SEC Modernizes Auditor Independence Rules

Posted by Securities Attorney Laura Anthony | January 8, 2021 Tags: Auditor Independence Rules, SEC, SEC Modernizes Auditor Independence Rules

On October 16, 2020, the SEC adopted amendments to codify and modernize certain aspects of the auditor independence framework.  The rule proposal was published in December 2019 (see HERE).

The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time.  The regulatory structure lays out governing principles and describes certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent.  Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances.  Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties.  Rule 2-01(c) provides a non-exclusive list of circumstances which the SEC would consider inconsistent with independence.

The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company.  The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets.  Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.”  However, under the old rules, technical violations that would not result in a lack of integrity were swept into the regulatory structure, causing unnecessary burdens and expenses associated with the client-auditor relationship.

The final amendments reflect updates based on recurring fact patterns that the SEC staff observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality.  Accordingly, the new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time-consuming audit committee review of non-substantive matters.

The SEC adopting release provides examples of the types of concerns the new rules are designed to address, including one related to student loans and one related to a portfolio company.  The student loan example is very straightforward, involving the technical independence violation where an auditor in an audit firm is still paying student loans to a large student loan lender and the audit firm audits the lender.  Under the new rules, this would no longer create an independence violation.

The second example is more complicated but, in essence, involves a fund with multiple (could be hundreds) of portfolio companies and an audit firm with multiple global network affiliates.  Under the prior rules, it was very complicated to sort out to make sure that the audit firm was not providing audit services to more than one portfolio company even though the only relationship between the companies was a common investor.  Furthermore, a scenario could result where no qualified large audit firm could be independent due to the widespread investing activing of the fund.

Although the SEC doesn’t name names, this scenario could be fairly common.  The three largest asset management firms, BlackRock, Vanguard and State Street, manage over $15 trillion in combined global assets, which is equivalent to more than three-quarters of the U.S. gross domestic product.  Under the current rules, if one of their portfolio companies wanted to complete an IPO, it is very likely that the best audit firms would fail an independence test.  The result would be that the company would be required to either: (i) replace their audit firm with another audit firm if one could be found; (ii) to wait to register with the SEC for up to three years after termination of the services provided to another portfolio company; or (iii) to make a determination, likely in consultation with SEC staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality.  The amended rules would eliminate the need for a company’s audit committee and their auditors to seek SEC staff guidance in these scenarios.

The amendments will be effective 180 days after publication in the Federal Register, but voluntary compliance is permitted for new relationships once published in the Federal Register.  However, auditors cannot retroactively apply the final amendments to relationships in existence prior to the effective date.

Amendments

                Definitions of Affiliate of the Audit Client and Investment Company Complex

The SEC has amended the definitions of an “affiliate of the audit client” and “investment company complex” with a focus on decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited.  Currently an audit client includes not only the entity being audited but also affiliates of the audit client.  Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities.  Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also any investment company advised by a sister investment adviser or which has a sister sponsor.

The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies.  In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.

Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality.  In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.

The SEC has amended the definition of affiliate and ICC as relates to an audit client to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor.   In reviewing materiality, the audit firm will need to consider both whether the sister entity and/or the audit client is material to the controlling entity.  The amendment to the definition does not alter the general requirement that an auditor review all facts and circumstances to confirm independence.  The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.

Audit and Professional Engagement Period

Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies.  For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC.  For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC.  That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.

The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI.  The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO.  Accordingly, the SEC has amended the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.

Loans and Debtor-Creditor Relationships

Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client.  The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.

The SEC has amended the rule to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions.  In addition, the SEC has added language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.

The SEC has also revised the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.

Business Relationship Rule

The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders.  The SEC has replaced the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”

As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.

Inadvertent Violations for Mergers and Acquisitions

An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction.  The SEC has added a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner.  Under the new rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances.  Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.

---

« SEC Proposes Amendments To Rule 144 Finders – Part 2 »

SEC Adopts Amendments To Management Discussion And Analysis

Posted by Securities Attorney Laura Anthony | December 10, 2020 Tags: SEC, SEC Adopts Amendments To Management Discussion And Analysis

It has been a very busy year for SEC rule making, guidance, executive actions and all matters capital markets.  Continuing its ongoing disclosure effectiveness initiative on November 19, 2020, the SEC adopted amendments to the disclosures in Item 303 of Regulation S-K – Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A).  The proposed rule had been released on January 30, 2020 (see HERE).  Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles-based approach to disclosure requirements.  In addition, the rule changes are intended to reduce repetition and disclosure of information that is not material.

The new rules eliminate Item 301 – Selected Financial Data – and amend Items 302(a) – Supplementary Financial Information and Item 303 – MD&A.  In particular, the final rules revise Item 302(a) to replace the current tabular disclosure with a principles-based approach and revise MD&A to: (i) to state the principal objectives of the disclosure; (ii) update liquidity and capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion; (vi) eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements; and (vii) add a requirement to discuss critical accounting estimates and (viii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.

The new rules also apply to foreign private issuers (FPIs). Finally, the amendments will make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.

Below the discussion of the rule changes is a chart of each of the amendments and its principal objective.  The amendments take effect thirty days after publication in the federal register.

Detail on Final Rules

Elimination of Item 301 – Selected Financial Data

Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years.  Smaller reporting companies (SRCs) are not required to provide this information, and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.

When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL.  Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends.  Accordingly, Item 301 is not useful and the SEC has eliminated it.

Amendment to Item 302 – Supplementary Financial Information

Item 302 requires selected disclosures of quarterly results and variances in operating results including the effects of any discontinued operations and unusual or infrequently occurring items.  SRCs and FPIs are not required to provide the information (note that FPIs are not required to report quarterly results or file quarterly reports at all).  Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).

The SEC had originally proposed eliminating this item altogether like Item 301.  However, the SEC recognized that while most quarterly financial information could be found in prior filings, certain fourth quarter information was only captured in Item 302.  Accordingly, the final rule release did not eliminate Item 302 but amended it such that it now only requires disclosure when there are one or more material changes for any of the quarters in the last two fiscal years for which financial statements are provided.  Duplicative disclosures are not required.

Elimination of Item 303(a)(5) – Contractual Obligations Table

Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format.  There is no materiality threshold for the disclosure.  The SEC has eliminated the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy.  Likewise, current Items 303(c) and (d) have been eliminated as these items have been picked up in amended 303(b).

Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)

Currently MD&A is broken down into 5 parts.  Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations.  Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information.  Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures.  Item 303(d) provides scaled-back disclosure accommodations for SRCs.  The amended rule substantially changes this structure.

The new Item 303 (i) adds a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods and to provide instructions to guide the rest of the rule; (ii) eliminates unnecessary cross-references, clarifies and removes outdated and duplicative language; (iii) updates capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) updates the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) updates the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (vi) eliminates the requirement to discuss the impact of inflation; (vii) replaces the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) adds a requirement to discuss critical accounting estimates,  and (ix) adds the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.

The new Item 303(a) instruction paragraph has been revised to set forth the principal objectives of MD&A. The instructions codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.”  The SEC stresses that MD&A should provide an analysis that encompasses short-term results as well as future prospects.  The SEC does not want companies to merely recite the amounts of changes from year to year that are readily calculated from the financial statements, but rather to provide greater analysis as to the reasons for changes.

Also, the instructions emphasize providing disclosure on:

(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;

(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and

(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.

Chart on Rule Changes

The following chart, copied from the SEC’s rule release, summarized the new rules.

Current Item or Issue	Summary Description of Amended Rules	Principal Objective(s)
Item 301, Selected financial data	Registrants will no longer be required to provide 5 years of selected financial data.	Modernize disclosure requirement in light of technological developments and simplify disclosure requirements.
Item 302(a), Supplementary financial information	Registrants will no longer be required to provide 2 years of tabular selected quarterly financial data. The item will be replaced with a principles-basedrequirement for material retrospective changes.	Reduce repetition and focus disclosure on material information. Modernize disclosure requirement in light of technological developments.
Item 303(a), MD&A	Clarify the objective of MD&A and streamline the fourteen instructions.	Simplify and enhance the purpose of MD&A.
Item 303(a)(2), Capital resources	Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cashrequirements, and the general purpose of such requirements.	Modernize and enhance disclosure requirements to account for capital expenditures that are not necessarily capital investments.
Item 303(a)(3)(iii),Results of operations	Clarify that a discussion of material changes in net sales or revenue is required (rather than only material increases).	Clarify MD&A disclosure requirements by codifying existing Commission guidance.
Item 303(a)(3)(iv), Results of operations   Instructions 8 and 9 (Inflation and price changes)	The item and instructions will be eliminated. Registrants will still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations.	Encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, and circumstances.
Item 303(a)(4), Off- balance sheet arrangements	The item will be replaced by a new instruction to Item 303. Under the new instruction, registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidatedbalance sheets.	Prompt registrants to consider and integrate disclosure of off-balance sheet arrangements within the context of their MD&A.
Item 303(a)(5),Contractual obligations	Registrants will no longer be required to provide a contractual obligations table. A discussion of material contractual obligations will remain required through an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cashrequirements from known contractual and other obligations.	Promote the principles-based nature of MD&A and simplify disclosures.
Instruction 4 to Item 303(a) (Material changes in line items)	Incorporate a portion of the instruction into amended Item 303(b). Clarify in amended Item 303(b) that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms isrequired.	Enhance analysis in MD&A. Clarify MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A.
Item 303(b), Interim periods	Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter. Registrants subject to Rule 3-03(b) of Regulation S-X will be afforded the same flexibility.	Allow for flexibility in comparison of interim periods to help registrants provide a more tailored and meaningful analysis relevant to their business cycles.
Critical Accounting Estimates	Registrants will be explicitly required to disclose critical accounting estimates.	Facilitate compliance and improve resulting disclosure. Eliminate disclosure that duplicates the financial statement discussion of significantpolicies. Promote meaningful analysis of measurement uncertainties.

 

Further Background on SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative.  The following is a recap of such initiative and proposed and actual changes.  I have scaled down this recap from prior versions to focus on the most material items.

On November 19, 2020, as discussed in this blog, the SEC adopted amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K.  In addition, to eliminate duplicative disclosures, the SEC also eliminated Item 301 – Selected Financial Data and revised Item 302 – Supplementary Financial Information.  For my blog on the rules January 30, 2020 proposal, see HERE.

On August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.  See HERE.

In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses.   See my blog HERE on the proposed amendments.  My blog on the final amendments will be published after this blog.

In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls.  See HERE.

On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE.  Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE, and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.

In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.

In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016.  In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.

On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K.  See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC.  The amendments 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 amendment also requires that all exhibits be filed in HTML format.  The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers.  See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

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.  Final amendments were approved on August 17, 2018 – see HERE

The July 2016 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.

In September 2015, the SEC issued a request for public comment 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.  In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities.  See my blog HERE.

In early December 2015, the FAST Act was passed into law.  The FAST Act required 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.  See my blog HERE.

---

« Updated Guidance On Confidential Treatment In SEC filings OTCQB And OTCQX Rule Changes »

Updated Guidance On Confidential Treatment In SEC filings

Posted by Securities Attorney Laura Anthony | December 3, 2020 Tags: SEC, SEC Filings, Updated Guidance On Confidential Treatment In SEC filings

In March 2019, the SEC adopted amendments to Regulation S-K as required by the Fixing America’s Surface Transportation Act (“FAST Act”) (see HERE).  Among other changes, the amendments allow companies to redact confidential information from most exhibits without filing a confidential treatment request (“CTR”), including omitting schedules and exhibits to exhibits.  Likewise, the amendments allow a company to redact information that is both (i) not material, and (ii) competitively harmful if disclosed without the need for a confidential treatment request.  The enacted amendment only applies to material agreement exhibits under Item 601(b)(10) and not to other categories of exhibits, which would rarely contain competitively harmful information.

After the rule change, the SEC streamlined its procedures for granting CTR’s and for applying for extended confidential treatment on previously granted orders.  The amendments to the CTR process became effective April 2, 2019.  See HERE for a summary of confidential treatment requests.  In December 2019, the SEC issued new guidance on confidential treatment applications submitted pursuant to Rules 406 and 24b-2.

Confidential Treatment Requests Under Rule 406 or 24b-2

Rule 406 of the Securities Act of 1933 (“Securities Act”) and Rule 24b-2 of the Securities Exchange Act of 1934 (“Exchange Act”) set forth the exclusive procedures for seeking confidential treatment for any information that may be required to be publicly filed under either Act and for which the streamlined procedures for confidential treatment of material contracts and their exhibits is not available.  Furthermore, a company may voluntarily seek approval under Rules 406 and 24b-2 even if the self-executing procedure for omitting information is available.  Later in this blog, I include a refresher on the streamlined, self-executing rules for omitting confidential information from material contract exhibits to SEC filings.

Like all CTR’s, requests under these rules must be made in paper format and not electronic.  Also, like all CTR’s, if a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.

To make a CTR under Rule 406 or 24b-2, a person must omit the confidential information from the relevant EDGAR filing, noting that information has been omitted based on a CTR, and concurrently file the CTR with the SEC using the specific fax number and designated person for receiving such information.  All documents and information must be marked “Confidential Treatment.”

The CTR must include one unredacted copy of the entire document for which confidential treatment is sought and a cover letter or memo containing (i) identification of the information sought to be kept confidential; (ii) a statement of the grounds for keeping the information confidential, including reference to particular provisions under FOIA and other SEC rules and regulations; (iii) the specific time period for which confidentiality is sought (year, month and date) and a justification for such period; (iv) a detailed explanation of why, based on the facts and circumstances of the particular case, disclosure of the information is unnecessary for the protection of investors; (v) a written consent to the furnishing of the confidential information to other government agencies, offices, or bodies and to the Congress; and (vi) the name, address and telephone number of the person to whom all notices and orders should be directed.

For an Exchange Act Rule 24b-2 CTR, the name of each exchange upon which the materials would be filed (or omitted) must also be included.  Furthermore, the submission must include a statement that: (i) none of the confidential information has been disclosed to the public; (ii) disclosure of the information will cause substantial competitive harm to the company; and (iii) disclosure of the confidential information is not necessary for protection of investors.

As discussed below, the SEC will not grant confidential treatment to information that is material.  Moreover, if information is omitted beyond what is customarily treated as private or confidential, the SEC will ask that an amendment be filed with fewer omissions and a new CTR filed.

If confidential treatment is granted, an order will be entered and filed on EDGAR.  If confidential treatment is denied, the company will have an opportunity to withdraw the filing with the confidential information if withdrawal is otherwise allowable (such as a voluntary S-1 filing or Exchange Act report by a voluntary filer). A denial may also be appealed.

Application for Extension of Confidential Treatment

Companies that have previously obtained a confidential treatment order for a material contract must continue to file extension applications under Rules 406 or 24b-2 if they want to protect the confidential information from public release pursuant to a Freedom of Information Act request after the original order expires.  The SEC has created a simple one-page form to apply for an extension of time for which a confidential treatment order had previously been granted.  Rather than submitting a whole new application, with the confidential information included, a company seeking to extend a confidential treatment order previously granted can simply affirm that the facts and circumstances that supported the prior application continue to be true, complete and accurate.

The short-form application allows for an extension of confidential treatment for a period of three, five or ten years and requires a brief explanation to support the request.  The request for extension must be filed prior to the original order’s expiration.  If the applicant reduces the redactions from the previous version, the revised redacted version of the contract must be publicly filed when the short-form extension application is submitted.  The short-form application cannot be used to add new exhibits to the application or make additional redactions.  In that case, a full application under Rules 406 or 24b-2 would still be required.

The SEC has provided an email address (CTExtensions@sec.gov) for submittal of the new short-form application.  The email address is exclusive to these short-form applications and, as such, should not be used in connection with any other type of confidential treatment or extension request.  Upon approval, the SEC will post the order granting CTR on the applicant’s EDGAR page.

Confidential Treatment Requests for Material Contracts

Effective March 2019, Item 601(b)(10) of Regulation S-K allows a company to file redacted material contracts without applying for confidential treatment of the redacted information provided the redacted information (i) is not material and (ii) would be competitively harmful if publicly disclosed.  If it does so, the company should mark the exhibit index to indicate that portions of the exhibit or exhibits have been omitted and include a prominent statement on the first page of the redacted exhibit that certain identified information has been excluded from the exhibit because it is both not material and would likely cause competitive harm to the registrant if publicly disclosed. The company also must indicate by brackets where the information is omitted from the filed version of the exhibit.

If requested by the SEC, the company must promptly provide an un-redacted copy of the exhibit on a supplemental basis. The SEC also may request the company to provide its materiality and competitive harm analyses on a supplemental basis.  Any requested supplemental information must be provided in paper format and only to the designated email address provided by the SEC to protect and preserve its confidential nature.  If the SEC does not agree with the analysis, it could request that the company amend its filing to include any previously redacted information. If a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.

The company may request confidential treatment of the supplemental material submitted to the SEC pursuant to Rule 83 while it is in the possession of the SEC.  After completing its review of the supplemental information, the SEC will return or destroy the information at the request of the company if the company complies with the procedures outlined in Rules 418 or 12b-4. Rules 418 or 12b-4 require that a company request that the SEC either return or destroy the supplemental information, at the same time as it is first furnished to the SEC and that returning or destroying the information (i) is consistent with the protection of investors and (ii) is consistent with the Freedom of Information Act.  Also, if information is electronically provided to the SEC, the SEC has no obligation to return or destroy same.

Although the letter requesting additional information, and the closing of the review letter, will both be made public on the EDGAR system, the SEC will not make public its comments regarding redacted exhibits, nor the company’s responses thereto.

The amendments are not meant to alter what information is deemed confidential or can be omitted, but rather to streamline the process by allowing a company to redact without the confidentiality treatment process.  The w may still randomly review company filings and “scrutinize the appropriateness of a registrant’s omissions of information from its exhibits.”

What Information Qualifies for Confidential Treatment

Generally speaking, a company can seek confidential treatment for information which could adversely affect the company’s business and financial condition, usually because of competitive harm, if disclosed, as long as the information is not material to investors.

A CTR must include specific citations to an exemption from disclosure under FOIA.  The FOIA specifies nine categories of information that may be exempted from the FOIA’s broad requirement to make information available to the general public. The most commonly used exemption for public companies allows for confidential treatment for “trade secrets and commercial or financial information obtained from a person and privileged or confidential.”  The U.S. Supreme Court’s case Food Marketing Institute v. Argus Leader Media (October 2018) held that where commercial or financial information is both customarily and actually treated as private by its owner and provided to the government under an assurance of privacy, the information is “confidential” within the meaning of FOIA and that it is not necessary to show substantial competitive harm.  The SEC’s new guidance refers CTA applicants to the Supreme Court case for assistance in crafting arguments for the CTA application.

Although FOIA may generally exempt trade secrets, not all trade secrets may be kept confidential by public companies.  In essence, when a company determines to go public and files a registration statement under either the Securities Act or Exchange Act, and thus agrees to file reports with the SEC, the company is agreeing to make public the information required by Regulation S-K and S-X.  A company cannot avoid these specific requirements by claiming confidentiality.  Examples of information that a private company may deem confidential, but for which a public company will need to disclose, include: (i) the identity of 10% or greater customers; (ii) the identity of 5% or greater shareholders; (iii) the dollar amount of firm backlog orders; (iv) the duration and effect of all patents, trademarks, licenses and concessions held; (v) related party transactions; and (vi) executive compensation.

Assuming that information is not specifically required to be disclosed under the Securities Act or Exchange Act, a “trade secret” is “a secret, commercially valuable plan, formula, process or device that is used for the making, preparing, compounding or processing of trade commodities and that can be said to be the end product of either innovation or substantial effort.”  Examples of information that a public company could successfully complete a CTR for include (i) pricing terms; (ii) technical specifications; (iii) payment terms; (iv) sensitive information regarding business strategy, or timing of research, development and commercialization efforts; (v) details of intellectual property (that isn’t already public, such as in a filed patent); (vi) details of cybersecurity procedures; and (vii) customer databases.

A company can never obtain confidential treatment for information that is already in the public domain or has been publicly disclosed, even if inadvertently.  Accordingly, it is important that a company be very careful to ensure that any information for which it seeks confidential treatment is kept strictly confidential, including by third parties.  For example, care should be given that a counterparty to a contract does not issue a press release or otherwise make provisions public.

Confidential Treatment Requests Under Rule 83

Rule 83 provides a procedure for requesting that information be kept confidential from Freedom of Information Act (“FOIA”) requests where no other procedure, such as Rules 406 or 24b-2, are available.  Generally, Rule 83 is used in the context of requests for supplemental information, examinations, inspections and investigations.  Under Rule 83, the submitter of information must mark each page with “Confidential Treatment Requested by [name]” and an identifying number and code, such as a Bates-stamped number. Also, the words “FOIA Confidential Treatment Request” must appear on the top of the first page of the request. Like all other CTR’s, the request must be via paper and not electronically.  The SEC has provided a specific fax line and office (the FOIA Office) to receive Rule 83 CTR’s to maintain their confidentiality, even among SEC staff.  A confidential treatment request will expire 10 years from the date the FOIA Office receives it unless that office receives a renewal request before it expires.

The requester may claim personal or business confidentiality, but need not substantiate his or her request until the FOIA Office notifies him or her of a FOIA request for the records.  If a FOIA request is received for the records, the person that requested confidential treatment will be notified and given an opportunity to provide a legal and factual analysis supporting confidential treatment.  A substantiation submittal must include: (i) the reasons that the information can be withheld under FOIA and referring to the specific provisions of FOIA supporting same; (ii) any other statutes or regulatory provisions that may govern the information; (iii) the existence and applicability of any prior determinations by the SEC, other federal agency or court relating to the confidential treatment of the information; (iv) the adverse consequences to a business enterprise, financial or otherwise, that would result from disclosure of confidential commercial or financial information, including any adverse effect on the business’ competitive position; (v) the measures taken to protect the confidentiality prior to and after submission to the SEC; (vi) the ease or difficulty of a competitor’s obtaining or compiling the commercial or financial information; (vii) whether the information was voluntarily submitted to the SEC; (viii) if the substantiation argument document itself should be kept confidential; and (ix) such additional facts and legal analysis as appropriate to support the request.

Where a Rule 83 CTR is being made in the course of live testimony or oral discussions, the request for confidential treatment must be made contemporaneously with providing the information and followed with a written request no later than 30 days later.

Rule 83 provides for an appeal process where an initial determination that confidential treatment is not warranted.  Rule 83 appeals are reviewed and decided by the SEC’s Office of General Counsel.  If the General Counsel decides the information does not need to be kept confidential, it will give the person 10 days’ notice during which time a person could file an action in federal court to continue to fight to maintain the confidentiality of the information.  Likewise, if the SEC determines that information should be kept confidential, the person seeking the information can appeal by filing suit in federal court.

Rule 83 cannot be relied upon to request confidential treatment for information that would otherwise be required to be disclosed in SEC registration statements or reports.  In that case, the person making the CTR would have to rely on the new procedures for redacting information in material contracts or make a CTR under Rules 406 or 24b-2.

---

« SEC Issues Transitional FAQ On Regulation S-K Amendments SEC Adopts Amendments To Management Discussion And Analysis »

SEC Adopts Amendments To Tighten Shareholder Proposals

Posted by Securities Attorney Laura Anthony | November 13, 2020 Tags: SEC

Following a tense period of debate and comments, on September 23, 2020, the SEC adopted amendments to Rule 14a-8 governing shareholder proposals in the proxy process.  The proposed rule was published almost a year before in November 2019 (see HERE).  The amendment increases the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement.  The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954.  The new rules represent significant changes to a shareholder’s rights to include matters on a company’s proxy statement.

Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years.  The rules have not been amended in decades and during that time, shareholder activism has shifted.  Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.

In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets.  The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”  Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements.  A study completed in 2018 found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.

The amendment alters the current ownership requirements for the submission of shareholder proposals to: (i) incorporate a tiered approach that provides for three options involving a combination of amount of securities owned and length of time held; (ii) specify documentation that must be provided when submitting a proposal; (iii) require shareholder proponents to specify dates and times they can meet with company management either in person or on the phone to discuss the submission; and (iv) provide that a person may only submit one proposal, either directly or indirectly, for the same shareholders meeting.  The amendment also raise the current thresholds for the resubmission of proposals from 3, 6 and 10 percent to 5, 15 and 25 percent.

The final amendments go into effect 60 days after being published in the federal register and will apply to any proposal submitted for an annual or special meeting to be held on or after January 1, 2022.

Background – Current Rule 14a-8

The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.

All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.

Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors.  Rule 14a-8 has been the source of considerable contention.  Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that subject to substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.

State laws in general allow a shareholder to attend a meeting in person and at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process.  By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost to themselves.  It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.

The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so.  Under the current Rule 14a-8 to qualify to submit a proposal, a shareholder must:

• Continuously hold 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;
• If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
• If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
• Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
• Clearly state the proposal and course of action that the shareholder desires the company to follow;
• Submit no more than one proposal for a particular annual meeting;
• Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
• Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
• If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
• The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.

A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.

Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC.  If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.

As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder.  The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion.  Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.

Substantive grounds for exclusion include:

• The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
• The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
• The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
• The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
• The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
• The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
• The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
• The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
• The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
• The proposal seeks to remove an existing director whose term is not completed;
• The proposal questions the competence, business judgment or character of one or more director nominees;
• The company has already substantially implemented the requested action;
• The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
• The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
• The proposal seeks to require the payment of a dividend; or
• The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.

Final Amended Rule

The need for a change in the rules has become increasingly apparent in recent years.  As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and, as such, is susceptible to abuse.  In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules.  Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals.  The SEC also conducted a Proxy Process Roundtable and invited public comments and input.  The SEC continued its research, including reviewing a plethora of comment letters, after the rule proposals.

Submission Eligibility and Process

The final rule changes amend eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal.  The amendments:

(i) Update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;

(ii) Investors who currently are eligible to submit proposals under the current $2,000 threshold/one-year minimum holding period, but currently do not satisfy the new requirements, will continue to be eligible to submit proposals through the expiration of the transition period that extends for all annual or special meetings held prior to January 1, 2023, provided they continue to hold at least $2,000 of a company’s securities;

(iii) Eliminate the 1% test as it historically is never used;

(iv) Eliminate the ability to aggregate ownership with other shareholders to meet the threshold for submittal.  Shareholders can still co-file or co-sponsor proposals, but each one must meet the eligibility threshold;

(v) Require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal including a signed statement by the shareholder;

(vi) Require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal (regardless of prior communications on the subject), and provide contact information (of the shareholder, not its representative) as well as business days and specific times (i.e., more than one date and time) that the shareholder is available to discuss the proposal with the company.

One Proposal Requirement

The final amendments change the “one proposal” requirements in Rule 14a-8(c) to:

(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.

Resubmission Thresholds

The final amendments also increase the resubmission thresholds.  Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.”

The final amendments amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to increase the current resubmission thresholds of 3%, 6% and 10% of shareholder support related to matters voted on once, twice or three or more times in the last five years, respectively, to 5%, 15% and 25%.

The final amendments did not adopt an amendment from the proposed rule release that would have: (i) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote.  Commenters strongly objected to this proposals and the SEC agreed with their reasoning.

SEC Process

As discussed above, a company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder.  In its proposing release, the SEC asked for comments on this process and how it might be improved upon, or whether the SEC should remove itself from the process altogether deferring to state law.  After reviewing comments, the SEC declined to implement any changes to the process.

---

« SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings SEC Proposed Conditional Exemption For Finders »

SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings

Posted by Securities Attorney Laura Anthony | November 6, 2020 Tags: SEC

Just eight months following the rule proposal (see HERE), on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.  The amendments make a more principles-based approach to business descriptions and risk factors, recognizing the significant changes in business models since the rule was adopted 30 years ago.  The amendments to disclosures related to legal proceedings continue the current prescriptive approach.  In addition, the rule changes are intended to improve the readability of disclosure documents, as well as discourage repetition and disclosure of information that is not material.

The Item 101 and Item 103 amendments only apply to domestic companies and foreign private issuer that elect to file using domestic company forms.  The forms generally used by foreign private issuers (F-1, F-3, 20-F, etc.) do not have references to Items 101 and 103 of Regulation S-K but rather refer to specific disclosure provisions in Form 20-F.  However, the Item 105 (Risk Factor) amendments will apply across the board to both domestic and foreign issuers as the foreign issuer forms specifically refer to that section of Regulation S-K.

The effective date of the new rules is November 9, 2020 and as such, compliance with the new rules will need to be included in any filings made after 5:30 EST on Friday, November 6.

Item 101 – Description of Business

Item 101(a) of Regulation S-K requires a description of the general development of the business of the company during the past five years (or three years for smaller reporting companies) and lists five specific categories of information to include in the disclosure, including, for example, the year the company was formed and a description of any acquisitions or dispositions of businesses.

The SEC has amended Item 101(a) related to a company’s description of its business, to:

(i) Make it largely principles-based by providing a non-exclusive list of the types of information that could be disclosed and only requiring that disclosure to the extent it is material to an understanding of the general development of the business.  The non-exclusive list includes: (a) material bankruptcy, receivership or similar proceeding; (b) nature and effects of any material reclassifications, merger or consolidation; (c) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (d) material changes to a company’s previously disclosed business strategy (note the proposed rule was more expansive on this topic but was determined to be repetitive to MD&A disclosures);

(ii) Eliminate a prescribed time frame for the disclosure.  The SEC would rather require companies to focus on the information material to an understanding of the development of their business, irrespective of a specific time frame; and

(iii) Permit a company, in filings made after a its initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period.  A company must incorporate the previous discussion by reference and can only incorporate from a single previously filed document.

Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by the company, focusing on the segments that are reported in the company’s financial statements. Item 101(c) currently includes a list of 12 topics to cover.  Like Item 101(a), the amendments make the rule largely principles-based and encourage a company to exercise judgment in evaluating what disclosure to provide.  Only material information need be provided.  The rule also provides a list of topics for a company to consider, and maintains the focus on providing company segment information.

The new list of topics include: (i) revenue generating activities, products or services, and any dependence on key products, services, product families, or customers, including governmental customers; (ii) status of development efforts for new or enhanced products, trends in market demand and competitive conditions; (iii) resources material to a company’s business, including raw materials; (iv) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held; (v) a description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (vi) the extent to which the business is or may be seasonal; (vii) compliance with material government regulations, including environmental regulations (the prior list only included environmental regulations) to the extent they impact capital expenditures, earnings and competitive position; and (viii) human capital disclosure.

The human capital category is completely new and would include any material human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy).  The final rule includes non-exclusive examples of subjects that may be material, depending on the nature of the registrant’s business and workforce.  The SEC declined to define “human capital” allowing a company to tailor the concept to its circumstances and objectives.

The human capital category is a win for advocates of environmental, social and governance (ESG) disclosures which have advocated for increased rule requirements related to these disclosure topics.  For more on ESG, see HERE). It is unlikely we will see more than minor incremental increases in ESG disclosures beyond human capital under the current SEC regime.  The SEC continues to review and study the issue, but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics.

Item 103 – Legal Proceedings

Item 103 of Regulation S-K requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or of which any of their property is the subject.  Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, and a description of the factual basis alleged to underlie the proceeding and the relief sought.

The SEC has amended Item 103 to: (i) expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage companies to avoid duplicative disclosure; and (ii) revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.

Item 105 – Risk Factors

Item 105 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky and specifies that the discussion should be concise and organized logically.  The disclosure of risk factors has always been principles-based with the SEC consistently discouraging the use of boilerplate items.  However, despite this guidance, most companies include a lengthy laundry list of boilerplate risks.

The SEC has amended Item 105 to: (i) require summary risk factor disclosure of no more than two pages if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.

A company rarely requires more than 15 pages of risk factors, and as such, the new rule should be a good lesson in brevity and pointedness.

Further Background on SEC Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative.  The following is a recap of such initiative and proposed and actual changes.  I have scaled down this recap from prior versions to focus on the most material items.

As discussed in this blog, on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.

In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses.   See my blog HERE on the proposed amendments.  My blog on the final amendments will be published after this blog.

In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls.  See HERE.

On January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K.  In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information.  See HERE.

On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE.  Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.

In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.

In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016.  In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE .

On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K.  See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).

On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC.  The amendments 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 amendment also requires that all exhibits be filed in HTML format.  The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers.  See my blog here on the Item 601 rule changes HERE and HERE related to SEC guidance on same.

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.  Final amendments were approved on August 17, 2018 – see HERE.

The July 2016 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.

In September 2015, the SEC issued a request for public comment 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.  In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities.  See my blog HERE

In early December 2015, the FAST Act was passed into law.  The FAST Act required 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.  See my blog HERE.

---

« SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses SEC Adopts Amendments To Tighten Shareholder Proposals »

SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses

Posted by Securities Attorney Laura Anthony | October 29, 2020 Tags: SEC, SEC Adopts Amendments To Disclosures Related To Acquisitions And Dispositions Of Businesses

One year after proposing amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses, in May 2020 the SEC adopted final amendments (see here for my blog on the proposed amendments HERE).  The amendments involved a long process; years earlier, in September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates which was the first step culminating in the final rules (see HERE).

The amendments make changes to Rules 3-05 and 3-14, 8-04, 8-05, and 8-06 of Regulation S-x, as well as Article 11.  The SEC also amended the significance tests in the “significant subsidiary” definition in Rule 1-02(w), Securities Act Rule 405, and Exchange Act Rule 12b-2.  Like all recent disclosure changes, the proposed rules are designed to improve the information for investors while reducing complexity and compliance costs for reporting companies.  The amendments also make several related conforming rule and form changes.  The new amendments go into effect on January 1, 2021 but voluntary compliance is permitted immediately.

Introduction

When a company acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires the company to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. Similarly, Rule 3-14 requires a company to file financial statements with respect to a significant real estate acquisition.  The number of years of financial information that must be provided depends on the relative significance of the acquisition to the company.

Article 11 requires a company to file unaudited pro forma financial information, including a balance sheet and income statements, relating to the acquisition or disposition of businesses.  Pro forma financial information is intended to show how the acquisition or disposition might have affected those financial statements.

Form 8-K generally requires that the audited financial statements and pro forma financial information be filed in an amendment to the original transaction closing form 8-K within 71 days of that closing 8-K (i.e., 75 days from the closing).  Where an acquisition or disposition is not significant, no separate audits or pro forma’s are required.

The final amendments will:

• update the significance tests under these rules by revising the investment test to compare the company’s investments in and advances to the acquired or disposed of business to the company’s worldwide market value;
• update the significance tests under these rules by revising the income test by adding a revenue component;
• expanding the use of pro forma financial information in measuring significance;
• conforming the significance threshold and tests for a disposed business;
• modify and enhance the required disclosure for the aggregate effects of acquisitions for which financial statements are not required by increasing the pro forma information related to the aggregated businesses and eliminating historical financial information for insignificant businesses;
• reduce the period of the financial statements of the acquired business from three years to the two most recent fiscal years;
• permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
• permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB);
• no longer require separate acquired business financial statements once the business has been included in the company’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;
• align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
• clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
• amend the pro forma financial information requirements to include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; “Autonomous Entity Adjustments,” reflecting the operations and financial position of a company as autonomous where it was previously part of another entity; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects;
• make corresponding changes to the smaller reporting company and Regulation A requirements in Article 8 of Regulation S-X;
• add a definition of significant subsidiary that is tailored for investment companies; and
• add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.

The rules related to disclosures for the acquisitions and dispositions of businesses are complex and involve a significant accounting analysis.  I like to leave the accounting to the accountants, but legal advisors need to be able to understand the requirements and assist client companies in making fully informed business decisions regarding the acquisition or disposition of a business.  This blog will focus on explaining the rules without diving into the overly labyrinthine accounting technicalities.

Rules 3-05 and 8-04 of Regulation S-X – Financial Statements of Businesses Acquired or to Be Acquired

               Summary of Current Rule

Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue-producing assets will likely be treated as the purchase of a business.

In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X.  The “investment test” considers the value of investments in and advances to the acquired business relative to the value of the total assets of the company prior to the purchase. The “asset test” considers the total value of the assets of the company pre- and post-acquisition. The “income test” considers the change in income of the company as a result of the acquisition.

Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal years and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.

Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.

Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.

An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.

The Rule 3-05 or Rule 8-04 financial statements are also required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.

In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.

Final Rule Change

The SEC has substantively revised the investment and income tests for non-investment companies and made non-substantive changes to the asset test.  All three significance tests have been revised for investment companies.  The final amendments also provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the company’s and its subsidiaries’ consolidated total assets when computing the Asset Test.

Investment Test

The investment test compares the company’s and its other subsidiaries’ investments in (i.e., the purchase consideration paid) and advances to the tested subsidiary to the total assets of the company and its subsidiaries consolidated reflected at the end of the most recently completed fiscal year, or in the case of an acquired business, in the company’s most recent annual financial statements required to be filed at or prior to the acquisition date.

The SEC has amended the investment test such that the company’s investments in and advances to the acquired business will be compared to the aggregate worldwide market value of the company’s voting and non-voting common equity when available.   If the company does not have a worldwide market value, the existing test would still be used.  The SEC believes that market value is a better parameter for determining the economic significance of an acquisition.  I agree.  Assets generally remain on the books at purchase price valuation, or are reduced for depreciation or amortization.  For non-investment companies, assets are never marked up to fair value and, as such, can quickly become a stale indication of a company’s current value.

The amendments specifically address when aggregate market value should be determined, provide instructions for determining investments and advances, including contingent consideration, and clarify the use of the test for related party transactions.

Income Test

The income test compares the company’s equity in the tested subsidiary’s income from continuing operations before income taxes, including only income amounts contributed to the company’s particular equity in the subsidiary (such as when the subsidiary is not wholly owned) to such income of the company for the most recently completed fiscal year.

The SEC has revised the income test by adding a revenue component and by using income or loss from continuing operations after income taxes (as opposed to before income taxes).  This change will help account for factors that could distort income in a given year such as non-recurring expense items.  In addition, the change will reduce the anomalous result of making an otherwise insignificant acquisition seem significant, where a company has marginal or break-even net income or loss in a year.

Under the amendment, where a company and the target have recurring revenue, both revenue and income should be tested.  By revising the income test to require that the company exceed both the revenue and net income components when the revenue component applies, the SEC believes the test will more accurately determine whether a tested subsidiary is significant.  If the company or the target does not have recurring revenue, only the net income test would be used.

In addition, the SEC has eliminated the requirement that three years of financial statements be provided for certain significant acquisitions and instead has capped the period at two years.  The SEC has also revised Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period.

The final amendments also clarify that where a Form 10-K is filed after an acquisition closes but prior to the filing of the target financial statements, significance can be determined using either the last Form 10-K filed prior to the acquisition closing, or the newest Form 10-K filed after the closing.  The final amendments also make various definition and word changes thought to more clearly and accurately reflect the implementation of the rules.

Asset Purchase

Where assets are purchased that constitute a business, but are not all of the assets or products of the seller, it can be difficult to create historical financial statements that only cover the sold assets.  Accordingly, the SEC has amended the rules to permit companies to provide abbreviated audited financial statements including a balance sheet consisting of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if: (i) the business constitutes less than 20% all of the assets and revenues of the seller, after eliminating intercompany transactions, as of the most recent fiscal year-end; (ii) the acquired business was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required; (iii) separate financial statements for the business have not previously been prepared; (iv) the seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements; (iv) interest expense may only be excluded if the corresponding debt will not be assumed; (v) the financial statements do not omit selling, distribution, marketing, general and administrative, research and development, or other expenses other than corporate overhead, interest in some cases, and income taxes, incurred by or on behalf of the acquired business during the periods to be presented; and (vi) the notes to financial statements include certain additional disclosures.

Foreign Business Acquisition

The SEC is modified Rule 3-05 to permit financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to permit foreign private issuers that prepare their financial statements using IFRS-IASB to provide Rule 3-05 financial statements prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP.

Smaller Reporting Companies and Regulation A Issuers

As mentioned above, Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the company is a smaller reporting company.  Regulation A issuers are permitted to follow Rule 8-04.

The SEC has revised Rule 8-04 such that smaller reporting companies would be directed to Rule 3-05 for the requirement relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Article 8.

Additionally, under the amendments, a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days prior to the date of the relevant final prospectus or prospectus supplement, rather than 74 days prior to the effective date of the registration statement as under the current rules.

Financial Statements in Registration Statements and Proxy Statements

Prior to the amendments, the rules could result in separate historical financial statements of the acquired business required to be included in registration statements and/or proxy statements after the closing of the acquisition and after SEC reports have been filed including the consolidated financial statements of the then combined entities.  The amendment rule no longer requires Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition company consolidated financial statements in certain circumstances.

Specifically, where an acquisition exceeds 20% but is less than 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least nine months, separate financial statements will no longer need to be included in proxy or registration statements.  Where an acquisition exceeds 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least a complete fiscal year, separate financial statements will no longer need to be included in proxy or registration statements.

Individually Insignificant Acquisitions

If the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.  The rule amendments require disclosure if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the company, exceeds 50%.  Pro forma financial information is only required for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.

Use of Pro Forma Financial Information to Measure Significance

A company is generally permitted to use pro forma, rather than historical, financial information to test significance of a subsequently acquired business if the company made a significant acquisition after the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K as required.   The amended rules continue to permit a company to use these pro forma financial statements and expands that ability to include pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end as long as such pro forma information has been filed in an 8-K or amended 8-K.

Rule 3-14 of Regulation S-X – Financial Statements of Real Estate Acquired or to Be Acquired

The SEC has historically believed that the real estate industry has distinct considerations.  For example, audited financial statements for a real estate operation are rarely available from the seller without additional effort and expense because most real estate managers do not maintain their books on a U.S. GAAP basis or obtain audits.  However, in reality the SEC had found that the differences between the financial statement materiality throughout the industries is much less significant than thought.   As such, the SEC has amended the rules to more closely align the financial statement requirement of Rule 3-14 with Rule 3-05.

Article 11 – Pro Forma Financial Information

Article 11 of Regulation S-X details the pro forma financial statement requirements that must accompany both Rule 3-05 and 3-14 financial statements.  Typically, pro forma financial information includes the most recent balance sheet and most recent annual and interim period income statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05 and Rule 3-14, respectively. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all companies.

The SEC has revised the accounting adjustments made in preparation of the pro forma financial statements with the intent of simplifying the requirements and better reflecting the synergies of the transaction.  The SEC amended Article 11, by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.

The SEC also raised the pro forma financial statement requirement for a disposition from 10% to 20% based on significance testing.  Rule 8-05 for smaller reporting companies and Regulation A issuers have been amended to align with the pro forma financial statement requirements in Article 11.

---

« Covid-19 Disclosures – Not Just Speculation Anymore SEC Adopts Amendments To Business Descriptions, Risk Factors And Legal Proceedings »

SEC Adopts Amendments To Accredited Investor Definition

Posted by Securities Attorney Laura Anthony | September 11, 2020 Tags: SEC, SEC Adopts Amendments To Accredited Investor Definition

The much anticipated amendments to the accredited investor definition and definition of qualified institutional buyer under Rule 144A were adopted by the SEC on August 26, 2020.  The amendments come almost five years after the SEC published a report on the definition of “accredited investors” ( see HERE)  and nine months after it published the proposed amendments (see HERE).  The rule changes also took into account the input and comment letters received in response to the SEC’s concept release and request for public comment on ways to simplify, harmonize and improve the exempt offering framework (see HERE).

As a whole industry insiders, including myself, are pleased with the rule changes and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.  As the SEC pointed out historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets.  The amendments are meant to improve the definition to include institutional and individual investors with knowledge and expertise in the marketplace.

The current test for individual accredited investors is a bright line income or net worth test.  The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications.  The amended definition will also add categories of businesses, entities, and organizations that can qualify with $5 million in assets and a catch-all category for any entity owning in excess of $5 million in investments.  The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.

The SEC has also amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities.  The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).

The amendments become effective 60 days after publication in the Federal Register.

Background

All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.

The definition of an accredited investor has become a central component of exempt offerings, including Rules 506(b) and 506(c) of Regulation D.  Qualifying as an accredited investor allows an investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds.  Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.

Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses.  In 2019 the estimated capital raised in exempt offerings was $2.7 trillion compared to $1.2 trillion in registered offerings.  The amended definition of accredited investor is part of the SEC’s larger effort to simplify, harmonize, and improve the exempt offering framework.  Earlier this year the SEC published broader proposed rule changes to the exempt offering structure, which I broke down into a 5-part blog series.  The first centered on the offering integration concept (see HERE); the second on offering communications, testing the waters and a new demo day exemption (see HERE); the third on Regulation D, Rule 504 and bad actor rules (see HERE); the fourth on Regulation A (see HERE); and the fifth on Regulation Crowdfunding (see HERE).

The Current Definition of “Accredited Investor”

An “accredited investor” is defined as any person who comes within any of the following categories:

1. Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
3. Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
8. Any entity in which all of the equity owners are accredited investors.

Summary of Amendments

The amendment to the accredited investor definition adds new categories of natural persons based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order.  In particular, to start the amendment provides that a holder in good standing of a Series 7, 65 or 82 license qualifies as an accredited investor.  The SEC further provides that it may add additional certifications, designations, or credentials in the future.  In addition, a knowledgeable employee of a private fund will now be considered accredited.  The amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test for natural persons.

The amendments also: (i) clarify that limited liability companies with $5 million in assets qualify as accredited and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify; (ii) add a new catch-all category for any entity,  including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (iii) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (iv) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

The amendments to the qualified institutional buyer definition in Rule 144A add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition.  The amendments also add a catch-all category that permits institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.

Professional Certifications, Designations and Credentials

Noting that relying solely on financial thresholds as an indication of financial sophistication is suboptimal, including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth, the final amendment adds new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations.  The final amendments track the proposed amendments in this area except that the final amendments require that any certification, license or designation be in good standing in order to qualify for accreditation.

The final amendment provides that the SEC may designate qualifying professional certifications, designations, and other credentials by order, with such designation to be based upon consideration of all the facts pertaining to a particular certification, designation, or credential.  The final amendment includes a non-exclusive list of attributes the SEC will consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.  The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status will be posted on the SEC’s website.

Concurrent with adopting the final amendments, the SEC issued an order designating good standing holders of a Series 7, 65 or 82 license as qualifying for accredited status.  Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and would leave too much discretion to the marketplace.  Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.

Requiring that a list of individuals that hold the certifications be publicly available will reduce the costs of verifying accredited status for companies relying on Rule 506(c).  Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.

Knowledgeable Employees of Private Funds

With respect to investments in a private fund, the SEC has added a new category based on the person’s status as a “knowledgeable employee” of the fund.  A knowledgeable employee is defined as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund who in connection with his or her regular functions or duties, participates in the investment activities of the fund and has been doing so for at least 12 months.

The private fund category is meant to encompass funds that rely on the investment company registration exemptions found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940.  These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.

Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.”  A qualified purchaser is one that owns $5 million or more in investments.  The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds.  In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser.  However, prior to this amendment, if the knowledgeable employee does not qualify as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded.

Spousal Equivalents

The SEC has added a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent.  A spousal equivalent is defined as a cohabitant in a relationship generally equivalent to a spouse.  The rule does not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.

Additional Entity Categories

The amended rules add the following entities to the accredited investor definition: (i) limited liability companies with total assets in excess of $5 million that were not formed for the specific purpose of making the investment; (ii) SEC and state registered investment advisers and exempt reporting advisors; (iii) rural business investment companies (RBICs); (iv) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (v) “family offices” with at least $5 million in assets under management, that were not formed for the purpose of making the investment, and their “family clients,” as each term is defined under the Investment Advisers Act as long as the prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.

These additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.

Qualified Institutional Buyer – Rule 144A

The SEC has amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities.  Rule 144A(a)(1)(i) specifies the types of institutions that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested threshold.  The amendments expand the definition of qualified institutional buyer by adding RBICs, limited liability companies, and all entities, including Indian tribes that meet the $100 million threshold.

The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).

---

« Nasdaq Rule Amendments 2020 NYSE Continues To Struggle With Direct Listing Rule Changes »

SEC Spring 2020 Regulatory Agenda

Posted by Securities Attorney Laura Anthony | August 21, 2020 Tags: SEC, SEC Spring 2020 Regulatory Agenda

In July 2020, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term.  The Agenda is published twice a year, and for several years I have blogged about each publication.

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

Items on the Agenda can move from one category to the next or be dropped off altogether.  New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months.  Portfolio margining harmonization was the only item listed in the pre-rule stage in the fall 2019 and remains so on the current list.

Nineteen items are included in the proposed rule stage, down from 31 on the fall list.  Still on the proposed rule list is executive compensation clawback (HERE).  Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.

Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements), and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list.  The SEC has recently amended the rules and issued a concept release (see HERE  and HERE) and appears committed to enacting much-needed updates and improvements to the rules.

Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the spring 2019 list and up to proposed in fall 2019 where it remains.  The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.

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

Other items that are still on the proposed rule list include amendments to Guide 5 on real estate offerings and Form S-11; amendments to the custody rules for investment advisors; investment company summary shareholder report; amendments to Form 13F filer thresholds; amendments to the family office rule; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and broker-dealer reporting, audit and notifications requirements.

Items moved up from long-term to proposed-rule stage include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; amendments to the Family Office Rule; amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and amendments to the rules regarding the consolidated audit trail.

New to the list and appearing in the proposed rule stage is a rule regarding the valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company.  Also new to the list and in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC.  Another new item that made it to the proposed stage is a proposal to amend Regulation ATS to increase operational transparency and foster oversight of ATSs that transact in government securities.

Twenty-one items are included in the final rule stage, increased from 16 on the fall list, including a few of which are new to the agenda.  Amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019 – see HERE) moved up from the proposed list to final rule stage.

Still in the final rule stage is the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE).  The SEC previously made some changes to risk factor disclosures in an amendment adopted in March 2019 (see HERE) but the newest proposals would go further to: (i) require summary risk factor disclosure if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.

Financial disclosures about acquired businesses are still listed in the final rule stage although final rules were adopted in May 2020, which are still on my list as a catch-up blog.  The proposed amendments were published in May 2019 (see HERE).  Similarly, amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE) still appear on the final rule list although final rules were adopted in July 2020 (also on my future blog list).

Jumping from a long-term action item to final rule stage is universal proxy process.  Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.

Moving up from proposed rule to final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE); proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); procedures for investment company act applications; NMS Plan amendments; use of derivatives by registered investment companies and business development companies; market data infrastructure including market data distribution and market access (proposed rules published in February 2020); amendments to the SEC’s Rules of Practice;  disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; amendments to marketing rules under the Advisors Act; and amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information.  Some amendments to MD&A were adopted in March 2019 (see HERE)

The much-needed amendments to the accredited investor definition moved from the proposed list to the final rule stage.  The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE).  As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.

Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, moved from the proposed rule list to the final agenda.  The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change.  I’ve written about 15c2-11 many times, including HERE and HERE .  In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject.  Comments and responses to the proposed rules have been voluminous and largely negative.  The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living.  However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system.

Other items remaining in the final rule stage include Fund of fund arrangements (proposed rules were issued in December 2018); customer margin requirements for securities futures (proposed rules published in July 2019); and amendments to the whistleblower program.

At least partially, new to the agenda and in the final rule stage is the harmonization of exempt offerings.  In March 2020 the SEC proposed sweeping rule changes.  For my five-part blog on the proposed rules, see HERE, HERE, HERE, HERE, and HERE.  Regulation A and Regulation CF amendments were on the fall 2019 proposed rule list and although dropped off as separate items, are encompassed in the harmonization of exempt offerings proposed amendments.

Several items have dropped off the agenda as they have now been implemented and completed, including financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE) and the final rules adopted in March 2020 (see HERE). Amendments to the definition of an accelerated and large accelerated filer were finalized in March 2020 (see HERE) and thus removed from the list.

Items also completed and removed from the agenda include offering reform for business development companies (adopted in April 2020); amendments to Title VII cross-border rules (final rules adopted in September 2019); recordkeeping and reporting for security-based swap dealers (adopted in September 2019); disclosure for unit investment trusts and offering variable insurance products (adopted in May 2020); a new definition for covered clearing agency (adopted in April 2020); and risk mitigation techniques (adopted on December 2019).

Thirty items are listed as long-term actions (down from 37 in fall 2019 and 52 in spring 2019), including many that have been sitting on the list for a long time now.  Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now.  Other items still on the long-term list include asset-backed securities disclosures (last amended in 2014); corporate board diversity (although nothing has been proposed, it is a hot topic); conflict minerals amendments (prior proposed rules were challenged in lengthy court proceedings on a constitutional First Amendment basis and yet another proposal was published in December 2019 – HERE); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); and stress testing for large asset managers.

Also still on the long-term action list is the modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; covered broker-dealer provisions under Title II of Dodd-Frank; additional changes to exchange-traded products; short sale disclosure reforms; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.

A few electronic filing matters remain on the long-term list including electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.

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

New to the list are requests for comments on fund names; amendments to improve fund proxy systems; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); records to be preserved by certain exchange members, brokers and dealers; and proposed Rule 15 to Regulation S-T, administration of the EDGAR system.

Items that dropped from the agenda without action include amendments to the registration of alternative trading systems and clawbacks of incentive compensation at financial institutions.  Sadly, completely dropped from the agenda is Regulation Finders.  The topic of finders has been ongoing for many years, but unfortunately has not gained any traction.  See here for more information HERE.

---

« SEC Final Amendments On Disclosures For Registered Debt Offerings A COVID IPO »

SEC Final Amendments On Disclosures For Registered Debt Offerings

Posted by Securities Attorney Laura Anthony | August 14, 2020 Tags: SEC, SEC Final Amendments On Disclosures For Registered Debt Offerings

Writing a blog once a week during a time when almost daily events are publish-worthy means that some topics will be delayed, at least temporarily.  Back in March, the SEC adopted final amendments to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities.  The proposed rule changes were published in the summer of 2018 (see HERE).

The amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies.  The SEC also created a new Article 13 in Regulation S-X, renumbered Rules 3-10 and 3-16 to Rules 13-01 and 13-02, and made conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.

As stated in the SEC press release on the new rules, the amended rules focus on the provision of material, relevant, and decision-useful information regarding guarantees and other credit enhancements, and eliminate prescriptive requirements that have imposed unnecessary burdens and incentivized issuers of securities with guarantees and other credit enhancements to offer and sell those securities on an unregistered basis. The amendments are intended to improve disclosure and reduce the SEC registration-related compliance burdens for issuers.  It is hoped that the rules will encourage registered debt offerings over unregistered offerings and thus improve disclosures and protections for investors.

The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.

Rule 3-10

Under the Securities Act, a guarantee of a debt is a separate security requiring either registration, with audited financial statement, or an exemption from registration upon its offer or sale.  Rule 3-10 of Regulation S-X requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements and that the subsidiary be 100% owned.  If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.

The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.

The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.

To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.

When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.

The amendments streamline the current structure, which has differing criteria depending on which exemption is being relied upon to unify all criteria.  The amendments broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the eligibility requirements to rely on the exception are met and the parent company includes specific financial and non-financial disclosures about those subsidiaries.

The amended rule will:

(i) Allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned;

(ii) Replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis;

(iii) New non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities;

(iv) Permit disclosures to be provided outside the footnotes of the parent’s audited and interim unaudited financial statements in the registration statement covering the offering and in the Exchange Act reports thereafter;

(v) Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, provided however, if the acquisition is significant, summarized financial information must be provided; and

(vi) Reduce the time in which additional Alternative Disclosure must be made to the period for which the issuer and guarantors have Exchange Act reporting obligations instead of the entire period that the guaranteed securities are outstanding.

To be eligible to rely on the exception, the following conditions must be met:

(i) The consolidated financial statements of the parent company have been filed;

(ii) The subsidiary or guarantor is a consolidated subsidiary of the parent;

(iii) The guaranteed security is debt or debt-like; and

(iv) One of the following issuer and guarantor structures is applicable: (a) the parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or (b) a consolidated subsidiary issues the security or co-issues the security with one or more other consolidated subsidiaries of the parent company, and the security is guaranteed fully and unconditionally by the parent company.

Importantly, as noted, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.  The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subjects the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.

The new rules include conforming amendments to also apply to the Rule 8-01 of Regulation S-X dealing with smaller reporting companies and Forms 1-A, 1-K and 1-SA to apply to Regulation A issuers.

Rule 3-16

Current Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.

The amendments replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security.  The amended financial and non-financial disclosures are included in new Rule 13-02.

The level of disclosure is based on materiality and would include certain line items of the balance sheet and income statement of the affiliate.  Where more than one affiliate provides collateral, financial information can be included on a consolidated rather than individual basis.  However, when information is applicable to one or more, but not all, affiliates, it will need to be separated out.  For example, when one or more affiliates separates trades, it would need to be clear which affiliate trading market information is being provided for.

In addition, the amendment changes the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.

Furthermore, the amendments replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered, with a requirement to provide the financial and non-financial disclosures to the extent material, eliminating numerical thresholds.  The rule leans towards materiality with the need to determine information is immaterial for it to be omitted.

---

« Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards SEC Spring 2020 Regulatory Agenda »

SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions

Posted by Securities Attorney Laura Anthony | July 23, 2020 Tags: SEC, SEC Adopts Amendments To Accelerated And Large Accelerated Filer Definitions

In March, 2020 the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer.”  The amendments were adopted largely as proposed in May 2019 (see HERE).

A company that is classified as an accelerated or large accelerated filer is subject to, among other things, the requirement that its outside auditor attest to, and report on, management’s assessment of the effectiveness of the issuer’s internal control over financial reporting (ICFR) as required by Section 404(b) of the Sarbanes-Oxley Act (SOX).  The JOBS Act exempted emerging growth companies (EGCs) from this requirement.  Moreover, historically the definition of a smaller reporting company (SRC) was set such that an SRC could never be an accelerated or large accelerated filer, and as such would never be subject to Section 404(b) of SOX.

In June 2018, the SEC amended the definition of an SRC to include companies with less than a $250 million public float (increased from $75 million) or if a company does not have an ascertainable public float or has a public float of less than $700 million, an SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year (see HERE).  At that time the SEC did not amend the definitions of an accelerated filer or large accelerated filer.  As a result, companies with $75 million or more of public float that qualify as SRC’s remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of SOX.

Under the new rules, smaller reporting companies with less than $100 million in revenues are not required to obtain an attestation of their internal controls over financial reporting (ICFR) from an independent outside auditor under Section 404(b) of SOX.  In particular, the amendments exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and that had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.

All Exchange Act reporting companies, whether an SRC or accelerated filer, will continue to be required to comply with SOX Rule 404(a) requiring the company to establish and maintain ICFR and disclosure control and procedures and have their management assess the effectiveness of each.  This management assessment is contained in the body of all quarterly and annual reports and amended reports and in separate certifications by the company’s principal executive officer and the principal financial officer.

The new rules also increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.

Like the change to the definition of an SRC, it is thought the new rules will assist with capital formation for smaller companies and reduce compliance burdens while maintaining investor protections. The SEC also hopes that the amendments will catch the attention of companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets.

In the press release announcing the rule change, Chair Jay Clayton stated: “[T]he JOBS Act provided a well-reasoned exemption from the ICFR attestation requirement for emerging growth companies during the first five years after an IPO. These amendments would allow smaller reporting companies that have made it to that five-year point, but have not yet reached $100 million in revenues, to continue to benefit from that exemption as they build their businesses, while still subjecting those companies to important investor protection requirements.”

Background

The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been prolific over the past few years with a slew of rule changes and proposed rule changes.  Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.

The SEC disclosure requirements are scaled based on company size.  The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities.  The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.

The filing deadlines for each category of filer are:

Filer Category	Form 10-K	Form 10-Q
Large Accelerated Filer	60 days after fiscal year-end	40 days after quarter-end
Accelerated Filer	75 days after fiscal year-end	40 days after quarter-end
Non-Accelerated Filer	90 days after fiscal year-end	45 days after quarter-end
Smaller Reporting Company	90 days after fiscal year-end	45 days after quarter-end

 

Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX.  Non-accelerated filers are not subject to Section 404(b) requirements.  Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).

An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets.  Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences.  These requirements apply to any and all companies subject to the SEC Reporting Requirements.

Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.

Furthermore, auditors review ICFR even where companies are not subject to 404(b).  Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit.  A necessary precondition is testing such controls.  Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence.  Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls.  In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.

The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with.  In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment.  The auditor’s report must contain specific information about this assessment (see HERE).  As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements.  Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.

The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and lower revenue companies.  I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues.

Detail on Amendments to Accelerated Filer and Large Accelerated Filer Definitions

Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories.  However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million, would be both an SRC and an accelerated filer.

The SEC has now amended the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC and that had annual revenues of less than $100 million during its most recently completed fiscal year for which audited financial statements are available.  The effect of this change is that such a company will not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement under SOX Section 404(b).

The rule change does not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance.  In particular, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.

The chart below illustrates the effect of the amendments:

Relationships between SRC’s and Non-Accelerated and Accelerated Filers
Status	Non-Affiliated Public Float	Annual Revenues
SRC and Non-Accelerated Filer	Less than $75 million	N/A
	$75 million to less than $700 million	Less than $100 million
SRC and Accelerated Filer	$75 million to less than $250 million	$100 million or more
Accelerated Filer (not SRC)	$250 million to less than $700 million	$100 million or more
Large Accelerated Filer (not SRC)	Over $700 million	N/A

 

The amendments also revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million and increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds.  Finally, the amendments allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.

The chart below illustrates the effect of the amendments on transition provisions:

Amendments to the Non-Affiliate Public Float Thresholds
Initial Public Float Determination	Resulting Filer Status	Subsequent Public Float Determination	Resulting Filer Status
$700 million or more	Large Accelerated Filer	$560 million or more	Large Accelerated Filer
		Less than $560 million but $60 million or more	Accelerated Filer
		Less than $60 million	Non-Accelerated Filer
Less than $700 million but $75 million or more	Accelerated Filer	Less than $700 million but $60 million or more	Accelerated Filer
		Less than $60 million	Non-Accelerated Filer

 

Determining Non-Affiliated Public Float

To determine the value of the public float, a company must multiply the aggregate worldwide number of shares of common equity held by non-affiliates by the price at which it was last sold, or the average of the bid and asked prices, in the principal trading market.   Derivative securities such as options, warrants and other convertible or non-vested securities are not included in the calculation.  An “affiliate” of, or a person “affiliated” with, a company, is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the company.  The term “control” (including the terms “controlling,” “controlled by” and “under common control with”) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a company, whether through the ownership of voting securities, by contract, or otherwise.

From a top line, directors, executive officers and their spouses and relatives living with them are always considered affiliates as are trusts and corporations of which that director, executive officer or their spouses control in excess of 10%.  There is a rebuttable presumption that 10% or greater stockholders are affiliates.  Beyond that, the SEC has consistently refused to provide definitive guidance on the matter, rather requiring companies and their management to make an analysis based on their individual facts and circumstances.

Through various guidance, including comment letters and SEC enforcement actions, important facts to consider in determining control/affiliate status include:

• Distribution of voting shares among all stockholders – Consider whether a stockholder has a large percentage of the company’s voting stock as compared to all other stockholders;
• Impact of possible resale – if a particular larger shareholder threatens to sell their stock into the market unless management takes certain actions, and management believes that such sale would have a material negative impact on the stock price, that person could be considered to have control;
• Influence of a stockholder – a particular stockholder could have influence because of their general position or power over other stockholders – this could be because of a direct or indirect relationship with other stockholders or because of the person’s reputation as a whole.  For example, certain activist shareholders such as Carl Icahn can exert control over management of companies in which they invest;
• Voting agreements – if a person has the right to vote on behalf of other people’s shares, they may have control;
• Contractual arrangements – any other contract that gives a person the right to assert control over management decisions.

---

« Proposed 2021 U.S. Budget SEC Further Comments On Emerging Markets »

Going Public Strategies Market Makers Cleaning Up Public Shells 15c211

Reverse Mergers Form 10 Registration Statements Pink Sheet Companies Go Public Glossary

S-1 Registration Statements IPO Initial Public Offerings Bulletin Board Shells Going Public Site Map