Monthly Archives: July 2013
SEC has Finalized Rules Disqualifying Felons and Other “Bad Actors” from Rule 506 Offerings
On July 10, 2013, the same day the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act, the SEC adopted new rules disqualifying felons and other bad actors from participating in Rule 506 offerings as required by Section 926 of the Dodd-Frank Act.
Background
The Dodd-Frank Act required the SEC to implement rules which disqualify certain Rule 506 offerings based on the individuals involved in the Issuer and related parties. On July 10, 2013 the SEC adopted such rules by amending portions of Rules 501 and 506 of Regulation D, promulgated under the Securities Act of 1933. The new rules go into effect on September 10, 2013. The new rule is not retroactive; that is, the disqualification provision will only apply to disqualifying events that occur after September 10; however, mandatory disclosure provisions for preexisting events have also been added.
Bad actor or “bad boy” disqualification provisions disqualify an Issuer from relying on an exemption if the Issuer or certain persons associated with the Issuer and its predecessors and affiliates (including underwriters, placement agents, director, officers, general partners, promoters and significant shareholders) have been convicted of, or are subject to, court or administrative orders related to securities fraud and certain other enumerated laws. Prior to the new rule, Rule 506 did not have a bad actor disqualification (although Rule 505 and Regulation A did). The new rule is similar to the existing Rule 262 of Regulation A disqualifying bad actors from participating in Regulation A offerings, in that it encompasses all of the bad actor disqualifications in Rule 262, but also adds additional disqualifying events. In addition, the new rule does not modify the existing Rule 262 or other bad actor disqualification rules, but rather is limited to Rule 506 offerings.
New Rule 506(d) Disqualifying Felons and Other Bad Actors
A. Covered Persons
New Rule 506(d) applies to the following categories of persons (“covered persons”):
The issuer and any predecessor of the issuer or affiliated issuer;
Any director, general partner or managing member of the issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);
Any beneficial owner of 20% or more of the outstanding equity securities of the issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting);
Investment managers of issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering, general partners and managing members of such investment managers; and the directors and executive officers of such general partners and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);
Any promoter connected with the issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);
Any person that has been or will be paid, either director or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
Any director, officer, general partner, or managing member of any such compensated solicitor.
Events relating to certain affiliated issuers are not disqualifying if they predate the affiliate relationship. That is, any disqualifying event associated with an affiliated issuer that arose before the affiliation does not disqualify an offering if the affiliated issuer is not (i) in control of the issuer or (ii) under common control, together with the issuer, by a third party that controlled the affiliated issuer at the time such disqualifying event occurred.
B. Disqualifying Events
New Rule 506(d) enumerates the following disqualifying events:
Criminal convictions (felony or misdemeanor) within the last five years in the case of issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
Final orders issued by state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, and the National Credit Union Administration, that at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203€ or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
Is the subject to any order of the SEC entered within five years before such sale, that at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of the federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
Suspension or expulsion from membership in, or suspension or a bar from association with a member of, an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.
The SEC added a definition of Final Order to the definitions of Rule 501 to mean “a written directive or declaratory statement issued by a federal or state agency… under applicable statutory authority that provides for notice and an opportunity for hearing, which constitutes a final disposition or action by that federal or state agency.”
Reasonable Care Exception
The new rule includes an exception from disqualification for offerings where the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a covered person. The steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances—provided, however, that if no investigation or steps have been taken, there can be no reasonable care exception. Issuers will need to conduct background checks and solicit information via questionnaires or certifications and perhaps contractual representations and covenants. If a broker dealer is involved, the issuer can rely on them to some extent in the performance of background checks and due diligence. Publicly available databases and information should be reviewed. If circumstances give an issuer reason to question or investigate further, they are obligated to do so.
Where an offering is continuous or long-term, factual information and inquiry should be updated on a reasonable basis.
Waivers
The SEC received many comments seeking to limit the disqualification provisions as written. As opposed to going that route, the SEC is relying on the procedure whereby a covered person can seek a waiver of the disqualification to limit disqualification on a case-by-case basis where appropriate. As written, the SEC can grant a waiver of disqualification if it determined that the issuer has shown good cause that disqualification is not necessary under the circumstances.
In addition, disqualification will not apply if the court or regulatory authority that entered the relevant order, judgment or decree advised in writing that disqualification should not result from the order, judgment or decree.
Timing
Events relating to certain affiliated issuers are not disqualifying if they predate the affiliate relationship. That is, any disqualifying event associated with an affiliated issuer that arose before the affiliation does not disqualify an offering if the affiliated issuer is not (i) in control of the issuer or (ii) under common control, together with the issuer, by a third party that controlled the affiliated issuer at the time such disqualifying event occurred.
However, an issuer is required to furnish, to any purchasers, a written description of any matter that would have caused disqualification but for the fact such event occurred prior to the effective date of the new rules.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016
New SEC Rules Have Eliminated the Prohibition Against General Solicitation and Advertising in Rules 506 and 144A Offerings
In a historic 4-1 vote on July 10, 2013, the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. On the same day, the SEC adopted amendments to Rule 506 to disqualify “felons and bad actors” from participating in Rule 506 offerings. This blog discusses the rules eliminating the prohibition against general solicitation and advertising. A separate blog will discuss the felon and bad actor disqualifications.
The SEC has also adopted modifications to Form D to require Issuers to specify if they are conducting an offering that permits general solicitation and advertising and to change the required time of filing the Form D for such offerings. Finally, also on July 10, 2013, the SEC issued proposed rules amending Regulation D, Form D and Rule 156 and requested comments on such proposed amendments. A separate blog will also discuss those proposed changes. The entire text of the final and proposed rule releases is available on the SEC website.
Background
Title II of the JOBS Act requires the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors. The JOBS Act calls for the same amendment to Rule 144A provided all purchasers are qualified institutional buyers (QIB). In both cases, the JOBS Act requires that the rules require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors or QIBs as the case may be, using such methods as determined by the SEC. Most of the pre-rulemaking comments and commentary by the public and advocacy groups centered on what steps and methods would be required by the SEC to verify purchaser qualification.
Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transaction by an issuer not involving a public offering. In a Rule 506 offering an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors. The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer. Currently, Rule 506 offerings must abide by certain general conditions set forth in Rule 502, including Rule 502(c), which prohibits general solicitation and advertising.
Presently, Rule 144A does not explicitly prohibit general solicitation and advertising but it does limit all offers of securities to QIBs, which has the same practical effect. Section 5 of the Securities Act of 1933 (the registration requirement) as well as most of the exemptions and safe harbor exemptions regulate both the offers and sales of securities. As further brief background on Rule 144A, it is noted that technically Rule 144A is not an Issuer’s exemption, but rather is a safe harbor for the resale of restricted securities to QIBs, much as Rule 144 is a safe harbor for the resale of restricted securities generally. However, since its passage in 1990, market participants have used Rule 144A as a means of raising capital for issuers by engaging in a Regulation S offering followed by the immediate resale of such securities to QIBs in reliance on Rule 144A. This method of raising capital has become widely known as a Rule 144A Offering.
The Amendment to Rule 506
The SEC has adopted a new Rule 506(c) which permits the use of general solicitation and advertising to offer and sell securities under Rule 506 provided that the following conditions are met:
1. the issuer takes reasonable steps to verify that the purchasers are accredited;
2. all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
3. all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.
Rule 501 sets out definitions, including the definition of accredited investors. Rule 502(a) is the integration rule providing a six-month safe harbor from integration for successive Regulation D offerings and setting out a five-factor fact test analysis which can be used if the six-month rule is not available. Rule 502(d) provides that securities sold in Regulation D offerings (with certain Rule 504 exceptions) are restricted under Rule 144.
The new Rule 506(c), unlike the proposed rule published August 29, 2012, includes a non-exclusive list of methods that issuers may use to verify that investors are accredited.
The current Rule 506 will also remain in place. Accordingly, an issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors. An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited. Both the old 506 and new 506(c) offerings are deemed to be federally covered securities and accordingly the offering provisions preempt state law.
Reasonable Steps to Verify Accredited Investor Status
In its proposed rule issued in August 2012, the SEC declines to define what actions suffice as reasonable steps to verify accredited investor status or in fact that such steps would be necessary in every case. However, in response to numerous comments on the issue, the SEC final rule requires that an Issuer take reasonable steps to verify that purchasers are accredited. Moreover, the SEC included a non-exclusive list of methods that issuers may use to satisfy the verification requirement. Note that the verification requirement is separate from the requirement that all investors in fact be accredited.
According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.” Among the factors that issuers should consider under the fact and circumstance analysis are:
a. The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker dealer registered with the SEC, verification could be a simple check on the FINRA website. Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements. Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that issuers may use to satisfy the verification requirement.
b. The amount and type of information that the issuer has about the purchaser. Clearly, the more information, the better. The SEC lists the obvious (W-2; tax returns; letters from a bank or broker dealer). Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.
c. Nature and terms of the offering, such as type of solicitation and minimum investment requirements. The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former. The SEC highlights the obvious, such as that the higher the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.
After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. Moreover, where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.
The more information an Issuer has evidencing that a prospective purchaser is accredited, the fewer additional steps it will have to take to verify the status, and vice versa. Examples of the type of information that Issuers can review and rely upon include:
(i) Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages)
(ii) Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms
(iii) Third-party accredited investor verification service providers
Regardless of the methods an issuer uses to verify accredited status, they should keep adequate and complete records. If the exemption is challenged, the burden is on the issuer to prove that under the facts and circumstances of their particular offering, they took reasonable steps to verify and they reasonably believed that an investor was accredited at the time of the sale. However, although the rules do not address the issue, the SEC is cognizant of the privacy concerns raised by having issuers obtain and maintain personal financial records from investors.
Non-Exclusive Methods that Issuers May Use to Satisfy the Verification Requirement
The SEC included four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the Issuer does not have actual knowledge that the purchaser is not accredited. Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:
aa. Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
bb. Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit report from a nationwide agency.
cc. Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
dd. A written certification verifying accredited investor status from existing accredited investors of the Issuer that have previously invested in a 506 offering with the same Issuer.
Reasonable Belief that all Purchasers are Accredited Investors
In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, the new Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors. Current Rule 506 requires that the issuer have a reasonable belief that investors are accredited, and the SEC desires to continue this standard with the new Rule 506(c). In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.
Form D Amendment
A Form D is the notice of an offering of securities conducted without registration under the Securities Act in reliance on Regulation D. Form D has been amended to add a new check box for 506(c) offerings. A Form D must be filed within 15 days after the first sale of securities in the offering.
Specific Issues for Hedge Funds
Private funds include hedge funds, private equity funds and other types of pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 under either section 3(c)(1) or 3(c)(7). Section 3(c)(1) is available to a fund that does not publicly offer its securities and has 100 or fewer beneficial owners of its securities. Section 3(c)(7) is available to a fund that does not publicly offer its securities and limits the owners of its securities to qualified investors.
Section 201(b) of the JOBS Act provides that offers and sales exempt under the new Rule 506(c) shall not be deemed public offerings under the federal securities laws as a result of general advertising or general solicitation. Private funds may engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.
The SEC rule release specifically reminds hedge funds of the anti-fraud provisions under the Advisors Act, including that it is a fraudulent, deceptive and manipulative act for an advisor to “make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading , to any investor or prospective investor in the pooled investment vehicle; or (2) otherwise engage in any act, practice or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.”
The SEC further noted that through its proposed rule releases and general duties, it will monitor the activity of hedge funds conducting general solicitation and advertising and amend rules in the future as necessary.
Amendment to Rule 144A
The JOBS Act directs the SEC to revise Rule 144A to provide that securities may be offered to persons other than QIBs, including by means of general solicitation and advertising, provided that securities are only sold to persons that the seller reasonably believes is a QIB. Taking the most direct and simplest route, the SEC has proposed to simply remove the terms “offer” and “offeree” to the existing Rule 144A such that only sales are limited to QIBs. As Rule 144A does not prohibit general solicitation, open offers have the effect of allowing such general solicitation.
Integration with Offshore Offerings
Regulation S provides a safe harbor for offers and sales of securities outside the United States. A condition of Regulation S is that there can be no directed selling efforts in the United States. Many practitioners have been concerned that the new general solicitation rules would de facto eliminate the ability to engage in concurrent Rule 144A or 506 and Regulation S offerings. However, the SEC notes that Regulation S, by its terms, does not integrate with either registered or “domestic offerings that satisfy the requirements for an exemption from registration under the Securities Act.” Since general solicitation under the new Rule 506(c) or Rule 144A would satisfy the requirements of a US exemption, the SEC will not view concurrent offerings under Rule 506(c) and/or Rule 144A and Regulation S as integrating such as to destroy the Regulation S exemption.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016
14C Information Statement Requirements for a Pre-Merger Recapitalization
Background on 14C Information Statements
All companies with securities registered under the Securities Exchange Act of 1934, as amended, (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act proxy requirements found in Section 14 and the rules promulgated thereunder. The proxy rules govern the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the approval of any corporate action requiring shareholder approval. The information contained in proxy materials must be filed with the SEC in advance of any solicitation to ensure compliance with the disclosure rules.
Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which shareholders are asked to vote. The disclosure information filed with the SEC and ultimately provided to the shareholders is enumerated in SEC Schedules 14A.
Where a shareholder vote is not being solicited, such as when a Company has obtained shareholder approval through written consent in lieu of a meeting, a Company may satisfy its Section 14 requirements by filing an information statement with the SEC and mailing such statement to its shareholders. In this case, the disclosure information filed with the SEC and mailed to shareholders is enumerated in SEC Schedule 14C. As with the proxy solicitation materials filed in Schedule 14A, a Schedule 14C Information Statement must be filed in advance of final mailing to the shareholder and is reviewed by the SEC to ensure that all important facts are disclosed. However, Schedule 14C does not solicit or request shareholder approval (or any other action, for that matter), but rather informs shareholders of an approval already obtained and corporate actions which are imminent.
In either case, a preliminary Schedule 14A or 14C is filed with the SEC, who then reviews and comments on the filing. Upon clearing comments, a definitive Schedule 14A or 14C is filed and mailed to the shareholders as of a certain record date.
Generally, the information requirements in Schedule 14C are less arduous those in a Schedule 14A in that they do not include lengthy material regarding what a shareholder must do to vote or approve a matter. Moreover, the Schedule 14C process is much less time-consuming, as the shareholder approval has already been obtained. Accordingly, when possible, Companies prefer to utilize the Schedule 14C Information Statement as opposed to the Schedule 14A Proxy Solicitation.
Pre-Merger Recapitalization
Generally, public company shareholders do not have the right to vote on a merger or acquisition transaction. Such mergers or acquisitions are usually structured such that the public company completes the merger or acquisition via the issuance of shares of common or preferred stock. In such cases, where the merger or acquisition is being accomplished via the issuance of authorized but previously unissued stock of a public company, the board of directors has the full power and authority to complete the transaction without shareholder approval.
However, in many instances the public company requires a pre-transaction recapitalization involving a reverse stock split and/or increase in authorized capital stock in order to have the available capital stock to issue at the closing of the merger or acquisition transaction and to provide the target entity and its shareholders with the agreed-upon share ownership and capital structure. Shareholders do have the right to vote on recapitalization transactions, including a reverse stock split and a change in authorized capital stock.
Here is the catch. Item 1 of Schedule 14C requires that the company provide information that would be required as if a vote were being solicited via a 14A Proxy Solicitation and specifically provides “[N]otes A, C, D, and E to Schedule 14A are also applicable to Schedule 14C.” Note A to Schedule 14A provides:
“Where any item calls for information with respect to any matter to be acted upon and such matter involves other matters with respect to which information is called for by other items of this schedule, the information called for by such other items also shall be given. For example, where a solicitation of security holders is for the purpose of approving the authorization of additional securities which are to be used to acquire another specified company, and the registrants’ security holders will not have a separate opportunity to vote upon the transaction, the solicitation to authorize the securities is also a solicitation with respect to the acquisition. Under those facts, information required by Items 11, 13 and 14 shall be furnished.”
In other words, if you are filing a Schedule 14C for a pre-merger or acquisition recapitalization, you must provide all the information related to that merger or acquisition as if the shareholders were voting on the merger or acquisition even though the shareholders are only voting on the recapitalization and even though the shareholders have no legal right to vote on the merger or acquisition itself.
Specific Disclosure Requirements in the Pre-Merger 14C
As enumerated in Note A to Schedule 14A, a pre-merger recapitalization 14C Information Statement must include the information required by Items 11, 13 and 14 of Schedule 14A. Items 11, 13 and 14 of Schedule 14A require in-depth disclosures on the merger or acquisition transaction itself and on both the target and acquiring companies, including audited financial statements and stub periods to date and pro forma financial statements on the combined entities. Management discussion and analysis must also be provided for both entities.
In addition to financial information, Item 14 also requires, for example, in-depth disclosure regarding the business operations and disclosures related to regulatory approvals, transaction negotiations and property descriptions. Many reading this will notice that the disclosures are analogous to a Super 8-K. The analogy is accurate, although the Super 8-K has additional requirements as well.
For entities engaging in a merger or acquisition transaction that would require the filing of a Super 8-K (i.e., where the public company is a shell company), the positive side is that the attorneys, accountants and auditors are putting together documents and information and engaging in efforts that would need to be completed for the Super 8-K in any event, just with an altered earlier timeline. The efforts can be seen as a head start on the Super 8-K preparation.
However, for entities that would not be required to file a Super 8-K, such as where the public company is not a shell company, the efforts and altered timeline are substantially different. When a public company that is not a shell company completes a merger or acquisition that requires the preparation and filing of financial statements on the acquired company (the determination of financial statement requirements is beyond the scope of this blog), it has 71 days following the closing to file such financial information via Form 8-K. In the case of a pre-merger recapitalization 14C filing, the financial information, including audited financial statements, must be completed and filed prior to the closing.
Conclusion
Companies with securities registered under the Securities Exchange Act of 1934 and the target companies that they are planning to acquire or merge with must be prepared to file audited financial statements, pro forma financial statements, management discussion and analysis and other in-depth disclosure in a pre-merger 14C Information Statement where such Information Statement is for the purpose of a pre-merger recapitalization.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
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Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016
Section 3(a)(10) Debt Conversions in a Shell Company Pre-Reverse Merger
Section 3(a) (10) of the Securities Act of 1933, as amended (“Securities Act”) is an exemption from the Securities Act registration requirements for the offers and sales of securities by Issuers. The exemption provides that “Except with respect to a security exchanged in a case under title 11 of the United States Code, any security which is issued in exchange for one or more bona fide outstanding securities, claims or property interests, or partly in such exchange and partly for cash, where the terms and conditions of such issuance and exchange are approved, after a hearing upon the fairness of such terms and conditions at which all persons to whom it is proposed to issue securities in such exchange shall have the right to appear, by any court, or by any official or agency of the United States, or by any State or Territorial banking or insurance commission or other governmental authority expressly authorized by law to grant such approval.”
The Securities and Exchange Commission (SEC) has given guidance on the operation of Section 3(a) (10) in its Division of Corporation Finance: Revised Staff Legal Bulleting No. 3. In particular, in order to rely on the exemption, the following conditions must be met:
- The securities must be issued in exchange for securities, claims, or property interests, not cash;
- A court or authorized governmental entity must approve the fairness of the terms and conditions of the exchange;
- The reviewing court or authorized governmental entity must (i) find that the terms and conditions of the exchange are fair to those that the securities will be issued to; and (ii) be properly advised that the Issuer will be relying on the court’s findings to issuer securities;
- The reviewing court or authorized governmental entity must hold a hearing before approving the fairness of the terms and conditions of the transaction;
- A governmental entity must be expressly authorized by law to hold the hearing;
- The fairness hearing must be open to everyone to whom securities would be issued in the proposed exchange;
- Adequate notice must be given to all those persons; and
- There cannot be any improper impediments to the appearance by those persons at the hearing.
Section 3(a) (10) does not preempt state law and accordingly, the implementing state statutes must also be abided by. Many state securities law statutes that authorize a Section 3(a) (10) court process require that there be a majority shareholder vote approving the transaction prior to the hearing.
Re-sale of 3(a)(10) securities
Importantly, SEC Staff Bulletin 3 provides that the resale of securities issued in a Section 3(a) (10) transaction may be had without regard to Rule 144 if the seller is not an affiliate of the Issuer either before or after the Section 3(a) (10) transaction. That is, as long as the Seller is not an affiliate of the Issuer, securities issued in a 3(a) (10) transaction are freely tradable.
If the seller is or will be an affiliate either before or after the Section 3(a) (10) transaction, resale’s are subject to Rule 144, except for the holding period and notice filing requirements. That is, affiliates would still be subject to the drip rules, manner of sale and current public information requirements, but not the holding period requirements.
As a practical matter, many over-the-counter traded securities (over-the-counter bulletin board or OTCBB and pinksheets) have been utilizing the exemption found in Section 3(a) (10) to convert debt into common stock. The conversion of debt into common stock can assist an Issuer in two ways. First, and obviously, it eliminates the debt from the balance sheet and increases liquidity and solvency. Second, and less obviously, is that the Section 3(a) (10) exemption can be used to convince lenders to make investments into a company without the investor relying solely on the Company cash flows for repayment.
3(a)(10) and shell company reverse mergers
As described herein, shareholders that receive their securities in a 3(a)(10) transaction by a shell company that subsequently completes a merger, reverse merger, reclassification or asset transfer will be restricted until (i) 6 months after issuance; and (ii) ninety (90) days after the reverse merger, reclassification or asset purchase has been completed.
Rule 145 promulgated under the Securities Act of 1933 governs the resale restrictions on shares of stock issued or received in a reclassification, merger or asset transfer. Like Rule 144, Rule 145 contains prohibitions against the resale of securities in a shell company.
Shareholders of an entity that has completed a reverse merger, reclassification or asset transfer and that receive their securities pursuant to a 3(a)(10) transaction can resell their securities in accordance with revised resale provisions pursuant to Rule 145(d)(1) and (2) below, which provide that:
Rule 145….
(d) Resale provisions for persons and parties deemed underwriters. Notwithstanding the provisions of paragraph (c), a person or party specified in that paragraph shall not be deemed to be engaged in a distribution and therefore not to be an underwriter of securities acquired in a transaction specified in paragraph (a) that was registered under the Act if:
(1) The issuer has ceased to be a shell company, is reporting and has filed the requisite Exchange Act reports and filings reflecting that the issuer is no longer a shell company; and
(2) One of the following three conditions is met:
(i) The securities are sold in accordance with the Rule 144 restrictions and at least 90 days have elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction;
(ii) The seller has not been, for at least three months, an affiliate of the issuer, and at least six months have elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction, and current information regarding the issuer is publicly available; or
(iii) The seller has not been, for at least three months, an affiliate of the issuer, and at least one year has elapsed since the date the securities were acquired from the issuer in the Rule 145 transaction.
Although Rule 145(d) specifically refers to shares received in a reclassification, merger or asset transfer that was registered under the Act, the Rule specifically provides that transactions for which statutory exemptions under the Act, including those contained in sections 3(a)(9), (10), (11) and 4(2), are otherwise available are not affected by Rule 145.
The bottom line is that a shell company can complete a 3(a)(10) transaction prior to and in contemplation of a reverse merger transaction and such shares will become freely tradable 90 days after the closing of the reverse merger and after a total of a 6-month holding period from the date of issuance in the 3(a)(10) transaction. The SEC analysis in Staff Legal Bulletin No. 3. supports this conclusion, and this firm’s personal and direct experience (including via SEC comment letters and responses) also support this conclusion.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016