ABA Journal’s 10th Annual Blawg 100
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Introduction and Background
On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these two actions, I have been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. Using this as a backdrop, this blog will also address Form 8-K filing requirements in general.
Back in August 2014, the SEC did a similar sweep related to 8-K filing failures associated with 3(a)(10) transactions. See my blog HERE for a discussion of those actions and 3(a)(10) proceedings in general. The 8-K filing deficiency actions were a precursor to a larger SEC investigation on 3(a)(10) transactions themselves which culminated in two well-known enforcement actions against active 3(a)(10) participants (the Ironridge companies and IBC Funds) and resulted in a chill on the 3(a)(10) activity in the industry as a whole. 3(a)(10) actions continue today but the volume of transactions has dramatically reduced and the attention to due diligence, detail and reporting requirements has likewise increased.
The SEC rarely takes enforcement action or expends time or resources on investigating the failure to file an 8-K. When such issues arise, it is usually in connection with a routine review of a company’s SEC reports or as part of the comment and review process associated with the filing of a registration statement. All reports filed with the SEC are subject to SEC review and comment and the Sarbanes-Oxley Act requires that the SEC undertake some level of review of every reporting company at least once every three years.
As was the case with the SEC’s investigation into 3(a)(10) transactions, it is my belief that the SEC is reviewing the PIPE industry as a whole and in particular the process, procedure and effects associated with convertible instruments. The majority of these transactions involve the issuance of convertible notes which then convert into common stock following a holding period in reliance on Rule 144 and Section 3(a)(9) of the Securities Act of 1933 (“Securities Act”). For a review of the use of Section 3(a)(9) related to convertible notes, see my blog HERE. Any convertible instrument can be used in the same manner, such as preferred stock and warrants.
The use of convertible instruments in PIPE transactions is perfectly legal and acceptable. However, like any other aspect of the securities marketplace, it can be abused. My belief is that the SEC is using the investigation into the failure to file 8-K’s in association with these transactions to assist in a larger investigation into related fraud and other violations. If a company is failing to file an initial 8-K for the transaction and subsequent 8-K’s to report the issuance of securities upon a conversion, there may also be other issues and violations. Examples of abusive or improper activity could include: (i) backdating of notes or failure to provide the funding associated with the note; (ii) improper undisclosed affiliations between investors and the company or its officers and directors; (iii) manipulative trading practices; (iv) improper stock promotion (although a topic for another blog, stock promotion itself is not illegal as long as, among other things, the information disseminated is true and accurate, there is no pump-and-dump activity, and Securities Act Section 17(b) disclosures are used); or (v) trading on insider information.
During a conversion process, the number of issued and outstanding shares of common stock can increase dramatically, causing dilution to existing shareholders and a decrease in stock price from large selling pressure. In an action against Connexus Corporation, the SEC noted that the unreported issuances of securities increased the amount of common stock by more than 600% from the last reported number.
The ability of an investor to convert and trade responsibly makes the difference between a successful financing relationship with the investment community and one that can cause long-term damage to a company.
To be clear, I do not think there is anything inherently wrong, illegal or improper with these corporate finance transactions. The exact same structure is used for PIPE investments in companies big and small, whether traded on the OTC Markets, NASDAQ or NYSE. However, smaller companies often do not have the volume and liquidity to bear the effect of sudden enormous selling pressure. Larger companies are not immune to issues, though. Nuanced provisions negotiated in these convertible derivative instruments can be problematic as well, such as the recent use of the Black-Scholes put option in warrants (see Vapor Corp. as a prime example).
When considering a PIPE transaction, companies are often presented with numerous term sheets and investors to choose from. The terms will only vary slightly and many investors will match terms from a competitor. In choosing a transaction it is incumbent upon the company to conduct due diligence on the investor, including their reputation in the industry and trading history associated with other investments and conversions.
Form 8-K Filing Requirements Related to PIPE Transactions
A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file reports with the SEC. For an overview of these reporting requirements, see my blog HERE. For a running update on the state of proposed changes to the specific reporting requirements in Regulations S-K and S-X, see my summary at the end of this blog.
Exchange Act Rule 13a-11 requires the filing of current reports on Form 8-K. Subject to certain exceptions, a Form 8-K must be filed within four (4) business days after the occurrence of the event being disclosed. No extension is available for an 8-K. Companies file this report with the SEC to announce major or extraordinary events that shareholders should know about, including entry into material agreements and the issuance of unregistered securities. It is these two specific events that are implicated with the entry into corporate financing transactions, and subsequent conversions of convertible instruments such as convertible debt or preferred stock.
In particular, Item 1.01 of Form 8-K requires that a company report if it has entered into “a material definitive agreement not made in the ordinary course of business…” Under Item 1.01, the company must report: (a) the date of the agreement; (b) the parties to the agreement; (c) a description of any material relationship between the parties, other than the reported agreement; and (d) a brief description of the terms and conditions of the agreement.
Item 3.02 of Form 8-K requires that a company report the unregistered sale of securities. Under Item 3.02, the company must report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. The report must disclose: (a) the date, title and amount of securities sold; (b) the nature and amount of consideration paid; (c) the Securities Act exemption being relied upon and a brief explanation of the facts relied upon to support the exemption; and (d) where applicable, the terms of conversion or exercise.
The Item 3.02 filing requirement is triggered if the volume threshold of the underlying equity securities issuable upon conversion is exceeded, even if those issuances are structured as takedowns over time, such as where a convertible note is partially converted in multiple tranches. That is, if it is foreseeable that the total number of securities issued in a corporate finance transaction will exceed 5% of the current outstanding securities, an Item 3.02 8-K must be filed. Likewise, where the actual conversions and issuances of common stock exceed the 5% threshold in aggregate, an 8-K is required.
The Item 3.02 8-K must disclose all unregistered issuances that resulted in increasing the total outstanding securities by the 5% threshold. As a simple example, if a company reports 10,000,000 shares of outstanding common stock in its 10-Q and then proceeds to issue 100,000 shares each in a series of conversions, as soon as the total outstanding reaches 10,500,000, the 8-K filing requirement would be triggered and each of the conversions would need to be reported.
Form 8-K Filing Requirements: A Broad Overview
As mentioned above, any U.S. reporting company must file periodic reports on Form 8-K. A foreign issuer uses a Form 6-K, which has different requirements. The following is a brief description of each of the events that trigger an 8-K filing requirement. Many transactions will require the filing under multiple Item numbers, in which case the company can set forth all the material information and cross-reference the disclosure under each Item. Also, a Form 8-K can serve double duty and satisfy certain other filing requirements, such as those related to proxy proceedings or business combination transactions. The front page of the form 8-K provides check boxes to disclose such double use.
Section 1 – Registrant’s Business and Operations
Item 1.01 Entry into a Material Definitive Agreement – Material agreements are those that create material obligations that are enforceable by or against a company. As a rule of thumb, if an agreement is material enough to require separate board or shareholder consent, it requires an 8-K filing. Non-binding term sheets or letters of intent generally do not trigger a filing requirement, though material binding provisions contained therein may, such as significant breakup fees. A company is not required to file a copy of the agreement itself with the 8-K, but if it does not, the agreement must be filed with the next periodic report on either Form 10-Q or 10-K. As is encouraged by the SEC, I usually recommend that the agreement be filed with the 8-K. The determination of an 8-K filing requirement that is made at the time the agreement is entered into such that if the agreement becomes material through the passage of time or events, an 8-K filing is not later triggered.
Item 1.02 Termination of a Material Definitive Agreement – The termination of an agreement that is reported or reportable in Item 1.01, other than by its own terms, must be reported.
Item 1.03 Bankruptcy or Receivership – An 8-K must be filed for bankruptcy or receivership actions involving either the company or its parent (majority shareholder).
Item 1.04 Mine Safety – Reporting of Shutdowns and Patters of Violations – The requirement for an 8-K is triggered by the receipt of a notice under the Federal Mine Safety and Health Act of 1977 or from the Mine Safety and Health Administration.
Section 2 – Financial Information
Item 2.01 Completion of Acquisition or Disposition of Assets – In addition to reporting the particular acquisition or disposition transaction, this section triggers the requirement to provide financial statements and information under Regulation S-X, including historical and/or pro forma financial statements. If the report also involves a change of shell status, the financial statements must be included with the initial report under Item 2.01. If the company was not a shell, the financial statements may be filed by amendment within 71 days of the initial 8-K reporting the Item 2.01 event.
Item 2.02 Results of Operations and Financial Conditions – An Item 2.02 is triggered by the disclosure of any material non-public financial information about a completed quarter of fiscal year-end. An Item 2.02 disclosure is usually accompanied by a press release, which can be “furnished” and not “filed.” See below for a discussion on the difference. Also, an Item 2.02 filing must be made prior to any associated earnings call.
Item 2.03 Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement of a Registrant – An example of an off-balance sheet transaction would be one where the company guarantees or lease or other obligation of a third party.
Item 2.04 Triggering Events that Accelerate or Increase a Direct Financial Obligation or an Obligation under an Off-Balance Sheet Arrangement – An example would be the default by the primary party to a guaranteed obligation.
Item 2.05 Costs Associated with Exit or Disposal Activities – An example would be the termination of a business division or manufacturing plant. Another example would be material write-offs or restructuring costs.
Item 2.06 Material Impairments – An example would be a material impairment to the value of assets such as goodwill or investment securities. Another example could be the loss of value to technology inventory due to obsolescence.
Section 3 – Securities and Trading Market
Item 3.01 Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing – An example would be a notice of delinquency with the listing requirements of an exchange such as the NASDAQ or NYSE MKT. If such notice culminates in an actual delisting, another 8-K would need to be filed under this item. Likewise, a company’s decision to delist and move to the OTC Markets would be reportable.
Item 3.02 Unregistered Sales of Equity Securities – For a smaller reporting company, this Item requires that a company report the unregistered sale of securities if the aggregate sales/issuances of securities constitutes 5% or more of the outstanding securities since the last reported number filed with the SEC. For all other companies, the threshold is triggered at a 1% change.
Item 3.03 Material Modification to Rights of Security Holders – Examples would be amendments to preferred stock preferences or the issuance of senior securities.
Section 4 – Matters Related to Accountants and Financial Statement
Item 4.01 Changes in Registrant’s Certifying Accountant – An 8-K filing under this Item will always be reviewed by the SEC and must meet the exact particular disclosure requirements.
Item 4.02 Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review – A filing on this Item is usually accompanied by or quickly followed by an amendment to the subject report and financial statements. Moreover, if the amended underlying report is not concurrently filed, an Item 4.02 filing in essence reports that the company is delinquent in its filing requirements, as an unreliable report is equivalent to no report. An Item 4.02 filing is due within 2 days of receipt of an auditor’s restatement letter.
Section 5 – Corporate Governance and Management
Item 5.01 Changes in Control of Registrant – Control includes changes in the board of directors, officers or control shareholders.
Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers – This Item includes any and all changes in officers or directors, whether by resignation, termination, refusal to stand for re-election or completion of a change of control transaction.
Item 5.03 Amendments to Articles of Incorporation or Bylaws; Changes in Fiscal Year – When completing a corporate action that is processed by FINRA, this item filing requirement is triggered when the amended articles are filed with the state, regardless of the timing of FINRA’s review and processing of the change with the markets. A restatement that does not make material changes does not trigger an 8-K filing, such as where a company is combining multiple amendments for ease of reference or cleaning up otherwise ambiguous language.
Item 5.04 Temporary Suspension of Trading Under Registrant’s Employee Benefits Plans – This item filing requirement is triggered by the receipt of a notice under the Employment Retirement Income Security Act of 1974 (ERISA).
Item 5.05 Amendments to the Registrant’s Code of Ethics, or Waiver of a Provision of the Code of Ethics – In addition to filing an 8-K, the company must carry through the change to the documents posted on its website.
Item 5.06 Change in Shell Company Status – An Item 5.06 filing is usually accompanied by an Item 2.02 disclosure and triggers the filing of Form 10 information, including financial statements.
Item 5.07 Submission of Matters to a Vote of Security Holders – This Item requires the reporting of voting results and is thus a retrospective report of a vote as opposed to a prospective notice of a matter to be submitted for vote. Item 5.07 also requires the disclosure of say-on-pay votes and the frequency on say-on-pay votes.
Item 5.08 Shareholder Director Nominations – This Item requires a company to inform shareholders of the date in which they must submit director nominations on Schedule 14N.
Section 6 – Asset-Backed Securities
Item 6.01 ABS Informational and Computational Materials
Item 6.02 Change of Servicer or Trustee – Requires a report of any changes, whether through resignation or termination.
Item 6.03 Change in Credit Enhancement or Other External Support – Requires a report of any material changes, whether through the loss, addition or change in support.
Item 6.04 Failure to Make a Required Distribution – Only requires the report of material failures to distribute in a timely manner.
Item 6.05 Securities Act Updating Disclosure – Includes material changes in an offering of AB securities.
Item 6.06 Static Pool – Alternative to filing a prospectus supplement required by Item 1105 of Regulation AB.
Section 7 – Regulation FD
Item 7.01 Regulation FD Disclosure – Information should be furnished and not filed. Where the information is material non-public information, such as in a press release, the filing must be made immediately prior to or simultaneously with the issuance of the release. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day. Regulation FD disclosures are an exception to the usual four-day filing rule.
Section 8 – Other Events
Item 8.01 – Other Events – This is a catch-all voluntary filing by companies that wish to report information that does not otherwise fit within an 8-K category. Because the information is voluntary and not otherwise required, there is no four-day filing rule.
Section 9 – Financial Statements and Exhibits
Item 9.01 Financial Statements and Exhibits – Requires the filing of all financial statements and exhibits required by other Items on Form 8-K and specifies such financial statement requirements. In addition, Item 9.01 sets forth the timing of filing of the financial statements for both shell and non-shell companies.
Penalties for Failure to File
Late or missed filings carry severe consequences to companies. To qualify to use Form S-3, a company must have filed all SEC reports in a timely manner, including Form 8-K, for the prior 12 months. Moreover, filing failures can result in enforcement proceedings and the conclusion of and disclosure related to inadequate controls and procedures.
Difference Between Filed and Furnished
Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The SEC allows certain information to be furnished as opposed to filed; however, it is incumbent upon the company to clearly disclose that it is avowing itself of the ability to furnish and not file. That is, unless otherwise specifically disclosed, information in a report made with the SEC will be deemed filed, not furnished. Note, however, that other liability provisions under the Exchange Act may apply that are not dependent on the filing of documents, such as the anti-fraud provisions under Rule 10b-5.
Further Reading
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. However, I note that with the recent election, and the GOP sweeping control of both the House and Senate, it is unclear what the future of these initiatives holds.
On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.
That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.
As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
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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