Monthly Archives: May 2014
What is A CUSIP and Legal Entity Identifier (LEI) Number?
CUSIP stands for Committee on Uniform Securities Identification Procedures. A CUSIP number identifies securities, specifically U.S. and Canadian registered stocks, and U.S. government and municipal bonds. The CUSIP system—owned by the American Bankers Association and operated by Standard & Poor’s—facilitates the clearing and settlement process of securities by giving each such security a unique identifying number.
The CUSIP number consists of a combination of nine characters, both letters and numbers, which act as individual coding for the security—uniquely identifying the company or issuer and the type of security. The first six characters identify the issuer and are alphabetical; the seventh and eighth characters, which can be alphabetical or numerical, identify the type of issue; and the last digit is used as a check digit. A CUSIP number changes with each change in the security, including splits and name changes.
Whereas CUSIP identifies securities, a Legal Entity Identifier (LEI) identifies issuers. An LEI is a new global standard identifier for legal entities involved in financial transactions and. once assigned. is that entity’s LEI number in perpetuity. The LEI standard was mandated by Dodd-Frank to help identify issuers engaging in financial transactions, including in different markets domestically and abroad. The CUSIP Service Bureau has teamed up with the Depository Trust Company (DTC) to assist in assigning LEI numbers to all issuers that apply for a CUSIP. The fee for the LEI is $200 and as noted, a single number is assigned to an issuer for the entire life span of that issuer. The Commodity Futures Trading Commission and National Association of Insurance Commissioners are also requiring and utilizing the LEI number.
The LEI number system is still in its incipient stages and will face challenges in its development. Many groups have raised concerns regarding repetitive use of numbers—not that the same LEI number will inadvertently be repeated, but rather that an issued LEI number will be the same as some other number issued by some other regulatory body and thus cause confusion. Moreover, the software and implementation costs associated with making LEI numbers useful to governmental and other organizations will be significant.
The Impact of a CUSIP Change – DTC and Potential Unintended Consequences
Many issuers that were eligible for DTC at the time of their DTC application are no longer eligible due to changes in their operating or reporting status. As I’ve explained in several past blogs, a basic premise of DTC eligibility and ongoing eligibility is the free tradability of the issuer’s securities. The issuance of a new CUSIP number triggers a DTC review and will bring to light a change in eligibility status. If the issuer’s securities are no longer DTC eligible, such ineligibility will require an exit from DTC of the issuer’s securities. DTC will actually return physical certificates to the broker dealer that deposited such securities and close out the issuer’s DTC account. The issuer can reapply upon meeting eligibility requirements.
An issuer is required to obtain a new CUSIP for each change in its security, such as a name change, reverse split or reorganization. That issuer then submits the new CUSIP number to FINRA as part of its corporate action notification documents. Both FINRA and CUSIP notify the DTC of the new CUSIP number, which triggers a review of the security and a requirement by DTC that the issuer submit an opinion letter supporting the ongoing eligibility of the securities. Like with a DTC chill notice, the issuer is required to submit an opinion letter, prepared by independent counsel, confirming that the issuer’s securities deposited at the DTC satisfy the DTC’s eligibility requirements, including that they are freely tradable. In particular, the opinion letter must specify that the securities (i) are not restricted securities under SEC Rule 144(a)(3), or (ii) are exempt from any restrictions on transferability under the Securities Act. The DTC provides a template for the legal opinion to the issuer.
Accordingly, if the free tradability of the issuer’s securities relies on Rule 144 and the issuer is not qualified for the use of Rule 144, that issuer will no longer be DTC eligible. After a period of time, almost all issuers rely on Rule 144 for ongoing DTC eligibility. Even shareholders of issuers that have completed a self-underwritten direct public offering (DPO) or initial public offering (IPO) eventually rely on Rule 144 for securities that were not included in such registration.
Rule 144 is not available to shell companies. A shell company is an issuer with no or nominal operations or no or nominal non-cash assets. The rule is unavailable for the sale of securities initially issued by a shell company or any issuer that has, at any time, previously been a shell company unless all the requirements of Rule 144(i)(2) are met. These requirements include that the issuer no longer be a shell company, is subject to the reporting requirements of the Exchange Act for 12 months following the time that it filed Form 10 information indicating it was no longer a shell company, and is current with all Exchange Act reporting requirements.
To be abundantly clear, if the issuer’s securities are not eligible for the use of Rule 144, that issuer is no longer DTC eligible. Since the DTC cannot monitor millions of securities, it relies on the issuance of a new CUSIP number to trigger a review. If the issuer is not Rule 144 eligible, that review will prompt an exit from the DTC of that issuer’s securities.
Many issuers that were eligible for the DTC at the time of their DTC application are no longer eligible due to changes in their operating or reporting status. In particular, the issuer may have once been a shell company and is either not subject to the ’34 Act Reporting Requirements or is delinquent in such requirements, or the issuer may currently be a shell company.
An unintended consequence can result where that issuer is party to a merger, acquisition, reverse merger or other agreement that requires the issuer to complete a name change, split or other corporate action as a precondition to closing and also requires that the issuer be DTC eligible as a precondition to such closing. The issuer who currently has shares trading in DTC without a problem may believe that they are DTC eligible and proceed unaware with the corporate action, resulting in their shares being exited from DTC and their entire transaction being derailed. Experienced competent counsel will foresee such a problem and fashion a transaction that is not set up for default from the outset.
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
Exemption to Broker-Dealer Registration Requirements for Officers, Directors and Key Employees
The topic of using unlicensed persons to assist in fundraising activities is discussed almost daily in the small and microcap community. For many years the SEC has maintained a staunch view that any and all activities that could fall within the broker-dealer registration requirements set forth in Section 15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), require registration. See also the SEC Guide to Broker-Dealer Registration on the SEC website.
In my blog on February 18th, 2014 I talked about the new no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act. In this blog, I am focusing on the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer.
Exchange Act Rule 3a4-1 – Persons Associated with an Issuer that are not Required to be Licensed as a Broker-Dealer
Exchange Act Rule 3a4-1 provides a statutory exemption for persons to engage in fundraising activity on behalf of an issuer without being licensed as a broker-dealer. The Rule acts as a safe harbor such that as long as a person meets the criteria of the rule, he or she will not be deemed to be a broker-dealer requiring registration under Section 15(b) of the Act. The Rule is not the only means by which a person may sell an issuer’s securities without registration as a broker-dealer; the Rule does, however, provide legal certainty to those persons who meet the conditions and qualifications of the Rule.
The exemption is not available to persons who are in fact licensed as a broker-dealer or associated with a broker-dealer. For purposes of the rule, “associated with” means a natural person (i.e., not an entity) who is a partner, officer, director, or employee of the issuer, and employees of companies or partnerships in a controlling relationship with the issuer. Rule 3a4-1 does not cover attorneys, accountants, insurance brokers, financial service organizations, or financial consultants who for a fee assist issuers in the sale of securities.
To qualify for the exemption, the person must comply with one of the following three criteria. I note that only one of the three criteria must be met to qualify for the exemption. The first set of criteria involves either who the securities are being sold to or the type of transaction. The second set involves the role of the person seeking the exemption and in particular the common officer, director or key employee exemption, and the third criteria again involve the role of the person but are limited to administrative type functions.
Criteria 1 – Exemption Based on Transaction
A person may qualify for the Rule 3a4-1 exemption if he or she restricts his or her participation to transactions involving offers and sales of securities:
(i) to registered broker-dealer, investment companies, banks, savings and loan associations; trust companies or similar institutions supervised by a state or federal banking authority;
(ii) in transactions exempt under Sections 3(a)(7) (involving certificates issued to a trustee or issuer in a Chapter 11 bankruptcy), Section 3(a)(9) (exchanges of securities) or Section 3(a)(10) (exchange of security for other security or claim after court approval);
(iii) that are made pursuant to a plan or agreement submitted for the vote or consent of the security holders who will receive securities of the issuer in connection with a reclassification of securities of the issuer, a merger or consolidation or a similar plan of acquisition involving an exchange of securities, or a transfer of assets of any other person to the issuer in exchange for securities of the issuer; or
(iv) that are made pursuant to a bonus, profit sharing, pension, retirement, thrift, savings, incentive, stock purchase, stock ownership, stock appreciation, stock option, dividend reinvestment or similar plan for employees of an issuer or a subsidiary of the issuer.
Criteria 2 – Exemption for Officers, Directors and Key Employees
A person may qualify for the Rule 3a4-1 exemption if they meet all of the following conditions:
(i) the person “primarily performs, or is intended primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer otherwise than in connection with transactions in securities”;
(ii) the person was not a broker-dealer or associated with a broker-dealer within the preceding 12 months; and
(iii) the person does not participate in selling an offering of securities for any issuer more than once every 12 months other than in reliance on one of the three criteria set forth herein.
Criteria 3 – Exemption for Administrative Assistance
A person may qualify for the Rule 3a4-1 exemption if they perform one or more of the following activities:
(i) Preparing any written communication or delivering such communication through the mail or other means that do not involve oral solicitation by the associated person of a potential purchaser; provided, however, that the content of such communication is approved by a partner, officer or director of the issuer;
(ii) Responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser; provided, however, that the content of such responses are limited to information contained in a registration statement filed under the Securities Act of 1933 or other offering document; or
(iii) Performing ministerial and clerical work involved in effecting any transaction.
Compensation
The SEC prohibits the payments of commissions or other transaction based compensation to entities that raise money for companies, unless that entity is a licensed broker-dealer. Rule 3a4-1 specifically states that persons exempted under this rule may not be “compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities.”
Bad Actors are Disqualified
The exemption is unavailable to anyone who is statutorily disqualified from being associated with a broker-dealer for certain “bad acts.” Section 3(a)(39) of the Exchange Act sets forth the statutory disqualification criteria, which is narrower than the new Rule 506(e) which disqualifies felons and bad actors from participating in a Rule 506 offering. See my blog here July 31st, 2013 for a discussion of the Rule 506 SEC felon and bad actor disqualification rules.
Section 3(a)(39) disqualifies any person who (i) is or has been expelled, suspended or barred from association with a FINRA or other self-regulatory organization based on an order from such self-regulatory organization; (ii) is subject to an order from the SEC or other regulatory organization denying, suspending or barring registration as or associated with a broker-dealer; (iii) is subject to an order from the CFTC denying, suspending or revoking registration under the Commodity Exchange Act; (iv) is subject to an equivalent order as the above from a foreign governmental or regulatory authority; (v) has been found to be the “cause” of an order described above; (vi) is associated with a person who is expelled, suspended or barred as set forth above; (vii) has been convicted of a felony or other fraud based securities law violation in the past 10 years; or (viii) has made a false or misleading statement or omission in any application to become associated with a broker-dealer or to become a broker-dealer.
Consequences for Violation
In addition to potential regulatory problems, using an unregistered person who does not qualify for either the statutory or another exemption to assist with the sale of securities may create a right of rescission in favor of the purchasers of those securities. That is a fancy way of saying they may ask for and receive their money back.
Section 29(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), provides in pertinent part:
“Every contract made in violation of any provision of this title or of any rule or regulation thereunder…the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract….”
In addition to providing a defense by the issuing company to paying the unlicensed person, the language can be interpreted as voiding the contract for the sale of the securities to investors introduced by the finder. The SEC interprets its rules and regulations very broadly, and accordingly so do the courts and state regulators. Under federal law the rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation. Accordingly, for a period of at least three years, an issuer that has utilized an unlicensed finder has a contingent liability on their books and as a disclosure item. The existence of this liability can deter potential investors and underwriters and create issues in any going public transaction.
In addition, SEC laws specifically require the disclosure of compensation and fees paid in connection with a capital raise. A failure to make such disclosure and to make it clearly and concisely is considered fraud under Section 10b-5 of the Securities Act of 1933 (for example, see SEC vs. W.P. Carey & Co., SEC Litigation Release No. 20501). Fraud claims are generally brought against the issuing company and its participating officers and directors.
Moreover, most underwriters and serious investors require legal opinion letters at closing, in which the attorney for the company opines that all previously issued securities were issued legally and in accordance with state and federal securities laws and regulations. Obviously an attorney will not be able to issue such an opinion following the use of an unlicensed or non-exempted person. In addition to the legal ramifications themselves and even with full disclosure and the time for liability having passed, broker-dealers and underwriters may shy away from engaging in business transactions with an issuer with a history of overlooking or circumventing securities laws.
Historically, it was the person who had acted in an unlicensed capacity who faced the greatest regulatory liability; however, in the past ten years that has changed. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective and a better deterrent to prosecute the issuing company than an unlicensed person who is here today and gone tomorrow.
The violations often go past the unlicensed broker-dealer issue. Persons who do not comply with the statutory and regulatory requirements for assisting in fundraising generally engage in inappropriate solicitation of investors, generous representations and the like in efforts to raise money and earn a commission.
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
Once Again, DTC Amends Proposed Procedures for Issuers Affected by Chills and Proposes Subsequent Rule Change
Background
On October 8, 2013, I published a blog and white paper providing background and information on the Depository Trust Company (“DTC”) eligibility, chills and locks and the DTC’s then plans to propose new rules to specify procedures available to issuers when the DTC imposes or intends to impose chills or locks. On December 5, 2013, the DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon. Following the receipt of comments on February 10, 2014, and again on March 10, 2014, the DTC amended its proposed rule changes. This blog discusses those rule changes and the current status of the proposed rules.
The new rules provide significantly more clarity as to the rights of the DTC and issuers and the timing of the process. For a complete discussion on background and DTC basics such as eligibility and the evolving procedures in dealing with chills and locks, including a complete discussion of the proposed rules published December 18, 2013, please see my white paper here 12/18/13.
As stated in the rule release, the current proposed rules “specify procedures available to issuers of securities deposited at DTC when DTC blocks or intends to block the deposit of additional securities of a particular issue (‘Deposit Chill’) or prevents or intends to prevent deposits and restrict book-entry and related depository services of a particular issue (‘Global Lock’).”
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, the 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. 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. As a result of this process, the DTC imposed a chill on the securities of IPWG. IPWG was unsuccessful in getting the DTC to be responsive to its inquiries, let alone determine a process for removing the chill. 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. In its opinion, the SEC held that an issuer, in this case IPWG, was an Interested Person for purposes of DTC 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 stated, “DTC should adopt procedures that accord with the fairness requirements of Section 17A(b)(3)(H), which may be applied uniformly in any future such issuer cases”; “Those procedures must also comply with Section 17A(b)(5)(B) of the Exchange Act, which requires clearing agencies when prohibiting or limiting a person’s access to services, to (1) notify such person of the specific grounds for the prohibition or limitation, (2) give the person an opportunity to be heard upon the specific grounds for the prohibition or limitation, and (3) keep a record.”
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.”
A DTC Chill or Global Lock – General
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.
DTC Statement of the Purpose of the Proposed Rule Changes
Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealers that are participants with the DTC (which is almost all such entities) may deposit securities into their DTC accounts on behalf of their respective clients. Securities deposited into the DTC may be transferred among brokerage accounts by book-entry (electronic) transfer, facilitating quick and easy transactions in the public marketplace. Eligible securities are registered on the books of a company in the DTC’s nominee name, Cede & Co.
A basic premise to use of the DTC is that securities be freely tradable. Therefore, in order to be DTC eligible, an issuer’s securities must (i) be issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) be issued in a transaction exempt from registration under the Securities Act and that, at the time of seeking DTC eligibility, are no longer restricted; or (iii) be eligible for resale pursuant to Rule 144A or Regulation S under the Securities Act.
Since deposited securities are in fungible bulk, the deposit or existence of any illegally or improperly deposited securities (restricted securities) taints the bulk of all securities held by the DTC for that company. As such, the 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. DTC Rule 6 allows the DTC to limit certain services to particular deposited securities. In addition, Section 1.B.2 of the DTC’s Operational Arrangements give the DTC the power to require companies’ outside counsel to provide legal opinions in support of eligibility and free tradability of deposited securities.
In addition, the DTC looks for other red flags, including FINRA’s list of red flags such as the following:
- A customer of the broker opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
- A customer of the broker deposits share certificates that are recently issued or represent a large percentage of the float of the security;
- The company was a shell company when it issued the shares;
- A customer of the broker with limited or no other assets under management at the firm receives an electronic transfer or journal transaction of large amounts of low-priced, unlisted securities;
- The issuer has been through several recent name changes, business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies;
- The issuer’s SEC filings are not current, or are incomplete or nonexistent.
Where the DTC’s monitoring raises concerns that securities held at the DTC have been distributed in violation of federal law, the DTC may impose a deposit chill or global lock. The two main scenarios when this occurs are as follows: (i) Where the DTC detects suspicious, unusually large deposits of a low-priced or thinly traded security, 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.” (ii) 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.
Chart Summary of DTC Proposed Rules
DTC Proposed Process for Issuers
The newest amendments to the proposed rules clarify and narrow the DTC’s authority as a protector of the overall marketplace, to just a protector of the DTC system. Rather than give an explanation of each of the changes from the last version of the proposed rules, this blog explains the proposed rules as they exist today.
The DTC has proposed rules (new Rules 22(A) and 22(B)) 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. The 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 (Rule 22(A)) In general, proposed Rule 22(A) provides companies with an opportunity to establish that they meet the DTC’s eligibility requirements, including by submitting an opinion from independent legal counsel: “Proposed Rule 22(A) will not apply when DTC impose[s] operational restrictions on deposits or other services in connection with ordinary course of business processing of Eligible Securities. One example of ‘ordinary course of business processing’ is the processing of corporate actions, including name changes and stock splits.”
Notification of Deposit Chill. Pursuant to its Proposed Rule, the DTC will notify an issuer of a deposit chill 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 send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.
The DTC has narrowed and clarified when a deposit chill may be imposed prior to notice. In particular, the DTC may impose the chill prior to notice “in order to prevent imminent harm, injury or other such consequences to DTC or its Participants” or “if DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through DTC.”
The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which DTC relies. The notice will state the actions that the issuer must take in order to prevent or remove the restrictions, including generally requiring a legal opinion from independent counsel. It will also provide the date the Deposit Chill was imposed or the date it will be imposed, should the issuer fail to respond to the Deposit Chill notice.
The issuer has 20 days to respond to the notice. The DTC may extend this deadline for up to an additional twenty business days if the issuer establishes “good cause.” If the issuer demonstrates to DTC’s “reasonable satisfaction” that the issue complies with the DTC’s eligibility requirements and the applicable procedures, the Deposit Chill will be lifted or will not be imposed.
The Proposed Rules provide that the issuer must support its response with a legal opinion, prepared by independent counsel, confirming that the issuer’s securities deposited at the DTC satisfy the DTC’s eligibility requirements, including that they are freely tradable. In particular, the opinion letter must specify that the securities “(i) are not restricted securities under SEC Rule 144(a)(3), or (ii) are exempt from any restrictions on transferability under the Securities Act.” The DTC will provide a template for the legal opinion to the issuer. It is not anticipated that the legal opinion requirements will be different than as in effect today.
DTC Review of Issuer Response. The DTC may request further or additional information, in which case the issuer will have at least ten (10) days to provide such additional information. 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.
Determination. 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. If the response from the issuer is sufficient, the chill will either not be imposed or will be lifted. If a chill was imposed prior to the issuance of a Notice, the determination whether to lift such chill will be provided to the issuer within ten business days after receipt of the issuer’s response. In the event of a pre-chill notice, the determination will be provided to the issuer within twenty business days after receipt of the issuer’s response. This timing was not in the prior version of the proposed rules.
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. In an adverse decision, prior to imposing a Global Lock, the DTC will give the issuer ten days in which to submit a supplemental response. The supplemental response will be limited to establishing that either (1) the issuer did timely respond to DTC previously, or (2) that the DTC’s determination was the result of the DTC’s clerical mistake or a mistake arising from an oversight or omission in reviewing the issuer’s response. This added process will not include an added substantive review. The DTC will provide a determination within ten (10) days of receipt of the supplemental response.
The Record: The record of a proceeding, for purposes of use in an appeal to the SEC, shall include: (i) The Deposit Chill Notice, the Deposit Chill Response, the Deposit Chill Decision, the Supplemental Deposit Chill Response, the Supplemental Deposit Chill Response Decision, the Additional Information Request, and the Additional Information Response; (ii) all documents submitted in connection with (i) and (iii) any written communications created pursuant to the proposed rules as described herein.
DTC reserves authority to modify or lift a chill or to impose a chill after making a favorable determination, with a restart of the proposed procedures.
B.Global Locks. Global locks can be imposed either where (i) an issuer has failed to respond or failed to adequately respond to a deposit chill notice or (ii) the DTC becomes aware that the SEC or other state or federal agency has commenced a judicial or administrative proceeding alleging that DTC-eligible securities have been sold in violation of Section 5 of the Securities Act or other applicable law.
Notification of Global Lock. Pursuant to its proposed rule, the DTC will notify an issuer of a Global Lock 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 issuer shall have twenty (20) days to respond. The DTC may extend the deadline for up to an additional twenty (20) days if the issuer establishes “good cause.”
The DTC will send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.
The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which the DTC relies. The DTC will impose the lock prior to notice (i) to prevent imminent harm, injury or other such consequences to the DTC or its participants or (ii) if the DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the DTC. It will also provide the date the Lock was imposed or the date it will be imposed, should the issuer fail to respond to the notice.
The proposed rules differentiate Global Locks based on enforcement proceedings and Global Locks based on an issuer’s failure to respond or adequately respond to a chill. Where the Lock is imposed as a result of an enforcement proceeding, the notice will provide that a “Global Lock will not be imposed, or, if already imposed, will be released if the issuer demonstrates either (1) that the Eligible Securities were not the intended subject of the Proceeding, or (2) that the Proceeding was withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants.” The DTC will not provide a forum for litigating or re-litigating the allegations or findings in the enforcement proceeding. As noted above, the notice will give twenty days to respond, with the ability to receive a twenty-day extension.
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 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 DTC decision will be to either (i) not impose or release the Lock; or (ii) impose or not release the Lock. Otherwise, the DTC will release the Global Lock upon the eligible securities becoming eligible for free trading status pursuant to Rule 144 – that is, within either one year or six months, depending on whether the issuer is subject to the reporting requirements of the Exchange Act and depending on the company’s Rule 144 eligibility.
In particular, the proposed rules 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 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 record for purposes of an appeal to the SEC will consist of the Global Lock Notice, the Global Lock Response and the Global Lock Decision. Moreover, the proposed rules give the DTC full discretion to lift or modify a Global Lock on the same grounds for which a Lock can be imposed or lifted as set forth above.
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
Say-On-Pay for Smaller Reporting Companies
Effective April 4, 2011, the SEC adopted final rules implementing shareholder advisory votes on executive compensation as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Upon enactment smaller reporting companies were given a two-year exemption from the compliance requirements. Smaller reporting companies are defined as entities which, as of the last business day of their second fiscal quarter, have a public float of less than $75 million. Beginning in 2013, that exemption expired and now these smaller reporting companies are required to include say-on-pay voting. Although smaller reporting companies have been subject to the rules for a year now, I still encounter questions from the entities as to their obligations and requirements under the rules.
The say-on-pay rules were implemented by adding Section 14A, which requires companies to conduct a separate shareholder advisory vote to approve the compensation of executives, which pay is disclosed pursuant to Item 402 (the “say-on-pay” vote). Section 14A also requires companies to conduct a separate shareholder advisory vote to determine how often an issuer will conduct a shareholder advisory vote on executive compensation (the “say-on-frequency” vote). In addition, Section 14A requires companies soliciting votes to approve merger or acquisition transactions to provide disclosure of certain “golden parachute” compensation arrangements and, in certain circumstances, to conduct a separate shareholder advisory vote to approve the golden parachute compensation arrangements (the “golden parachute” vote).
Say-on-Pay Vote
A say-on-pay vote is a non-binding advisory vote on whether to approve the company’s compensation for its named executive officers as disclosed pursuant to the SEC’s executive compensation disclosure standards (Item 402 of Regulation S-K).
The vote must be held at least once every three calendar years and is required when there is an annual meeting of shareholders at which proxies are solicited for the election of directors. Companies are required to disclose in the proxy statement that separate say-on-pay (and say-on-frequency votes) are being included, and briefly explain the nature of each vote, including that it is non-binding. Companies must also disclose the current frequency of the say-on-pay votes and when the next say-on-pay vote will occur.
The vote must cover all executive compensation disclosed pursuant to Item 402 of Regulation S-K, including the compensation discussion and analysis (CD&A), if any, the summary compensation table, and the related tables and narrative sections. Note that smaller reporting companies are not required to include CD&A but may do so voluntarily.
The JOBS Act provides an exemption from the say-on-pay and say on golden parachute requirements for emerging growth companies (EGC). An EGC is defined as a company with total annual gross revenues of less than $1 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. Total revenues are as posted on the company’s income statement prepared in accordance with US GAAP. The registered offering of debt securities prior to December 8, 2011, does not disqualify an otherwise qualifying EGC.
The SEC Division of Corporation Finance Compliance and Disclosure Interpretations (C&DI) has provided guidance on suggested language to include in a proxy to explain the vote. For instance, the SEC has provided examples of phrases that can be used to describe the say-on-pay advisory vote, including:
- To approve the company’s executive compensation
- Advisory approval of the company’s executive compensation
- Advisory resolution to approve executive compensation
- Advisory vote to approve named executive officer compensation
Although the vote is advisory and non-binding, it does provide valuable information regarding shareholder confidence and is often used as a factor in institutional investors’ investing decision making and in third-party proxy advisory firms’ recommendations on whether to vote in favor of or against director nominees.
Say-on-Frequency Vote
A say-on-frequency vote is a vote on whether to hold the say-on-pay vote every one, two or three years. The say-on-frequency vote must be held at least once every six calendar years. Proxy statements must disclose whether a separate say-on-frequency vote is being provided, the current frequency of such votes and when the next such vote will occur. Shareholders must be given four choices: whether the say-on-pay vote will occur every (1) one, (2) two, or (3) three years, or (4) to abstain from voting. Companies may include a recommendation on the frequency, as long as shareholders are presented with all four choices.
A company’s decision as to how frequently it will offer say-on-pay voting must be reported on a Form 8-K, which must be filed no later than 150 calendar days after the meeting, but in no event later than 60 days prior to deadline for submission of shareholder proposals for the next meeting. Companies that adopt a policy to hold the say-on-pay vote in accordance with the frequency selected by a majority of the votes cast, may exclude any subsequent shareholder proposal seeking a different frequency for the say-on-pay vote on the basis that such proposal has been “substantially implemented.”
Golden Parachute Vote
A golden parachute vote is only held in connection with a merger, acquisition or similar extraordinary business transactions. A company that solicits a proxy with respect to such a transaction must disclose any golden parachute arrangements between it and its named executive officers, or between it and the named executive officers of the acquiring company, if the company soliciting the merger proxy is not the acquiring company. Moreover, unless the golden parachute was already subject to a say-on-pay vote, the company must give shareholders a non-binding advisory vote on such golden parachute arrangement. If there have been changes or modifications to the golden parachute arrangements since the say-on-pay vote, a new advisory vote must be included in the merger proxy.
The disclosure only applies to golden parachute arrangements, which means any arrangements concerning compensation that is based on or otherwise related to the merger or similar transaction, including accelerated vesting of equity awards and enhanced pension or nonqualified deferred compensation benefits, but excluding previously vested equity awards, compensation previously disclosed in the Pension Benefits or Nonqualified Deferred Compensation tables, and compensation from bona fide post-transaction employment agreements. The disclosure is only required with respect to golden parachute compensation that is actually triggered by the subject transaction. The disclosure applies to golden parachute arrangements between either the target or the acquiring company on one hand, and the named executive officers of either the target company or the acquiring company on the other.
The rules require that the disclosure be in tabular format. Tabular disclosure must be presented in the following form. However, companies are encouraged to expand on or modify the chart to take into account their particular circumstances
Footnotes to the table must identify and quantify (i) each separate form of compensation included in each column (other than the “total” column), and (ii) amounts payable under “single-trigger” arrangements vs. amounts payable under “double-trigger” arrangements included in each column (including the “total” column). In contrast to annual proxy reporting requirements, all perquisites (including perquisites with an aggregate incremental value less than $10,000) must be reported, as must the value of all health and welfare plan benefits (including benefits under plans that do not discriminate in favor of executive officers). The narrative disclosure must describe any material conditions or obligations applicable to golden parachute payments (i.e., restrictive covenant agreements), specific circumstances that trigger payment, the form and source of those payments, and any other material factors concerning each agreement.
When an advisory vote is required in addition to the disclosure, the vote is limited to arrangements between the soliciting company and its named executive officers and not the named executive officers of the target company. In the typical case where a target company solicits the merger proxy, a say-on-golden-parachute vote is not required with respect to any golden parachute arrangements between the acquiring company and the named executive officers of the target company.
General Rules Effecting All Section 14A Votes
Shareholder advisory votes on executive compensation, including the say-on-pay and say-on-frequency votes, do not require the filing of a preliminary proxy with the SEC. Section 14A votes are not subject to broker discretionary votes. That is, brokers may not vote uninstructed shares on the say-on-pay, say-on-frequency votes or the say-on-golden-parachute vote.
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