On September 13, 2017, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) held its final meeting and issued its final report. The Committee was organized by the SEC for a two-year term to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”
As the two-year term is expiring, Congress has determined to establish an Exchange Act-mandated, perpetual committee to be named the Small Business Capital Formation Advisory Committee. The SEC is also setting up a new Office of Advocate for Small Business Capital Formation and is actively seeking to fill both the advocate and Committee positions.
The September 13, 2017 Advisory Committee meeting discussed: (i) the auditor attestation report under Section 404(b) of the Sarbanes Oxley Act (“SOX”); (ii) the proposed amendments to the definition of a “smaller reporting company”; (iii) amendments to the definition of an “accredited investor”; (iv) potential updates to modernize Securities Act Rule 701 of the Securities Act related to employee stock compensation from private companies; (v) finders in private placement transaction; (vi) disclosure of board diversity; and (vii) the creation of a new secondary market for accredited investors to trade small-cap equities.
Amendment to Smaller Reporting Company Definition
The Advisory Committee believes that public company disclosure requirements disproportionately burden smaller reporting companies. In July 2015 the Advisory Committee made specific recommendations to the SEC for changes to the definition of a “smaller reporting company” (see HERE). Under the current rules a “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues. Similarly, a company is considered a non-accelerated filer if it has a public float of less than $75 million as of the last day of the most recently completely second fiscal quarter. The Advisory Committee has made the following recommendations:
- The SEC should revise the definition of “smaller reporting company” to include companies with a public float of up to $250 million. This will increase the class of companies benefiting from a broad range of benefits to smaller reporting companies, including (i) exemption from the pay ratio rule; (ii) exemption from the auditor attestation requirements; and (iii) exemption from providing a compensation discussion and analysis. I note that the SEC proposed rules conforming to this recommendation and in the most recent meeting urged the SEC to finalize the rule. For more on the SEC proposed rule change, see HERE.
- The SEC should revise its rules to align disclosure requirements for smaller reporting companies with those for emerging-growth companies. These include (i) exemption from the requirement to conduct shareholder advisory votes on executive compensation and on the frequency of such votes; (ii) exemption from rules requiring mandatory audit firm rotation; (iii) exemption from pay versus performance disclosure; and (iv) allow compliance with new accounting standards on the date that private companies are required to comply. For more information on the differences between a smaller reporting company and an EGC, please see HERE.
- The SEC should revise the definition of “accelerated filer” to include companies with a public float of $250 million or more but less than $700 million. As a result, the auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act would no longer apply to companies with a public float between $75 million and $250 million.
As an aside, one of the recommendations flowing from the 2016 SEC Government-Business Forum on Small Business Capital Formation is that the definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies.
Amendment to Definition of an Accredited Investor
Previously on June 19, 2016, and in early 2015, the Advisory Committee made specific recommendations for changes to the definition of an “accredited investor.” See here for my prior blog on the subject HERE. The Advisory Committee has reiterated its prior recommendations, including:
(i) The core of prior recommendations remain the same with the added statement that “the overarching goal of any changes the Commission might consider should be to ‘do no harm’ to the private offering ecosystem.”
(ii) The SEC should not change the current financial thresholds in the definition except to adjust for inflation on a going-forward basis.
(iii) The definition should be expanded to take into account measure of non-financial sophistication, regardless of income or net worth, thereby expanding rather than contracting the pool of accredited investors.
(iv) “Simplicity and certainty are vital to the utility of any expanded definition of accredited investor. Accordingly, any non-financial criteria should be able to be ascertained with certainty”; and
(v) The SEC should continue to gather data on this subject and, in particular, what “attributes best encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”
Amendment to Rule 701
The Advisory Committee heard presentations and made recommendations to the SEC to amend Rule 701. Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Exchange Act. The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.
Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. However, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.
Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.
The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.
Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701 a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the company must provide the following disclosures to investors within a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors within a reasonable time before the date of the irrevocable election to defer is made.
The Advisory Committee made the following recommendations related to Rule 701:
(i) Eliminate the Requirement that consultants be natural persons. The original limitation was intended to prevent Rule 701 from being used for capital-raising transactions; however, many smaller companies use outside employees or employee rental services that are run through entities. The Advisory Committee believes that this change will bring Rule 701 more in line with the realities of today’s business operations and that other provisions of the rule adequately address the prohibition against improper use of the Rule, such as for capital-raising transactions.
(ii) Remove the Rule 701 limits of the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. The Advisory Committee believes that the analysis required by these limits outweigh any benefits.
(iii) Increase the $5 million disclosure requirement cap to at least $10 million. Note that bills have now passed both the House and Senate that would increase the cap to $10 million and are expected to be signed by the President in the near future.
(iv) Exclude “material amendments” from the calculation of the limits in the Rule. Currently SEC CD&I on the Rule require repriced options to be counted as new grants or sales. However, it is argued that repricing merely keeps options within the intended use of the Rule, i.e., as compensation. Moreover, it is thought that companies avoid repricing when it would be beneficial, to avoid reaching the Rule limits.
(v) Clarify the application of the Rule to Restricted Stock Units (RSU’s). RSU’s are not currently addressed in the Rule. It is recommended that they be treated the same as options. In addition, it is recommended that any disclosure obligations be triggered by exercise or settlement and not the grant itself. Note, however, that a CD&I does include RSU’s under Rule 701 and requires disclosure, and limit analysis, as of the date of grant.
(vi) Require disclosure only after the threshold has been exceeded. Currently, expanded disclosure must be provided to any person who receives securities under Rule 701 during the 12-month period in which the company sells securities under Rule 701 with a value over $5 million. As disclosure is required prior to a grant, a company could inadvertently fail to comply with the Rule when it did not properly predict it would reach the cap, or future amendments result in reaching the cap. This is another reason that amendments should be excluded from the cap calculation. Moreover, it was recommended that the disclosure requirements be simplified to require only a current balance sheet and income statement, and only requiring updates upon a material change or once a year.
(vii) Clarify timing and delivery requirements for disclosure documents. Currently disclosure is required to be delivered “a reasonable period of time prior to the sale.” It is recommended that disclosure be clearly allowed to be delivered at any time prior to the sale and that “access equals delivery” satisfy deliver requirements. Since Rule 701 only applies to private companies, companies sometimes do, and could be formally allowed to set up data rooms accessible to equity recipients. Note that on November 6, 2017, the SEC issued a new CD&I on the subject which specifically allows a company to implement cyber security safeguards when electronically transmitting or providing disclosure in accordance with Rule 701.
For more on Rule 701, see my blog HERE.
Private Placement Finders
In a repeated and ongoing theme, the Advisory Committee once again recommended that the SEC take action to provide regulatory certainty to finders in private placement transactions. The Advisory Committee has previously made recommendations to the SEC and sought regulatory action on May 15, 2017 and on September 23, 2015. In addition to a plea for any guidance and support, in 2015 the Advisory Committee had made the following specific recommendations:
(i) The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act;
(ii) The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level;
(iii) The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and
(iv) The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.
For a review of my ongoing discussion on finder’s fees, see my blog HERE.
Board Diversity
The Advisory Committee believes that board diversity improves competitiveness and creates greater access to capital, more sustainable profits and better shareholder relationships. As such, the Advisory Committee recommends that the SEC amend its current very broad rule on board diversity disclosure to require companies to describe their policies with respect to diversity and to disclose the extent to which their boards are diverse. As with the current rule, the definition of diversity can be left to the company; however, disclosure should include information regarding race, gender and ethnicity.
Market Structure – Secondary Trading
The Advisory Committee recognizes that liquidity is an issue for smaller companies. The Advisory Committee advocates for a new U.S. equity market for the trading by accredited investors in smaller company securities. The Advisory Committee also advocates for federal law preemption over the secondary trading of Tier 2 Regulation A securities. Moreover, the Advisory Committee recommends that the SEC allow for smaller exchange-listed companies to voluntarily choose larger trading increments or tick sizes. It is thought that widening spreads from the current one-penny increments could provide economic incentives that would encourage the provision of trading support to the equity securities of small and mid-cap companies. More flexibility and larger tick sizes could also encourage IPO’s for small companies. For more on the SEC tick size pilot program, see HERE.
Sarbanes-Oxley Section 404(b)
The Advisory Committee has heard presentations on the Sarbanes-Oxley Section 404(b) requirement for an auditor attestation and report on management’s assessment of internal control over financial reporting. Among other things, Section 404(b) of SOX requires companies to include in their annual reports filed with the SEC, an accompanying auditor’s attestation report on the effectiveness of the company’s internal control over financial reporting. In other words, reporting companies must employ their auditor to audit and attest upon their financial internal control process, in addition to the financial statements themselves.
Section 404(b) has been a hot topic recently, with those already or soon to be required to comply almost unilaterally requesting relief, and those that benefit from its application, including accountants and auditors, almost unilaterally touting its benefits. The Financial Choice Act, which is not likely to pass in its complete form, includes a provision that would increase the Rule 404(b) compliance threshold from a $250 million public float to $500 million.
In one Advisory Committee presentation, a representative from a large accounting firm supported Section 404(b) and touted improvements in accounting quality. According to studies, companies that have control audits have fewer restatements, higher valuations and lower costs of debt.
However, in the second presentation by the CEO of a relatively small pre-revenue biotech company, the reality of the onerous cost and effort involved to comply with Section 404(b) was illustrated. The cost of 404(b) compliance took away from R&D, growth, and additional employees, and could add 1% or more to the company’s overall burn rate. That CEO advocated for an exemption from 404(b) for all companies with either a public float under $250 million or annual revenues under $100 million.
The Advisory Committee seems to agree that 404(b) is not necessary or helpful for smaller companies but did not make a specific recommendation as suggested by the biotech CEO. Rather, the Advisory Board has recommended a change in the definition of “accelerated filer” as noted above, which would include a higher threshold for Section 404(b) compliance.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
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West Palm Beach, FL 33401
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LAnthony@LegalAndCompliance.com
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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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