog on the proposed rules can be read HERE. In March and again in June 2016, FINRA published amendments to the proposed rules. The final rules enact the December proposed rules as modified by the subsequent amendments.

A CAB will generally be a broker-dealer that engages in M&A transactions, raising funds through private placements and evaluating strategic alternatives and that collects transaction-based compensation for such activities. A CAB will not handle customer funds or securities, manage customer accounts or engage in market making or proprietary trading.

Description of Capital Acquisition Broker (“CAB”)

There are currently FINRA-registered firms which limit their activities to advising on mergers and acquisitions, advising on raising debt and equity capital in private placements or advising on strategic and financial alternatives. Generally these firms register as a broker because they may receive transaction-based compensation as part of their services. However, they do not engage in typical broker-dealer activities, including carrying or acting as an introducing broker for customer accounts, accepting orders to purchase or sell securities either as principal or agent, exercising investment discretion over customer accounts or engaging in proprietary trading or market-making activities.

The proposed new rules will create a new category of broker-dealer called a Capital Acquisition Broker (“CAB”). A CAB will have its own set of FINRA rules but will be subject to the current FINRA bylaws and will be required to be a FINRA member. FINRA estimates that there are approximately 750 current member firms that would qualify as a CAB and that could immediately take advantage of the new rules.

FINRA is also hopeful that current firms that engage in the type of business that a CAB would, but that are not registered as they do not accept transaction-based compensation, would reconsider and register as a CAB with the new rules. In that regard, FINRA’s goal would be to increase its regulatory oversight in the industry as a whole. I think that on the one hand, many in the industry are looking for more precision in their allowable business activities and compensation structures, but on the other hand, the costs, regulatory burden, and a distrust of regulatory organizations will be a deterrent to registration. It is likely that businesses that firmly act within the purview of a CAB but for the transactional compensation and that intend to continue or expand in such business, will consider registration if they believe they are “leaving money on the table” as a result of not being registered. Of course, such a determination would include a cost-benefit analysis, including the application fees and ongoing legal and compliance costs of registration. In that regard, the industry, like all industries, is very small at its core. If firms register as a CAB and find the process and ongoing compliance reasonable, not overly burdensome and ultimately profitable, word will get out and others will follow suit. The contrary will happen as well if the program does not meet these business objectives.

A CAB will be defined as a broker that solely engages in one or more of the following activities:

Advising an issuer on its securities offerings or other capital-raising activities;

Advising a company regarding its purchase or sale of a business or assets or regarding a corporation restructuring, including going private transactions, divestitures and mergers;

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;

Qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in respect to the purchase or sale of newly issued unregistered securities (see below for the FINRA definition of institutional investor, which is much different and has a much higher standard than an accredited investor);

Qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer or control person in connection with a change of control of a privately held company. For purposes of this section, a control person is defined as a person that has the power to direct the management or policies of a company through security ownership or otherwise. A person that has the power to direct the voting or sale of 24% or more of a class of securities is deemed to be a control person; and/or

Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters. For more information on this, see my blog HERE regarding the SEC no-action letter granting a broker registration exemption for certain M&A transactions.

Since placing securities in private offerings is limited to institutional investors, that definition is also very important. Moreover, FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. Under the proposed CAB rules, an institutional investor is defined to include any:

Bank, savings and loan association, insurance company or registered investment company;

Government entity or subdivision thereof;

Employee benefit plan that meets the requirements of Sections 403(b) or 457 of the Internal Revenue Code and that has a minimum of 100 participants;

Qualified employee plans as defined in Section 3(a)(12)(C) of the Exchange Act and that have a minimum of 100 participants;

Any person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million;

Persons acting solely on behalf of any such institutional investor; or

Any person meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (i.e., any natural person that owns at least $5 million in investments; family offices with at least $5 million in investments; trusts with at least $5 million in investments; or any person acting on their own or as a representative with discretionary authority, that owns at least $25 million in investments).

A CAB will not include any broker that does any of the following:

Carries or acts as an introducing broker with respect to customer accounts;

Holds or handles customers’ funds or securities;

Accepts orders from customers to purchase or sell securities either as principal or agent for the customer;

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making; or

Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act (interesting that FINRA would include Regulation A in this, as currently no license is required at all to maintain such a platform – only platforms for Regulation Crowdfunding require such a license).

Application; Associated Person Registration; Supervision

A CAB firm will generally be subject to the current member application rules and will follow the same procedures for membership as any other FINRA applicant, with four main differences. In particular: (i) the application has to state that the applicant will solely operate as a CAB; (ii) the FINRA review will consider whether the proposed activities are limited to CAB activities; (iii) FINRA has set out procedures for an existing member to change to a CAB; and (iv) FINRA has set out procedures for a CAB to change its status to regular full-service FINRA member firm.

The CAB rules also set out registration and qualification of principals and representatives, which incorporate by reference to existing NASD rules, including the registration and examination requirements for principals and registered representatives. CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs will also be subject to current rules regarding Operations Professional registration.

CABs would have a limited set of supervisory rules, although they will need to certify a chief compliance officer and have a written anti-money laundering (AML) program. In particular, the CAB rules model some, but not all, of current FINRA Rule 3110 related to supervision. CABs will be able to create their own supervisory procedures tailored to their business model. CABs will not be required to hold annual compliance meetings with their staff. CABs are also not subject to the Rule 3110 requirements for principals to review all investment banking transactions or prohibiting supervisors from supervising their own activities.

CABs would be subject to FINRA Rule 3220 – Influencing or Rewarding Employees of Others, Rule 3240 – Borrowing form or Lending to Customers, and Rule 3270 – Outside Activities of Registered Persons.

Conduct Rules for CABs

The proposed CAB rules include a streamlined set of conduct rules. This is a brief summary of some of the conduct rules related to CABs. CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Rules 2080 and 2081 regarding expungement of customer disputes; and the FINRA arbitration requirements in Rules 2263 and 2268. CABs will also be subject to know-your-customer and suitability obligations similar to current FINRA rules for full-service member firms, and likewise will be subject to the FINRA exception to that rule for institutional investors. CABs will be subject to abbreviated rules governing communications with the public and, of course, prohibitions against false and misleading statements.

CABs are specifically not subject to FINRA rules related to transactions not within the purview of allowable CAB activities. For example, CABs are not subject to FINRA Rule 2121 related to fair prices and commissions. Rule 2121 requires a fair price for buy or sell transactions where a member firm acts as principal and a fair commission or service charge where a firm acts as an agent in a transaction. Although a CAB could act as an agent in a buy or sell transaction where a counter-party is an institutional investor or where it arranges securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters on such M&A deals, FINRA believes these transactions are outside the standard securities transactions that typically raise issues under Rule 2121.

Financial and Operational Rules for CABs

CABs would be subject to a streamlined set of financial and operational obligations. CABs would be subject to certain existing FINRA rules including, for example, audit requirement, maintenance of books and records, preparation of FOCUS reports and similar matters.

CABs would also have net capital requirements and be subject to suspension for noncompliance. CABs will be subject to the current net capital requirements set out by Exchange Act Rule 15c3-1.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

Download our mobile app at iTunes.

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Changes In India’s Laws Related To Foreign Direct Investments- A U.S. Opportunity; Brief Overview For Foreign Private Issuers

Posted by Securities Attorney Laura Anthony | November 11, 2016

In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian owned and domiciled companies. The new rules continue a trend in laws supporting India as an open world economy. A large portion of the U.S. public marketplace is actually the trading of securities of foreign owned or held businesses. Foreign businesses may register and trade directly on U.S. public markets as foreign private issuers, or they may operate as partial or wholly owned subsidiaries of U.S. parent companies that in turn quote and trade on either the OTC Markets or a U.S. exchange.

Brief Overview for Foreign Private Issuers

Definition of Foreign Private Issuer

Both the Securities Act of 1933, as amended (“Securities Act”) and the Securities Exchange Act of 1934, as amended (“Exchange Act”) contain definitions of a “foreign private issuer.” Generally, if a company does not meet the definition of a foreign private issuer, it is subject to the same registration and reporting requirements as any U.S. company.

The determination of foreign private issuer status is not just dependent on the country of domicile, though a U.S. company can never qualify regardless of the location of its operations, assets, management and subsidiaries. There are generally two tests of qualification as a foreign private issuer, as follows: (i) relative degree of U.S. share ownership; and (ii) level of U.S. business contacts.

As with many securities law definitions, the overall definition of foreign private issuer starts with an all-encompassing “any foreign issuer” and then carves out exceptions from there. In particular, a foreign private issuer is any foreign issuer, except one that meets the following as of the last day of its second fiscal quarter:

(i) a foreign government;

(ii) more than 50% of its voting securities are directly or indirectly held by U.S. residents; and any of the following: (a) the majority of the executive officers or directors are U.S. citizens or residents; (b) more than 50% of the assets are in the U.S.; or (c) the principal business is in the U.S. Principal business location is determined by considering the company’s principal business segments or operations, its board and shareholder meetings, its headquarters, and its most influential key executives.

That is, if fewer than a foreign company’s shareholders are located in the U.S., it qualifies as a foreign private issuer. If more than 50% of the record shareholders are in the U.S., the company must further consider the location of its officers and directors, assets and business operations.

Registration and Ongoing Reporting Obligations

Like U.S. companies, when a foreign company desires to sell securities to U.S. investors, such offers and sales must either be registered or there must be an available Securities Act exemption from registration. The registration and exemption rules available to foreign private issuers are the same as those for U.S. domestic companies, including, for example, Regulation D (with the primarily used Rules 506(b) and 506(c)) and Regulation S) and resale restrictions and exemptions such as under Section 4(a)(1) and Rule 144.

When offers and sales are registered, the foreign company becomes subject to ongoing reporting requirements. Subject to the exemption under Exchange Act Rule 12g3-2(b) discussed at the end of this blog, when a foreign company desires to trade on a U.S. exchange or the OTC Markets, it must register a class of securities under either Section 12(b) or 12(g) of the Exchange Act. Likewise, when a foreign company’s worldwide assets and worldwide/U.S. shareholder base reaches a certain level ($10 million in assets; total shareholders of 2,000 or greater or 500 unaccredited with U.S. shareholders being 300 or more), it is required to register with the SEC under Section 12(g) of the Exchange Act.

The SEC has adopted several rules applicable only to foreign private issuers and maintains an Office of International Corporate Finance to review filings and assist in registration and reporting questions. Of particular significance:

(i) Foreign private issuers may prepare financial statements using either US GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to US GAAP;

(ii) Foreign private issuers are exempt from the Section 14 proxy rules;

(iii) Insiders of foreign private issuers are exempt from the Section 16 reporting requirements and short swing trading prohibitions; however, they must comply with Section 13 (for a review of Sections 13 and 16, see my blog HERE);

(iv) Foreign private issuers are exempt from Regulation FD;

(v) Foreign private issuers may use separate registration and reporting forms and are not required to file quarterly reports (for example, Form F-1 registration statement and Forms 20-F and 6-K for annual and periodic reports); and

(vi) Foreign private issuers have a separate exemption from the Section 12(g) registration requirements (Rule 12g3-2(b)) allowing the trading of securities on the OTC Markets without being subject to the SEC reporting requirement.

Although a foreign private issuer may voluntarily register and report using the same forms and rules applicable to U.S. issuers, they may also opt to use special forms and rules specifically designed for and only available to foreign companies. Form 20-F is the primary disclosure document and Exchange Act registration form for foreign private issuers and is analogous to both an annual report on Form 10-K and an Exchange Act registration statement on Form 10. A Form F-1 is the general registration form for the offer and sale of securities under the Securities Act and, like Form S-1, is the form to be used when the company does not qualify for the use of any other registration form.

A Form F-3 is analogous to A Form S-3. A Form F-3 allows incorporation by reference of an annual and other SEC reports. To qualify to use a Form F-3, the foreign company must, among other requirements that are substantially similar to S-3, have been subject to the Exchange Act reporting requirements for at least 12 months and filed all reports in a timely manner during that time. The company must have filed at least one annual report on Form 20-F. A Form F-4 is used for business combinations and exchange offers, and a Form F-6 is used for American Depository Receipts (ADR). Also, under certain circumstances, a foreign private issuer can submit a registration statement on a confidential basis.

Once registered, a foreign private issuer must file periodic reports. A Form 20-F is sued for an annual report and is due within four months of fiscal year-end. Quarterly reports are not required. A Form 6-K is used for periodic reports and captures: (i) the information that would be required to be filed in a Form 8-K; (ii) information the company makes or is required to make public under the laws of its country of domicile; and (iii) information it files or is required to file with a U.S. and foreign stock exchange.

As noted above, a foreign private issuer may elect to use either U.S. GAAP; International Financial Reporting Standards (“IFRS”); or home country accounting standards with a reconciliation to U.S. GAAP in the preparation and presentation of its financial statements. Regardless of the accounting standard used, the audit firm must be registered with the PCAOB.

All filings with the SEC must be made in English. Where a document or contract is being translated from a different language, the SEC has rules to ensure the translation is fair and accurate.

The SEC rules do not have scaled disclosure requirements for foreign private issuers. That is, all companies, regardless of size, must report the same information. A foreign private issuer that would qualify as a smaller reporting company or emerging growth company should consider whether it should use and be subject to the regular U.S. reporting requirements and registration and reporting forms. The company should also consider that no foreign private issuer is required to provide a Compensation Discussion & Analysis (CD&I). If the foreign company opts to be subject to the regular U.S. reporting requirements, it must also use U.S. GAAP for its financial statements. For further discussions on general reporting requirements and rules related to smaller reporting and emerging growth companies, see my blogs HERE, HERE, and HERE related to ongoing proposed changes and which includes multiple related links under the “further background” subsection.

Deregistration

The deregistration rules for a foreign private issuer are different from those for domestic companies. A foreign private issuer may deregister if: (i) the average daily volume of trading of its securities in the U.S. for a recent 12-month period is less than 5% of the worldwide average daily trading volume; or (ii) the company has fewer than 300 shareholders worldwide. In addition, the company must: (i) have been reporting for at least one year and have filed at least one annual report and be current in all reports; (ii) must not have registered securities for sale in the last 12 months; and (iii) must have maintained a listing of securities in its primary trading markets for at least 12 months prior to deregistration.

American Depository Receipts (ADRs)

An ADR is a certificate that evidences ownership of American Depository Shares (ADS) which, in turn, reflect a specified interest in a foreign company’s shares. Technically the ADR is a certificate reflecting ownership of an ADS, but in practice market participants just use the term ADR to reflect both. An ADR trades in U.S. dollars and clears through the U.S. DTC, thus avoiding foreign currency issuers. ADR’s are issued by a U.S. bank which, in turn, either directly or indirectly through a relationship with a foreign custodian bank, holds a deposit of the underlying foreign company’s shares. ADR securities must either be subject to the Exchange Act reporting requirements or be exempt under Rule 12g3-2(b). ADR’s are always registered on Form F-6.

OTC Markets

OTC Markets allows for the listing and trading of foreign entities on the OTCQX and OTCQB that do not meet the definition of a foreign private issuer as long as such company has its securities listed on a Qualifying Foreign Stock Exchange for a minimum of the preceding 40 calendar days subject to OTC Markets’ ability to waive such requirement upon application. If the company does not meet the definition of foreign private issuer, it still must fully comply with Exchange Act Rule 12g3-2(b). For details on the OTCQX listing requirements for international companies, see my blog HERE and for listing requirements for OTCQB companies, including international issuers, see HERE.

India as an emerging market

India is widely considered the world’s fastest growing major economy. The small and micro-cap industry has been eyeing India as an emerging market for the U.S. public marketplace for several years now. In my practice alone, I have been approached by several groups that see the U.S. public markets as offering incredible potential to the exploding Indian start-up and emerging growth sector. Taking advantage of this opportunity, however, was stifled by strict Indian laws prohibiting or limiting foreign investment into Indian companies. In June 2016, the Indian government announced new rules allowing for foreign direct investments into Indian owned and domiciled companies opening up the country to foreign investment, including by U.S. shareholders.

The new rules allow for up to 100% foreign investment in certain sectors. U.S. investors who already invest heavily in Indian-based defense, aviation, pharmaceutical and technology companies will see even greater opportunity in these sectors, which will now allow up to 100% foreign investment. Although certain sectors, including defense, will still require advance government approval for foreign investment, most sectors will receive automatic approval. U.S. public companies will now be free to invest in and acquire Indian-based subsidiaries. Likewise, more India-based companies will be able to trade on U.S. public markets, attracting U.S. shareholders and the benefits of market liquidity and public company valuations.

Indian companies are slowly starting to take advantage of reverse merger transactions with U.S. public companies. In July 2016, online travel agency Yatra Online, Inc., entered into a reverse merger agreement with Terrapin 3 Acquisition Corp, a U.S. SPAC. The transaction is expected to close in October 2016. Yatra is structured under a U.S. holding company with operations in India though an India domiciled subsidiary.

Last year Vidocon d2h became the first India-based company to go public via reverse merger when it completed a reverse merger with a U.S. NASDAQ SPAC. In January, 2016 Bangalore-based Strand Life Sciences Pvt Ltd became the second India based reverse merger when it went public in the U.S. in a transaction with a NASDAQ company.

In addition, U.S.-based public companies, venture capital and private equity firms, and hedge funds and family offices have been investing heavily in the Indian start-up and emerging growth boom. Yatra and Strand Life had both received several rounds of U.S. private funding before entering into their reverse merger agreements. NASDAQ-listed firm Ctrip.com International recently invested $180 million into another India-based online travel company, MakeMyTrip.

India’s Mumbai/Bombay Stock Exchange is already a Qualified Foreign Exchange for purposes of meeting the standards to trade on the U.S. OTCQX International. For details on all OTCQX listing requirements, including for international companies, see my blog HERE and related directly to international companies including Rule 12g3-2(b), see HERE. At least 5 companies currently trade on the OTCQX, with their principal market being in India.

Exchange Act Rule 12g3-2(b)

Exchange Act Rule 12g3-2(b) permits foreign private issuers to have their equity securities traded on the U.S. over-the-counter market without registration under Section 12 of the Exchange Act (and therefore without being subject to the Exchange Act reporting requirements). The Rule is automatic for foreign issuers that meet its requirements. A foreign issuer may not rely on the rule if it is otherwise subject to the Exchange Act reporting requirements.

The Rule provides that an issuer is not required to be subject to the Exchange Act reporting requirements if:

(i) the issuer currently maintains a listing of its securities on one or more exchanges in a foreign jurisdiction which is the primary trading market for such securities; and

(ii) the issuer has published, in English, on its website or through an electronic information delivery system generally available to the public in its primary trading market (such as the OTC Market Group website), information that, since the first day of its most recently completed fiscal year, it (a) has made public or been required to make public pursuant to the laws of its country of domicile; (b) has filed or been required to file with the principal stock exchange in its primary trading market and which has been made public by that exchange; and (c) has distributed or been required to distribute to its security holders.

Primary Trading Market means that at least 55 percent of the trading in the subject class of securities on a worldwide basis took place in, on or through the facilities of a securities market or markets in a single foreign jurisdiction or in no more than two foreign jurisdictions during the issuer’s most recently completed fiscal year.

In order to maintain the Rule 12g3-2(b) exemption, the issuer must continue to publish the required information on an ongoing basis and for each fiscal year. The information required to be published electronically is information that is material to an investment decision regarding the subject securities, such as information concerning:

(i) Results of operations or financial condition;

(ii) Changes in business;

(iii) Acquisitions or dispositions of assets;

(iv) The issuance, redemption or acquisition of securities;

(v) Changes in management or control;

(vi) The granting of options or the payment of other remuneration to directors or officers; and

(vii) Transactions with directors, officers or principal security holders.

At a minimum, a foreign private issuer shall electronically publish English translations of the following documents:

(i) Its annual report, including or accompanied by annual financial statements;

(ii) Interim reports that include financial statements;

(iii) Press releases; and

(iv) All other communications and documents distributed directly to security holders of each class of securities to which the exemption relates.

Click Here To Print- PDF Printout Changes In India’s Laws Related To Foreign Direct Investments- A U.S. Opportunity; Brief Overview For Foreign Private Issuers

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

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Florida Broker-Dealer Registration Exemption For M&A Brokers

Posted by Securities Attorney Laura Anthony | October 25, 2016 Tags: Broker-Dealer Registration Exemption, Florida, Florida Broker-Dealer Registration Exemption, Florida M&A Broker Exemption, M&A Broker, M&A Brokers, M&A offer and sale exemption, M&A Transactions

Following the SEC’s lead, effective July 1, 2016, Florida has passed a statutory exemption from the broker-dealer registration requirements for entities effecting securities transactions in connection with the sale of equity control in private operating businesses (“M&A Broker”). As discussed further below, the new Florida statute, together with the SEC M&A Broker exemption, may have paved the way for Florida residents to act as an M&A broker in reverse or forward merger transactions involving OTCQX-traded public companies without broker-dealer registration.

Florida has historically had stringent broker-dealer registration requirements in connection with the offer and sale of securities. Moreover, Florida does not always mirror the federal registration requirements or exemptions. For example, see my blog HERE detailing some state blue sky concerns when dealing with Florida, including the lack of an issuer exemption from the broker-dealer registration requirements for public offerings.

However, in a move helpful to merger and acquisition (M&A) transactions in the state, Florida has now passed an M&A broker-dealer exemption and concurrent securities registration exemption for M&A transactions. The Florida exemption is similar but not identical to the federal exemption. For a review of the SEC exemption for M&A brokers, see my blog HERE and the summary at the end of this blog. The SEC exemption specifically limited itself to the federal broker-dealer registration requirements. In addition, to Florida, other states have passed similar M&A broker exemptions; however, as of the writing of this blog, I have not conducted a survey on same.

Florida M&A Broker Exemption

The sale of securities in Florida is regulated by the Florida Office of Financial Regulation, Division of Securities and is generally found in Chapter 517 Florida Statutes and corresponding rules adopted under the Florida Administrative Code (F.A.C.), Chapter 517, Florida Statutes – Securities and Investor Protection Act and Chapter 69W-100 through 69W-1000, Florida Administrative Code.

Any offer or sale of securities in Florida, which offer or sale is not pre-empted by federal law, must either be registered or exempted from registration in accordance with the state securities laws. The Florida registration exemptions can be found in Florida Statutes section 517.061. All sales of securities in Florida must be made by a properly registered dealer (Chapter 517.12(1), Florida Statutes) or by someone utilizing an exemption provided by Chapter 517.12, Florida Statutes.

The new M&A offer and sale exemption has been codified by adding a new securities registration exemption to Section 517.061 and a new broker-dealer registration exemption to Section 517.12.

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The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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SEC Whistleblower Awards Pass $100 Million As It Continues To Crack Down On Confidentiality Provisions In Employment Agreements

Posted by Securities Attorney Laura Anthony | September 27, 2016 Tags: Rule 21F-2, Rules 21F-1, SEC Enforcement Proceedings, Section 21F, The Dodd-Frank Act Whistleblower Statute, whistleblower regulations, whistleblower statute

The SEC has proudly announced that including a $22 million award on August 30, 2016, its whistleblower awards have surpassed $100 million. The news comes in the wake of two recent SEC enforcement proceedings against companies based on confidentiality and waiver language in employee severance agreements. Like two prior similar actions, the SEC has taken the position that restrictive language in confidentiality, waiver or settlement agreements with employees violates the anti-whistleblower rules adopted under Dodd-Frank.

Background – The Dodd-Frank Act Whistleblower Statute

The Dodd-Frank Act, enacted in July 2010, added Section 21F, “Whistleblower Incentives and Protection,” to the Securities Exchange Act of 1934 (“Exchange Act”). As stated in the original rule release, the purpose of the rule was “to encourage whistleblowers to report possible violations of the securities laws by providing financial incentives, prohibiting employment related retaliation, and providing various confidentiality guarantees.” Upon enactment of Section 21F, the SEC established the Office of the Whistleblower and created the SEC Whistleblower Program (“Whistleblower Program”).

The whistleblower regulations are comprised of Section 21F of the Exchange Act and Rules 21F-1 through 21F-17 promulgated thereunder. The bulk of the whistleblower regulations relate to the submission of original information leading to successful enforcement actions, and the eligibility, calculation and payment of awards to the whistleblower. The regulations also implement measures to protect the whistleblower from retaliatory actions.

Rule 21F-2, “Whistleblower status and retaliation protection,” defines a whistleblower as follows:

(a)(1) “You are a whistleblower if, alone or jointly with others, you provide the Commission with information pursuant to the procedures set forth in § 240.21F-9(a) of this chapter, and the information relates to a possible violation of the Federal securities laws (including any rules or regulations thereunder) that has occurred, is ongoing, or is about to occur. A whistleblower must be an individual. A company or another entity is not eligible to be a whistleblower.”

(b) Prohibition against retaliation. (1) “[F]or purposes of the anti-retaliation protections…, you are a whistleblower if: (i) you possess a reasonable belief that the information you are providing relates to a possible securities law violation… that has occurred, is ongoing, or is about to occur, and; (ii) you provide that information in a manner described in Section 21F(h)(1)(A); (iii) The anti-retaliation protections apply whether or not you satisfy the requirements, procedures and conditions to qualify for an award.”

Rule 21F-17, “Staff communications with individuals reporting possible securities law violations,” which is the subject of the enforcement actions, provides:

(a) “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement… with respect to such communications.”

Enforcement Proceedings

The SEC brought two enforcement proceedings against companies during the month of August based on restrictive language in confidentiality and waiver provisions in employee severance agreements. The two new proceedings are similar to two prior proceedings based on the same issue. The SEC enforcement proceedings claim that the restrictive language acts as a method to stifle or retaliate against whistleblowers.

In early 2016, the SEC began issuing requests to companies for copies of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and settlement agreements entered into with employees and former employees of the companies. The initiative specifically requested copies of documents since the enactment of the Dodd-Frank provisions that grant awards and protections for whistleblowers. The SEC was also asking for copies of company human resource policies, employee memos, training guides and any and all documents that discuss “whistleblowers” either directly or indirectly.

The SEC’s concern is that corporations are retaliating against potential whistleblowers and attempting to curb the whistleblowing incentives in the Dodd-Frank Act by providing detriments to employment in contracts and policies veiled as confidentiality protections. The Dodd-Frank Act directly prohibits retaliatory conduct by companies.

In the action filed on April 1, the SEC charged KBR, Inc., with violating Rule 21F-17 under the Dodd-Frank Act. In this case, KBR required employees participating in internal investigations related to potential securities law violations, to sign confidentiality agreements that prohibited the employee from discussing the matter with outside parties without KBR approval with a consequence of discipline or termination in the event of a violation of such confidentiality agreement. As the investigations included allegations of securities law violations, the terms in the agreement were found to violate Rule 21F-17 of the Dodd-Frank Act, which specifically prohibits companies from taking any action to impede whistleblowers from reporting possible securities law violations to the SEC. KBR agreed to pay a penalty of $130,000 and to amend its confidentiality statement to make it clear that employees are free to report possible violations to the SEC and other federal agencies without KBR approval or fear of retaliation.

In its press release on the matter, Andrew J. Ceresney, SEC Director of the Division of Enforcement, was quoted as saying, “By requiring its employees and former employees to sign confidentiality agreements imposing pre-notification requirements before contacting the SEC, KBR potentially discouraged employees from reporting securities violations to us. SEC rules prohibit employers from taking measures through confidentiality, employment, severance, or other type of agreements that may silence potential whistleblowers before they can reach out to the SEC. We will vigorously enforce this provision.”

The SEC enforcement action came despite the factual conclusion that no employee had actually been prevented from reporting a violation to the SEC or had sought to do so.

On August 10, 2016, the SEC brought a settled administrative proceeding against BlueLinx Holdings, Inc., ordering a $265,000 penalty for a violation of Rule 21F-17 by illegally using severance agreements requiring outgoing employees to waive their rights to seek monetary compensation under the SEC Whistleblower Program. A violation of the agreement would result in a loss of severance payments and other post-employment benefits. Similarly, in a settled administrative proceeding on August 16, 2016, the SEC ordered Health Net, Inc., to pay a $340,000 penalty for violating Rule 21F-17 with a similar provision.

In both cases, the agreements specifically did not preclude a former employee from participating in an investigation, communicating with or cooperating with investigators or reporting wrongdoing, but it did prevent the employee from seeking monetary compensation for doing so. Like the earlier KBT case, there was no evidence that an employee had actually been deterred from taking action as a result of the provision in the severance agreements. However, the SEC notes that the financial incentive portion of the Whistleblower Program is “a critical component of the Whistleblower Program… that any individual could look towards in determining whether to take the enormous risk of blowing the whistle in calling attention to fraud.”

The SEC is sending a clear message that any efforts to chill whistleblowers will be considered a violation of the rules.

Success of Whistleblower Program

As indicated, the Whistleblower Program has been a resounding success since its inception, resulting in over $500 million in financial remedies against wrongdoers and the payout of $111 million in awards to 34 whistleblowers. On August 30, 2016, the second-largest award, at $22 million, was granted to a whistleblower. On September 20, 2016 a $4 million dollar award was announced. The funds to pay out the awards come from an investor protection fund entirely financed through monetary sanctions paid to the SEC from securities law violators.

Whistleblowers may be eligible to receive an award when they voluntarily provide unique and useful information to the SEC that results in an enforcement action and monetary penalty against a wrongdoer. The awards range from 10% to 30% of the amount collected when sanctions ordered are in excess of $1 million.

In an August 30, 2016 press release, SEC Chair Mary Jo White stated, “[T]he SEC’s whistleblower program has proven to be a game changer for the agency in its short time of existence, providing a source of valuable information to the SEC to further its mission of protecting investors while providing whistleblowers with protections and financial rewards.”

The same press release contains some interesting facts, including that the Whistleblower Office has received more than 14,000 tips. Moreover, to help ensure that employees continue to utilize the statute without fear of repercussions, the SEC has now brought a total of 5 enforcement actions against companies related to retaliation. One of these actions was for actual retaliatory conduct, and the other 4 related to confidentiality and severance agreements as discussed herein.

Conclusion

The SEC has found the whistleblower statute to be extremely beneficial in uncovering and prosecuting large-scale securities fraud. In essence, the whistleblower statute, and potential monetary awards for successful prosecutions, provides the SEC with an army of investigators well beyond what the agency could afford using its own resources. Several states have taken notice of the success of the program and enacted their own version of the . Recently the State of Indiana awarded $95,000 to a whistleblower for helping bring an enforcement action against JP Morgan Chase for failing to disclose certain conflicts of interest to RIA clients.

When the SEC filed its first action back in April 2016, this firm made particular modifications to its forms of confidentiality agreements, non-disclosure agreements, employment agreements, severance agreements and employee settlement agreements. We urge all companies to seek the advice of competent counsel prior to entering into any such contracts, and of course, when conducting internal investigations which include allegations of potential securities law violations. Additional enforcement actions are expected as the SEC continues to review documents requested and provided by various employer companies.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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Confidentially Marketed Public Offerings (CMPO)

Posted by Securities Attorney Laura Anthony | July 5, 2016 Tags: CMPO, Confidentially Marketed Public Offering, Confidentially Marketed Public Offerings, Form 8-K, NASDAQ Considerations, NASDAQ Rules, Regulation FD, S-3 Eligibility, S-3 Registration Statement, S-3 Shelf Registration

Not surprisingly, I read the trades including all the basics, the Wall Street Journal, Bloomberg, The Street,The PIPEs Report, etc. A few years ago I started seeing the term “confidentially marketed public offerings” or “CMPO” on a regular basis. The weekly PIPEs Report breaks down offerings using a variety of metrics and in the past few years, the weekly number of completed CMPOs has grown in significance. CMPOs count for billions of dollars in capital raised each year.

CMPO Defined

A CMPO is a type of shelf offering registered on a Form S-3 that involves speedy takedowns when market opportunities present themselves (for example, on heavy volume). A CMPO is very flexible as each takedown is on negotiated terms with the particular investor or investor group. In particular, an effective S-3 shelf registration statement allows for takedowns at a discount to market price and other flexibility in the parameters of the offering such as the inclusion of warrants and terms of such warrants. A CMPO is sometimes referred to as “wall-crossed,” “pre-marketed” or “overnight” offerings.

In a typical CMPO, an underwriter confidentially markets takedowns of an effective S-3 shelf registration statement to a small number of institutional investors. The underwriter will not disclose the name of the issuing company until the institutional investor agrees that they have a firm interest in receiving confidential information and agrees not to trade in such company’s securities until the offering is either completed or abandoned.

When an investor confirms their interest, the company and its banker will negotiate the terms of the offering with the investor(s), including amount, price (generally a discount to market price), warrant coverage and terms of such warrant coverage. The disclosure of the name of the issuer and confidential information related to the offering is referred to as bringing the investor “over the wall.” Once brought over the wall, the potential investor(s) will complete due diligence. This process is completed on a confidential basis.

Once the terms have been agreed upon, the offering is “flipped” from confidential to public and a prospectus supplement, free writing prospectus, if any, a Rule 134 press release and a Form 8-K are prepared and filed informing the market of the offering. These public documents are almost always filed after the market closes and the offering itself generally closes that night as well, though sometimes the closing occurs the next trading day. The closing is the same as a firm commitment underwritten offering, such that there is a single closing of the entire takedown. The closing process and documents are also the same as a firm commitment underwritten offering including an underwriting agreement, opinion of counsel and a comfort letter. As the public disclosure and closing of the offering generally occurs overnight, a CMPO earned the name an “overnight” offering.

Generally the necessary closing documents and public filings have been prepared and are on standby ready to be utilized when a deal is agreed upon. Both the company and investors will wait for a favorable market window, such as an increase in the price and volume of the company’s stock, to close the offering.

S-3 Eligibility; NASDAQ Considerations; FINRA

A CMPO requires an effective S-3 shelf registration statement and accordingly is only available to companies that qualify to use an S-3. Among other requirements, to qualify to use an S-3 registration statement a company must have timely filed all Exchange Act reports, including Form 8-K, within the prior 12 months. An S-3 also contains certain limitations on the value of securities that can be offered. Companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, may offer the full amount of securities under an S-3 registration. For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, the company can offer up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.”

To calculate the non-affiliate float for purposes of S-3 eligibility, a company may look back 60 days and select the highest of the last sales prices or the average of the bid and ask prices on the principal exchange. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold under the same S-3 in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases.

A company should be careful that a CMPO is structured to comply with the NASDAQ definition of “public offering,” thereby avoiding NASDAQ’s rules requiring shareholder approval for private placements where the issuance will or could equal 20% or more of the pre-transaction outstanding shares. In particular, NASDAQ requires advance shareholder approval when a company sells 20% or more of its outstanding common stock (or securities convertible into common stock) in a private offering, at a discount to the greater of the market price or book value per share of the common stock. A separate NASDAQ rule also requires shareholder approval where officers, directors, employees, consultants or affiliates are issued common stock in a private placement at a discount to market price. CMPO’s have been stopped in their tracks by NASDAQ requiring pre-closing shareholder approval.

A CMPO differs from a standard public offering as it is confidentially marketed and is completed with little or no advance market notice. Accordingly, in determining whether a CMPO qualifies as a public offering, NASDAQ will consider: (i) the type of offering including whether it is being completed by an underwriter on a firm commitment or best-efforts basis (firm commitment being favorable); (ii) the manner of offering and marketing, including number of investors marketed to and how such investors were chosen (the more broad the marketing, the better); (iii) the prior relationship between the investors and the company or underwriter (again, the more broadly marketed, the better, as public offerings are generally widely marketed); (iv) offering terms including price (a deeper discount is unfavorable); and (v) the extent to which the company controls the offering and its distribution (insider participation is unfavorable).

NASDAQ also has rules requiring an advance application for the listing of additional shares resulting from follow-on offerings. Generally NASDAQ requires 15 days advance notice, but will often waive this advance notice upon request.

A CMPO will need to comply with FINRA rule 5110, the corporate finance rule. Generally FINRA will process a 5110 clearance on the same day. Moreover, there are several exemptions to issuer 5110 compliance, including based on the size of the company’s public float. For a brief overview of Rule 5110, see my blogHERE.

Confidentiality; Regulation FD; Insider Trading

By nature a CMPO involves the disclosure of confidential information to potential investors, including, but not limited to, that the company is considering a public offering takedown, the pricing terms of the offering, warrant coverage, and the disclosure of potentially confidential information during the due diligence phase. To ensure compliance with Regulation FD and avoid insider trading, the company and its underwriters will obtain a confidentiality agreement from the potential investors. The agreement will include a trading blackout for a specific period of time, generally until the offering either closes or is abandoned.

Although the confidential portion of the CMPO usually occurs very quickly (a week or two), many institutional investors require that the company issue a public “cleansing” statement if the offering does not proceed within a specified period of time. The cleansing statement would need to disclose any material non-public information disclosed to the potential investor as part of the negotiation and due diligence related to the offering. In the event the offering proceeds to a close, the offering documents (including potential free writing prospectus or prospectus supplement, Rule 134 press release and 8-K) will include all material non-public information previously disclosed to potential investors during the confidential phase. Both the company and the investor need to be careful that the filed offering materials and/or cleansing statement contain all necessary information to avoid potential insider trading issues.

The company must be sure to also file with the SEC all written marketing offering materials associated with a registered offering either as part of the prospectus or as a free writing prospectus. Generally with a CMPO, the written materials provided to investors are limited to public filings and investor presentation materials such as a PowerPoint already in the public domain that do not, in and of themselves, contain any material non-public information and therefore do not need to be filed with the SEC as offering materials.

As a reminder, Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence (such as potential investors in a CMPO); and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings and, accordingly, generally does not include a CMPO).

Benefits of a CMPO

A CMPO offers a great deal of flexibility to a company and its bankers. Utilized correctly, a CMPO can have minimal market impact. It is widely believed that announcements of public offerings, and impending dilution and selling pressure, invite short selling and speculative short-term market activity. Since a CMPO is confidential by nature and the time between the public awareness and completion of a particular takedown is very short (oftentimes the same day), the opportunity for speculating and short sellers is minimized. Moreover, as a result of the confidential nature of a CMPO, if a particular offering or takedown is abandoned, the market is unaware, relieving the company of the typical downward pricing pressure associated with an abandoned offering. Likewise, this confidential process allows the company to test the waters and only proceed when investor appetite is confirmed.

As a registered offering, CMPO securities are freely tradable and immediately transferable, incentivizing investment activity and reducing the negotiated discount to market associated with restricted securities. Offering expenses for a CMPO are also less than a fully marketed follow-on public offering. The CMPO is based on an existing S-3 shelf registration, thus reducing drafting costs. Also, the expense of marketing an offering itself, including a road show, is reduced or eliminated altogether.

Although the structure of a CMPO requires that the issuing company be S-3 shelf registration eligible, CMPOs are often used by small and development-stage companies (such as technology and biotech companies) that have smaller market capitalizations and need to tap into the capital of the public markets on a more frequent basis to fund ongoing research and development of products.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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

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

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