Monthly Archives: October 2013
Board of Directors Obligations as Applied to Mergers and Acquisitions
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Generally a court will not second-guess directors’ decisions as long as the board has conducted an appropriate process in reaching its decision. This is referred to as the “business judgment rule.” However, in certain instances, such as in a merger and acquisition transaction, where a board may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ actions face a higher level of scrutiny. This is referred to as “enhanced scrutiny business judgment rule.” The same standards apply to officers of a corporation.
Directors’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director to provide complete and materially accurate information to a corporation.
In the seminal case of Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985), the Court found that the board was grossly negligent where it approved the sale of the company after only a few hours of deliberation, failed to inform itself of the Chairman’s role and benefits in the sale and did not seek the advice of outside counsel. Similarly in Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993) found that the board was negligent in approving the sale of a company where it did not search for real alternatives, did not attempt to find a better offer and had insufficient knowledge of the terms of the proposed merger agreement.
On the other hand, the court in In re CompuCom Sys., Inc. Shareholders Litigation., 2005 Del. Ch. LEXIS 145 (Del. Ch. Sept. 29, 2005) upheld the board of directors’ business judgment even though the transaction price per share was less than market value, as the board showed it was adequately informed, acted rationally and sought better deals.
Many states’ corporate laws allow entities to include provisions in their corporate charters allowing for the exculpation and/or indemnification of directors. Exculpation refers to a complete elimination of liability, whereas indemnification allows for the reimbursement of expenses incurred by an officer or director. Delaware, for example, allows for the inclusion of a provision in the certificate of incorporation eliminating personal liability for directors in stockholder actions for breaches of fiduciary duty, except for breaches of the duty of loyalty that result in personal benefit for the director to the detriment of the shareholders. Indemnification generally is only available where the director has acted in good faith. Exculpation is generally only available to directors, whereas indemnification is available to both officers and directors.
To show that a director acted in good faith, the director must meet the same general test of showing that they met their duties of care, loyalty and disclosure. The best way to do this is to be fully informed and to participate in the process, whether that process involves a merger or acquisition or some other business transaction. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for and review of documents and contracts.
In advising the board of directors, counsel should stress that the director be actively involved in the business decision-making process, review the documents and files, ask questions and become fully informed. The higher the level of diligence, the more the protection. Significantly, it is not important whether the decision ultimately turns out to be good or bad. Hindsight is 20/20. The important factor in seeking protection (via the business judgment rule, and through exculpation and indemnification) is that best efforts are made. Of course, directors should be careful to document their diligence.
Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions. Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where a director is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the director. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested director, it is vital that all directors take a very active role in the merger or acquisition transaction; that the interested director inform both the directors, and ultimately shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; that negotiations are diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
A common question I am asked by directors is how to balance the interest of two competing classes of stock (such as common and preferred). In such a case, the business judgment rule will be used as opposed to the entire fairness standard. Accordingly, a director who is not conflicted and who otherwise takes all measures required (in-depth involvement in the process, review of all documents, advice of outside professionals, seeking highest price for all classes of stock) will be protected from liability.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. Most companies obtain third-party fairness opinions as to the transaction.
The duty to disclose (like other duties) only extends to material facts and circumstances: “Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available” TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976). In the case of a merger or acquisition requiring shareholder vote, for instance, directors must provide shareholders with material information necessary to make an informed decision.
In In Re Pure Res., 808 A.2d 448, the court held that the directors had a duty to disclose to shareholders the substantive work performed and total involvement of investment bankers in pending merger transactions. The court reasoned that this information would assist an investor in determining whether the value being paid was fair. Other courts have concurred with this opinion and specified that shareholders are entitled to see valuation reports and financial projections prepared by investment bankers in a merger transaction, and it is the board of director’s duty to supply this information. Moreover, other courts have held that shareholders are entitled to be informed of financial advisors’ roles and compensation in a merger or acquisition transaction.
A director’s duty of disclosure is based in state law and is separate and distinct from a company’s duty to disclose under both the Securities Act of 1933 and Securities Exchange Act of 1934. Whereas the state law duty to disclose supports private causes of action, including possible class action lawsuits, the federal duty supports both private causes of action (including class actions) and regulatory enforcement proceedings.
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
How to Complete an Unregistered Spin-Off
A spin-off is when a parent company distributes shares of a subsidiary to the parent company’s shareholders such that the subsidiary separates from the parent and is no longer a subsidiary. The distribution normally takes the form of a dividend by the parent corporation. In Staff Legal Bulletin No. 4, the Securities and Exchange Commission (SEC) explains how and under what circumstances a spin-off can be completed without the necessity of filing a registration statement.
In particular, the subsidiary shares (the shares distributed to the parent company shareholders) do not need to be registered if the following five conditions are met: (i) the parent shareholders do not provide consideration for the spun-off shares; (ii) the spin-off is pro-rata to the parent shareholders; (iii) the parent provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets; (iv) the parent has a valid business purpose for the spin-off; and (v) if the parent spins-off restricted securities, it has held those securities for at least one year. Below is a discussion of each of the five conditions.
The first condition is that the parent shareholders do not provide consideration for the spun-off shares. This is because if value is provided, a “sale” has occurred and a “sale” requires registration under Section 5 of the Securities Act of 1933, as amended, unless an exemption is available. In a spin-off, an exemption is rarely available due to the wide variety of shareholders receiving the spun-off shares.
The second condition is that the spin-off must be pro rata. When the spin-off is pro rata, the parent shareholders have the same proportionate interest in the parent and the subsidiary both before and after the spin-off. If a spin-off is not pro rata, the shareholders’ relative interests change and some shareholders give up value for the spun-off shares, requiring registration pursuant to the first condition.
The third condition requires that adequate information be provided to the shareholders. If the subsidiary is a non-reporting company it can satisfy this condition by providing the shareholders with an information statement which satisfies the Section 14 proxy rules of the Securities Exchange Act of 1934 prior to or contemporaneously with providing the spun-off shares. In addition, the non-reporting subsidiary must file a Form 10 registration statement, which can be accomplished after the spin-off but prior to the start of trading on the spun-off subsidiary. A reporting subsidiary is deemed to have satisfied its information requirements as long as it is current in its reporting obligations and it provides any pertinent information directly related to the spin-off itself.
Where both the parent company and the subsidiary are non-reporting, the adequate information requirement is met if the by the date of the spin-off: (i) the parent provides the shareholders with an information statement which satisfies the Section 14 proxy rules of the Securities Exchange Act of 1934,(ii) the shares are restricted until such time as a Form 10 is filed; and (iii) the transfer restrictions are enforced such as by means of stop transfer instructions to the transfer agent.
The fourth condition is that there is a valid business purpose for the spin-off. Although there may be many valid business purposes, the SEC specifically recognizes the following as valid: (i) allowing management of each business to focus solely on that business; (ii) providing employees of each business stock-based incentives linked solely to her or her employer; (iii) enhancing access to financing by allowing investments into each business separately; and (iv) enabling the companies to do business with each others competitors.
Likewise, although there are numerous purposes that would not be valid, the SEC specifically lists the following as not valid: (i) creating a market in the spun-off securities without providing adequate information and (ii) creating a public market in a shell or development-stage company.
Finally, the last condition is that the parent has held the shares for a minimum of one year. This is so the receiving shareholder may tack with the parent’s holding period and thereby satisfy the holding period requirements of Rule 144.
The SEC has also taken the position, that as long as all the above conditions have been satisfied, the spin-off will not require registration under Rule 145 merely because the shareholders have voted on the spin-off and/or assets are transferred into the subsidiary as part of the spin-off. Furthermore, except where specifically delineated above (non-reporting parent and subsidiary) as long as all the above conditions are satisfied, the shares issued in the spin-off are not restricted securities.
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
OTC Markets Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156
On July 10, 2013, the SEC issued proposed rules further amending Regulation D, Form D and Rule 156. On September 23, 2013 the OTC Markets Group published a letter responding to the SEC’s request for comments on the proposed rules. The entire OTC Markets comment letter is available on both the OTC Markets website and the SEC website. The OTC Markets Group, through OTC Link, owns and operates OTC Markets and its quotation platforms including OTCQX, OTCQB and pink sheets.
Summary of Proposed Rule Changes
The proposed amendments will (i) require the filing of a Form D to be made before the Issuer engages in any general solicitation or advertising in a Rule 506(c) offering and require the filing of a closing amendment to the Form D at the termination of the offering; (ii) require that all written general solicitation material used in a Rule 506(c) offering include certain legends and disclosures; (iii) require that all written material used in general solicitation and advertising be submitted to the SEC; (iv) disqualify an Issuer from relying on Rule 506 for one year for future offerings if the Issuer, or any predecessor or affiliate of the Issuer, failed to comply with the Form D filing requirements for a Rule 506 offering in the last five years; (v) amend the Form D to include additional information about offerings; and (vi) amend Rule 156 to extend the antifraud guidance in the rule to include sales literature of private funds (hedge funds). In addition, as part of the proposed rule release, the SEC is seeking comments from the public on the definition of “Accredited Investor.”
On August 20, 2013, I published a blog detailing the proposed rule changes related to Form D and Rule 507, which can be viewed here. On August 27, 2013, I published a blog detailing the remainder of the proposed rule changes including the proposed amendments to general solicitation materials and the temporary requirement that all such materials be submitted to the SEC, which can be viewed here.
OTC Markets Comment Letter
OTC Markets has been vocal about its support of the lifting of the ban on general solicitation and advertising, and it continues to be so in its comment letter. However, OTC Markets is not supportive of the proposed new rules and, in fact, is concerned that the rules “would counteract the positive impact of the new general solicitation and advertising rules, contradict the intent of the JOBS Act, and ultimately harm small capital formation.” The OTC Market’s biggest concern is the proposed advance Form D filing requirement.
OTC Markets Comments Related to the Proposed Advance Form D Requirement
Currently, an Issuer must file a Form 15 within 15 days of the first sale of securities in a Regulation D offering. An Issuer must file an amendment if there is a material change to the information filed in the original Form D. The proposed rule would require the Issuer to file an advance Form D with the SEC at least 15 days prior to using advertising or general solicitation in conjunction with the new 506(c) offering exemption. OTC Markets has many issues with the proposed new filing requirement.
First, OTC Markets is concerned that the advance filing requirement will chill communications between Issuers and potential investors. It is unclear what constitutes general solicitation and advertising or non-confidential information. This lack of clarity will likely result in confusion by Issuers as to when or if an advance Form D is required. Moreover, the lack of clarity could cause Issuers to err on the cautious side and instead of providing more information to the public, maintain such information as confidential. One of the underlying intents of the JOBS Act was to increase the amount of publicly available information about Issuers.
OTC Markets points out that “[F]or many small companies, the fear of violating the Advance Form D requirement will cause them to keep information confidential. Investors, employees, the press and regulators would be deprived of valuable company information, leading to unreliable price discovery, a lack of market efficiency, reduced incentive to participate in private offerings, and less capital raising by small companies.” OTC Markets goes further to conclude that “the Advance Form D requirement may completely frustrate the Congressional intent behind the JOBS Act and make the end of the ban on general solicitation and advertising a non-event for small companies.”
In addition, OTC Markets takes issue with the SEC’s reasoning behind the proposed advance Form D requirement. In particular, the SEC has indicated that the requirement will help it analyze and better understand the market for Rule 506(c) private placements. The SEC does not offer a rationale as to how an advance Form D would provide information not already provided by the current Form D. Moreover, the SEC has access to documents submitted to FINRA by broker dealers acting as placement agent or participating in private placements. The current Form D filing requirement together with FINRA information already provides the SEC with enough data to analyze any market impact of 506(c) offerings without the negative effect of chilling small companies’ communications and capital raising efforts.
In a point very well taken, the OTC Markets states, “[T]he capital formation process would be much better served if the SEC engaged in thoughtful private placement rulemaking 12 months from now after conducting a thorough analysis of the impact of the new general solicitation rules on the private placement market. Implementing the Advance Form D requirement simultaneously with the end of the ban on general solicitation and advertising deprives the markets of the opportunity to properly evaluate the impact of the JOBS Act on small company capital formation.”
OTC Markets Comments – the Benefits of Adequate Current Public Information
OTC Markets advocates full public disclosure by all Issuers, especially those engaging in private placement offerings. The OTC Markets comment letter advocates “mandatory public disclosure of the information required under Securities Act Rule 144 in connection with any Rule 506(c) offering that utilizes general solicitation and advertising.” Rule 144 requires adequate current public information as a prerequisite to the sale of securities under the Rule. For a reporting company, the current public information requirement is met by being current in its reporting requirements with the SEC. For a non-reporting company, the current public information requirement is met by having all the information required by SEC Rule 15c2-11 made publicly available. Generally, this information is uploaded onto the OTC Markets website.
OTC Markets points out that prior to the new Rule 506(c), Regulation D required that information be kept confidential and not publicly available. OTC Markets sees the new rule as an opportunity for the SEC to increase and encourage public information by Issuers.
Although OTC Markets does not address this in its letter, one of the SEC’s reasons behind previously prohibiting public information was to ensure that only qualified investors had access to such information. However, in the proverbial “throw the bath water out with the baby,” the result was an influx of private secondary markets (such as pre-IPO Facebook) where everyone could see the trading of a security but only a qualified few could access information related to the Issuer. The new 506(c) is a tremendous shift whereby everyone can access the public information but only a qualified investor can make the actual investment.
OTC Markets rightfully points out that “[Public] availability of company information builds trust in our capital markets and provides vital protection against fraud.”
OTC Markets Comments on Proposed 506 Ban for Form D Noncompliance
The SEC has proposed a rule whereby Issuers would be banned from Rule 506 offerings for one year if that Issuer has failed to comply with the Form D filing requirements within the past 5 years. OTC Markets points out—and I couldn’t agree more—that the complexity of the Form D filing requirements, especially if the advance Form D is required, will lead to substantial technical noncompliance by well-intentioned Issuers. The one-year penalty is an overly severe punishment, especially in the environment of changing rules and regulations.
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
DTC Unveils Procedures and Plans for a Rule Change that Applies to Issuers Affected By Chills and Locks
Background
Back in October and November of 2011, I wrote a series of blogs regarding DTC eligibility for OTC (over-the-counter) Issuers. A key eligibility criterion is that the securities that were distributed in accordance with Section 5 of the Securities Act of 1933 do not have transfer restrictions and are freely tradable. To meet this criterion, the securities must have been issued pursuant to an effective registration statement or valid exemption thereto. I have followed that series with various blogs regarding DTC chills and the evolving process to first learn the cause of the chill and second, to reach a resolution.
The Depository Trust Company (“DTC”) is a central securities depository in the U.S. which was originally created as a central holding and clearing system to handle the flow of trading securities and the problems with moving physical certificates among trading parties. DTC is regulated by the SEC, the Federal Reserve System and the New York State Department of Financial Services. Today, and as noted by the SEC, “… DTC provides clearance, settlement, custodial, underwriting, registration, dividend, and proxy services for a substantial portion of all equities, corporate and municipal debt, exchange traded funds, and money market instruments available for trading in the United States. In 2010, DTC processed 295,000,000 book entry transfers of securities worth $273.8 trillion.” If the DTC doesn’t process and settle trading in your securities, it just doesn’t happen.
A DTC Chill or Global Lock – General
Many OTC Issuers have faced a “DTC chill” without understanding what it is, let alone how to correct the problem. A DTC chill is the suspension of certain DTC services with respect to an Issuer’s securities. Those services can be book entry clearing and settlement services, deposit services (“Deposit Chill”) or withdrawal services. A chill can pertain to one or all of these services. In the case of a chill on all services, including book entry transfers, deposits, and withdrawals, the term of art is a “Global Lock.”
From the DTC’s perspective, a chill does not change the eligibility status of an Issuer’s securities, just what services the DTC will offer for those securities. For example, the DTC can refuse to allow further securities to be deposited into the DTC system or while an Issuer’s securities may still be in street name (a CEDE account), the DTC can refuse to allow the book entry trading and settlement of those securities.
Although I’m sure it’s unintentional, the term “chill” speaks volumes as to the reality of the effects of a DTC chill. A DTC chill results in a chilling of trading in a security, a chilling of any financing negotiations, a chilling of potential reverse or forward acquisitions or mergers, and a chill as to shareholder protections and ability to assert control over their own property.
In the Matter of the Application of International Power Group, Ltd.
On March 15, 2012, the Securities and Exchange Commission (SEC) issued an administrative opinion stating that an Issuer is entitled to due process proceedings by the DTC as a result of a DTC chill placed on an Issuer’s securities (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687).
In September 2009, DTC put a chill on the trading of International Power Group, Ltd. (IPWG) securities following the initiation by the SEC of an action against certain defendants, not IPWG, for improper issuance and trading in certain OTC securities, including IPWG and 3 other Issuers. Neither IPWG nor any of its officers or directors was a party to the SEC proceeding. The portion of the SEC action related to IPWG indicated that about 80,000,000 shares of IPWG stock was sold in the public markets without proper registration or an exemption from registration. In May 2010, the SEC settled with the Defendants related to IPWG for the usual penalties and permanent injunctions, which settlement did not address the already issued securities.
Upon learning of the DTC chill, IPWG requested that the DTC provide a hearing in accordance with its Rule 22, the only DTC rule that allows for some sort of hearing process. Rule 22 provides an opportunity for Interested Persons to be heard on any determination by the DTC that an Issuer’s security is no longer an eligible security. The DTC denied IPWG’s request for a hearing, stating that IPWG’s securities were still eligible and that it would lift the chill “once the matter of the unregistered IPWG shares is resolved with the SEC.” The DTC suggested that IPWG take the matter up with the SEC. IPWG was in a quandary. There was no action pending with the SEC within which IPWG was a party, and the SEC action related to IPWG shares had been settled without addressing the “matter of the unregistered IPWG shares.”
There was no clear way to take the matter up with the SEC. In addition, there was no clear way to take the matter up with DTC. DTC works through Participants – i.e., licensed broker-dealers, not Issuers. (See my previous blog on DTC eligibility.) Moreover, the shares it actually holds and trades are already issued and belong to shareholders, not the Issuer. So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, at the time the DTC took the position that it didn’t have any particular obligation to IPWG for its actions.
IPWG filed an administrative appeal with the SEC looking for assistance. A discussion of jurisdiction and the rules vis-à-vis getting this matter in front of the SEC is beyond the scope of this blog, but suffice it to say, after much legal wrangling and a realization by all involved that there was no precedent to look upon, the SEC agreed to take the matter on.
In its opinion, the SEC held that an Issuer, in this case IPWG, was an Interested Person for purposes of Rule 22 and was impacted by the DTC chill such that they are entitled to due process and fair proceedings. The SEC did not tell the DTC what the criteria were for determining whether the chill was appropriate or not should be, but only that the Issuer is entitled to “fair procedures.” Moreover, the SEC held that in the future, an Issuer who is negatively impacted by DTC action can avail itself of the SEC administrative proceedings process for appeal following a negative decision in a DTC hearing and proceeding.
Finally, the SEC confirmed that the DTC can still put a chill on an Issuer’s security, prior to giving notice and an opportunity to be heard to that Issuer, in an emergency situation, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”
Following International Power, DTC immediately began changing its procedures in dealing with Issuers, although it was a slow and evolving process. I have written on the immediate impact of International Power in the past and will not reiterate that information here.
In September 2013, the DTC published a white paper explaining the circumstances under which a Deposit Chill or Global Lock may be imposed, and procedures that the DTC has developed for issuers, including notice and opportunities to object. The DTC is proposing to adopt these new procedures in the “near future” by filing a rule change with the SEC.
DTC Rationale for Imposing Chills and Global Locks
The DTC considers itself a critical part of the U.S. securities industry infrastructure and therefore responsible for ensuring that no illegal, improperly unrestricted securities enter the marketplace. As such, DTC monitors enforcement actions, regulatory actions and pronouncements and red flags in the securities of DTC-eligible securities. A red flag includes unusually large deposits of thinly traded, low-priced securities.
Where the DTC detects suspicious unusually large deposits, they may and often do impose a Deposit Chill until, in the words of the DTC, “the issuer convincingly demonstrates that the securities are freely transferable.” Moreover, if the DTC determines that there is “definitive evidence” that restricted shares have been deposited, it will impose a Global Lock. According to the DTC, definitive evidence is established if the SEC or other regulatory agency has brought an enforcement action against any defendant that has deposited the Issuer’s securities into the DTC. The DTC may also impose a Global Lock where the Issuer fails to respond to or adequately resolve a Deposit Chill.
Historically, the DTC provides Issuers with a notice following the entry of a chill or lock and requests an opinion letter from an independent attorney in order to remove the chill. The opinion letter requires the independent attorney to review all documents associated with each issuance, even if prior opinion letters have been issued. Moreover, the opinion letter and request from the DTC not only cover the offending deposits or transactions, but all securities on deposit with DTC, and more recently, all issuances for the past five years. It is not a small task.
DTC Proposed Process for Issuers
The DTC has proposed rules such that Issuers will be notified in writing of chills and locks, have a set time frame in which to respond, and will have clear guidelines to be met to either prevent a chill or lock or remove same. DTC will agree to respond within a set time frame. Moreover, and importantly, the DTC will agree to keep communication open between the Issuer and its counsel, and the DTC and its counsel, throughout the process.
A. Deposit Chills.
Notification of Deposit Chill. Pursuant to its proposed rule, the DTC will notify an Issuer of a deposit chill by overnight courier no later than 20 business days prior to imposition of the Deposit Chill, or if the chill has already been imposed, no later than three business days after the chill has been imposed. The DTC will impose the chill prior to notice where “there is a threat of imminent harm or injury to DTC or the industry, including if circumstances suggest that advance notice might accelerate improper deposits.” The notice will require a legal opinion from independent counsel. It is not anticipated that the legal opinion requirements will be different than as in effect today. The DTC readily grants extensions to Issuers in providing responses.
DTC Review of Issuer Response. The DTC will respond in writing to the Issuer’s submission and legal opinion within twenty business days for pre-chill notices and within ten business days if the chill has already been imposed. An officer of the DTC who did not participate in the decision to impose the chill, together with outside counsel as appropriate, will decide whether the Issuer’s response is satisfactory. The DTC may request further or additional information.
Determination. If the response from the Issuer is sufficient, the chill will either not be imposed or will be lifted. If the Issuer does not respond in a timely manner (including after extensions) or such response is not sufficient, the chill will remain and a lock may be imposed. Prior to imposing a Global Lock, the DTC will give a type of appeal period. In particular, the DTC will give an Issuer ten days to provide a supplemental submittal supporting that either the original response was appropriate and adequate and/or that the DTC made a clerical error in its review. The proposed rules will set firm deadlines on both the Issuers and the DTC. Moreover, the new rules will give the DTC full discretion to lift or modify a chill at any time it deems in the best interest of the DTC and its participants.
B. Global Locks.
Notification of Global Lock. Pursuant to its proposed rule, DTC will notify an Issuer of a Global Lock by overnight courier no later than 20 business days prior to imposition of the Global Lock, or if the lock has already been imposed, no later than three business days after the lock has been imposed. The DTC will impose the lock prior to notice where there is a threat of imminent harm or injury to the DTC or the industry, including where the SEC has alleged that defendants are in possession of additional unregistered securities that could be deposited into the system. The notice will provide the reason for the lock and identify the regulatory or enforcement proceeding upon with the lock is based. The notice will give twenty days to respond with the ability to receive a twenty-day extension. The Issuer will have the opportunity to prove that the securities deposited at the DTC are not a part of the legal or enforcement proceeding or that the proceeding has been withdrawn, terminated, settled or otherwise resolved in favor of the defendant that deposited the securities at DTC.
To be very clear, a DTC Global Lock may be imposed if an action is brought against any shareholder that has deposited the Issuer’s securities into the DTC and the DTC reasonably believes that the action relates to the Issuer’s securities. The Issuer itself does not have to be a party to the enforcement or legal proceeding.
DTC Review of Issuer Response. The DTC will respond in writing to the Issuer’s submission and legal opinion within twenty business days for pre-lock notices and within ten business days if the lock has already been imposed. The DTC is cognizant of not providing an alternative forum for an Issuer to litigate enforcement proceedings. Accordingly, where there is a pending enforcement action, it is unlikely that a Global Lock will be lifted and the DTC’s review will be limited.
Determination. If the response from the Issuer is sufficient, the lock will either not be imposed or will be lifted.
Additional DTC Proposed Procedures for Removing Global Locks and Deposit Chills
The DTC recognizes that Locks are imposed after securities have already been issued and deposited into a shareholder’s account. Using Rule 144 as an analogy, securities become free trading (and thus eligible to be deposited into the DTC if they were not already eligible) after a holding period. The DTC’s proposed rules will include a provision whereby Global Locks can be lifted and removed after a holding period analogous to Rule 144. In particular, the DTC’s proposed rules will include the lifting of a Global Lock after the following periods have elapsed:
- For non-reporting Issuers – one year after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any defendant that deposited securities at the DTC.
- For reporting issuers – six months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant.
- Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for non-reporting issuers – one year after the date the Global Lock was imposed;
- Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for reporting issuers – six months after the date the Global Lock was imposed.
The release of the Global Lock as set forth above would only be available to Issuers that are not and have never been a “shell company” as defined by Securities Act Rule 144(i), unless the Issuer had ceased to be a shell company and filed Form 10 type information.
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.
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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
SEC has Modified Policies on Offerings by Shell Companies
Recently, albeit not officially, the Securities and Exchange Commission (“SEC”) has materially altered its position on offerings by shell companies that are not blank-check companies. In particular, over the past year, numerous shell companies that are not also blank-check companies have completed offerings using an S-1 registration statement and successfully obtained market maker support and a ticker symbol from FINRA and are trading. As recently as 18 months ago, this was not possible.
Rule 419 and Blank-Check Companies
The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank-check company. Rule 419 requires that the blank-check company filing such registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger.
In addition, the registrant is required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement, upon the execution of an agreement for such acquisition or merger. The rule provides procedures for the release of the offering funds in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and resale or secondary offerings.
Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the Company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the Company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected to not remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon enough funds remaining in escrow to close the transaction.
The definition of “blank-check company” as set forth in Rule 419 of the Securities Act is a company that:
- Is a development-stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
- Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.
Shell Companies
The definition of “shell company” as set forth in Rule 405 of the Securities Act (and Rule 12b-2 of the Securities Exchange Act of 1934) means a Company that has:
- No or nominal operations; and
- Either:
- No or nominal assets;
- Assets consisting solely of cash and cash equivalents; or
- Assets consisting of any amount of cash and cash equivalents and nominal other assets.
Clearly the definitions are different. Although a shell company could also be a blank-check company, it could be a development stage company or start-up organization or an entity with a specific business plan but nominal operations. Until recently, however, the SEC has firmly held the position that Rule 419 applies equally to shell and development-stage companies.
In fact, the SEC Staff Observations in the Review of Smaller Reporting Company IPO’s published by the SEC Division of Corporate Finance contains the following comments:
“Rule 419 applies to any registered offering of securities of a blank-check company where the securities fall within the definition of a penny stock under the Securities Exchange Act of 1934. We frequently reviewed registration statements of recently established development stage companies with a history of losses and an expectation of continuing losses and limited operations. These companies often stated that they may expand current operations through acquisitions of other businesses without specifying what kind of business or what kind of company. In other cases, the stage of a company’s development, when considered in relation to the surrounding facts and circumstances, may raise questions regarding the company’s disclosed business plan. We generally asked companies like these to review Rule 419 of Regulation C. We asked these companies either to revise their disclosure throughout the registration statement to comply with the disclosure and procedural requirements of Rule 419 or to provide us with an explanation of why Rule 419 did not apply.”
Change in SEC Policy
The SEC will now allow a shell company that is not also a blank-check company to embark on an offering using an S-1 registration statement without the necessity to comply with Rule 419. As noted above, an entity can be a shell company, but not a blank-check company, as long as it has a specific business purpose and plan and is taking steps to move that plan forward, such as a start-up or development stage entity. In the last 18 months, several companies have filed S-1 registration statements with little more than a specific business plan, and such S-1’s have been declared effective, the shares have been successfully placed, and the company’s common stock is trading on the over-the-counter market. A review of the comment letters associated with these shell company S-1 filings has not shown a single comment requesting that the issuing company comply with or explain why they did not have to comply with Rule 419.
Such entity will clearly need to disclose that it is a shell company as defined by Rule 405 of the Securities Act and accordingly, investors in the registered offering would not be able to rely on Rule 144 for resale unless all of the conditions of Rule 144(i) were met. That is, in order for the investors buying in the S-1 to use Rule 144, the company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company—then, those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.
The question arises as to when a development-stage or start-up company ceases to be a shell. Generally shell companies complete a clear transaction removing them from shell company status, such as a merger or acquisition, and file Form 10 information on the newly acquired business. My review of the filings made by shell companies following the effectiveness of the S-1 registration statement indicate that each is still a shell. However, I would suggest that at some point, such as when the company generates its first revenues or launches its product, or upon some other identifiable marker that would reasonably be interpreted as a change in shell company status, the company file Form 10 information disclosing its own business and operations and thereafter begin the one-year holding period for use of Rule 144.
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