Monthly Archives: October 2019
During lulls in the very active rule changes and blog-worthy news coming from the SEC and related regulators, it is great to step back and write about basics that affect SEC attorneys and market participants on a daily basis. In the realm of securities laws, the concept of “incorporation by reference” is simple enough – information from another document, registration statement or filing is included in a current document, registration statement or filing by referring to the other without repeating its contents. Similarly, “forward incorporation by reference” means that a document is automatically updated with information contained in a future SEC filing.
Although the concepts are relatively straight forward, their application is complex with differing rules for different classes of companies (such as an emerging growth company, smaller reporting company, or well-known seasoned issuer) and different filings such as a registration statement filed under the Securities Act of 1933 (“Securities Act”) or a periodic report filed under the Securities Exchange Act of 1934 (“Exchange Act”). Although rule changes to Regulation S-K enacted in March of this year (see HERE) revised several rules and forms to help simplify the incorporation-by-reference puzzle and facilitated access to incorporated documents by requiring hyperlinks, the provisions are still complicated and spread among a variety of rules and forms. This blog unwinds and summarizes the various rules and eligibility criteria to benefit from incorporation by reference. I’ve also included a chart for quick reference at the end of the blog.
As an aside, incorporation by reference can also include referencing disclosures in another part of the same registration statement or report to avoid repetition. The ability to incorporate by reference in the same document is universal to all reports and classes of companies and is encouraged by the SEC.
Securities Act Rule 411
Securities Act Rule 411 is a part of Regulation C governing registration statements and prospectus requirements. Rule 411 generally prohibits incorporation by reference in a prospectus unless the particular form being used specifically allows it. However, as discussed below, most forms of registration statements specifically allow it in some instances. In any financial statements, incorporating by reference, or cross-referencing to, information outside of the financial statements is not permitted unless otherwise specifically permitted or required by SEC rules or by GAAP or IFRS rules. Hyperlinks must be included to any information that is incorporated by reference.
Rule 411 further provides that incorporation by reference is allowed in parts of a registration statement that do not include the prospectus. Exhibits may be filed by incorporation by reference to any other exhibit in a SEC filing, whether filed by the same company or a different company, but a hyperlink must be included to that exhibit.
Rule 411 also contains a general statement that incorporation by reference may not be used in any case where such incorporation would render the disclosure incomplete, unclear, or confusing. For example, unless expressly permitted or required, disclosure must not be incorporated by reference from a second document if that second document incorporates information by reference to a third document.
Rule 411 does not mention forward incorporation by reference.
Exchange Act Rule 12b-23
Rule 12b-23 governs incorporation by reference for Exchange Act registration statements and periodic reports. Where Rule 411 prohibits incorporation by reference unless expressly allowed in a form, Rule 12b-23 allows incorporation by reference unless expressly prohibited in the rule or a particular form.
The remainder of Rule 12b-23 is substantially the same as Rule 411, including related to financial statements, exhibits, hyperlinks and general requirements related to unclear or confusing references.
Incorporation by reference to exhibits has been allowed by all issuers since the enactment of the Securities Act and Exchange Act. Subject to the requirements of Rules 411 and 12b-23, any exhibits required to be filed pursuant to Item 601 of Regulation S-K (the Exhibits Rule), all exhibits may be filed by incorporation by reference. On March 1, 2017, the SEC passed final rule amendments to Item 601 to require hyperlinks to exhibits in filings made with the SEC. The amendments 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 amendment also requires that all exhibits be filed in HTML format. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.
Although it would seem common sense, Item 601 also specifically provides that an exhibit filed by incorporation by reference, must not have thereafter been materially amended or changed. In other words, when filing an exhibit today by using incorporation by reference, make sure the referenced exhibit is up to date.
The rules related to the ability to use incorporation by reference and forward incorporation by reference in a Form S-1 are confusing. The eligibility requirements to use incorporation by reference in a Form S-1 include:
- The company must be subject to the reporting requirements of the Exchange Act (not a voluntary filer);
- The company must have filed all reports and other materials required by the Exchange Act during the prior 12 months (or such shorter period that such company was reporting);
- The company must have filed an annual report for its most recently completed fiscal year;
- The company may not currently be, and during the past 3 years neither the company nor any of its predecessors were, (i) a blank check company; (ii) a shell company other than a business combination shell company (SPAC), or (iii) have offered a penny stock;
- The company cannot be registering an offering for a business combination transaction; and
- The company must make its reports filed under the Exchange Act that are incorporated by reference, available on its website, and include a disclosure of such availability and that it will provide such document upon request.
If a company elects to incorporate by reference, it must include specific language regarding the incorporation by reference and forward incorporation by reference.
The FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies that meet the eligibility requirements to use historical incorporation by reference. In what was probably unintended in the drafting, the FAST Act changes only included smaller reporting companies and not emerging growth companies. Prior to the FAST Act, forward incorporation by reference was only available for companies that use Form S-3 or F-3. The FAST Act change has created an anomaly whereby a smaller reporting company can utilize forward incorporation by reference but other classes of company, including emerging growth companies and large accelerated filers, cannot.
The SEC is aware of the continuing confusing distinction between the obligations of smaller reporting companies vs. emerging growth companies and has included forward incorporation by reference on Form S-1 on its long-term action list (see HERE). Unfortunately, this topic is not new to the long-term list.
Form S-3 allows for both incorporation by reference and forward incorporation by reference for all companies that are eligible to use the form. In particular, a company’s latest annual report on Form 10-K and all other reports filed pursuant to the Exchange Act following the latest annual report are specifically incorporated by reference into a Form S-3. Furthermore, all documents filed under the Exchange Act following the filing of the Form S-3 are incorporated by reference and the future annual reports on Form 10-K act as a prospectus update requiring a review of continued eligibility to use the Form S-3.
Companies filing the Form S-3 are required to include specific language regarding the incorporation by reference and forward incorporation by reference and must agree to provide copies of any documents incorporated by reference upon request.
For more on Form S-3, including eligibility requirements, see HERE.
Form S-4 allows for both incorporation by reference and forward incorporation by reference for all companies that are eligible to use Form S-3 with substantially the same requirements as Form S-3.
A Form S-8 registration statement can be used by issuers to register securities to be offered to employees and certain consultants underwritten employee benefit plans. For more on a Form S-8, see HERE and HERE. A Form S-8 registration statement is popular with all public companies, but particularly with small public companies as it becomes effective immediately upon filing and allows for incorporation by reference, both of which benefits are not always available to smaller public companies.
A Form S-8 allows for incorporation by reference of both previously filed Exchange Act reports and Securities Act registration statements in the Form. As a Form S-8 is effective upon filing, any requests for confidential treatment of the incorporated document must be fully resolved prior to the filing of the Form S-8. For more on confidential treatment requests, see HERE.
Likewise, a Form S-8 is updated by forward incorporation by reference to future filed Exchange Act reports for all companies, including smaller reporting companies. A Form S-8 even goes one step further and allows certain documents that are required to be delivered to an employee as part of an employee incentive plan, to be incorporated by reference into a Form S-8 and not be filed with the SEC at all.
Form 10-K Incorporation by Reference to Proxy Statement
A company may elect to omit Part III information from its Form 10-K and incorporate this information by reference from its proxy statement if the proxy statement is filed within 120 days after the end of the fiscal year. In such case, the company must provide a statement to that effect in the Form 10-K under each item under Part III. If the company is then unable to file its proxy statement by the 120th day, it must amend its Form 10-K, and file a Form 10-K/A by the 120th day after the end of its fiscal year to include all of the Part III information that was previously omitted.
Part III information includes: (i) information related to directors, executive officers and corporate governance; (ii) executive compensation; (iii) security ownership of certain beneficial owners and management and related stockholder matters; (iv) certain relationships and related transactions and director independence; and (v) principal accountant fees and services.
Furthermore, if a company prepares an annual report to shareholders separate from its Form 10-K, it may incorporate some or all of the Part I and Part II information required to be in Form 10-K by reference from its annual report as long as the annual report is filed as an exhibit to the Form 10-K.
Quick Reference Chart
I created the below quick reference chart.
|Form/Filing||Incorporation by Reference||Forward Incorporation by Reference|
|Exhibits in Exchange Act Reports and Securities Act Registration Statements||Allowed by all issuers – requires the use of hyperlinks to all exhibits listed on the exhibit list||N/A|
|S-1||Allowed by issuers that meet certain eligibility requirements, including that during the past 3 years, neither the company nor any of its predecessors were (i) a blank check company; (ii) a shell company other than a business combination shell company (SPAC), or (iii) have offered a penny stock.||Only allowed by smaller reporting companies that meet the eligibility requirements for use of historical incorporation by reference.|
|S-3||Allowed by all issuers||Allowed by all issuers|
|S-8||Allowed by all issuers||Allowed by all issuers|
|S-4||Allowed for issuers that are eligible to use Form S-3||Allowed for issuers that are eligible to use Form S-3|
|Financial Statements||Not allowed to information outside of the financial statements unless specifically permitted by an SEC rule or GAAP or IFRS rule.||Not allowed|
|Form 10-K||Can incorporate Part I and II information into an annual report that is filed as an Exhibit||Can incorporate Part III information into a proxy statement that is filed after the 10-K|
On September 24, 2019, all five SEC commissioners gave testimony to, and were questioned by, members of the U.S. House of Representatives Committee on Financial Services. Commissioner Robert J. Jackson, Jr. also gave an opening statement at the Committee hearing.
Commissioner Jackson’s Opening Statement
Commissioner Jackson’s short opening statement was consistent with his prior public views, consisting of a list of three areas in which he believes legislation should intervene to prevent corporate insiders from spending shareholder money to advance their own interests over those of investors.
His first recommendation is to shorten the current four-day 8-K filing requirement in which a company must notify the public of certain material events. For an overview of 8-K filing categories, including the categories that require an advance filing (Regulation FD) or lesser time period than the standard four days, see HERE. Commissioner Jackson states that there is “evidence that corporate insiders often trade during the ‘gap’ between key business events and when our rules require that event to be revealed to the public.” Trading on material insider information is illegal. Although I think a company could file an 8-K in a shorter period of time, persons that are engaging in illegal activity are not likely to stop; they would just have less time to do so.
His second recommendation is to limit stock buyback programs. Commissioner Jackson has been vocal in his disdain for stock buyback programs, including in a speech last year and a separate letter to Senator Van Hollen this spring. Commissioner Jackson believes that when a company engages in a stock buyback program, it is, more often than not, company insiders that are selling back to the company. He also believes that a company’s performance declines after a stock buyback program.
I don’t have enough information to argue against Commissioner Jackson’s views on this, but I do know that insiders, especially in smaller-cap companies, are often compensated in stock, which stock is very hard to liquidate. In addition to regulatory hurdles, including Section 16 limits on short-swing profits, Rule 144 controls on share rules including drip rules, insider-trading rules and a few open-trading windows, there are the optics and negative market impact resulting from an insider selling. Add to that the challenges with supporting a stock price in the face of selling pressure, and I think that for a smaller public company with cash reserves, a stock buyback program that an insider happens to participate in can benefit the company as a whole. The insiders of smaller public companies do not make millions of dollars in compensation like their large-cap counterparts might. Some liquidity can be a big motivator for hard work. However, with that said, I am a staunch believer in full disclosure, and as such if insiders are selling into a stock buyback company, of course they should be filing their Form 4’s in a timely manner.
Jackson’s third recommendation is to require public companies to disclose direct and indirect political expenditures. Jackson believes that money is often filtered to political parties, candidates or other political causes through third parties furthering the personal political interests of executives and insiders. Again, I do not have enough information to effectively address this belief; however, this could turn into a rabbit hole. I can see requiring a company to disclose a direct contribution on behalf of a particular political candidate if the amount is material, but what is or isn’t political could be amorphous. For example, would it be a political expenditure if an executive chooses one vendor over another because he/she supports the political beliefs of that vendor? Moreover, companies may have valid business reasons for supporting candidates in a particular jurisdiction, such as where they have operations and an employee base. If the amount is not material, such a disclosure may be confusing without providing any additional investor protection or useful information.
Below is a summary of the written testimony on behalf of all five Commissioners. In addition, the House Committee spent several hours questioning each of the Commissioners.
The SEC begins its testimony with a brief summary of their purpose and responsibilities. As is often repeated, the SEC’s mission is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. The SEC has almost 4,400 employees in Washington over 11 regional offices and oversees (i) approximately $96 trillion in securities trading annually on U.S. equity markets; (ii) the disclosures of approximately 4,300 exchange-listed public companies with an approximate aggregate market capitalization of $33 trillion; and (iii) the activities of over 26,000 registered entities and registrants including, among others, investment advisers, broker-dealers, transfer agents, securities exchanges, clearing agencies, mutual funds and exchange-traded funds (ETFs), who employ over one million people in the United States. The SEC also has oversight of self-regulatory organizations (SROs) such as the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB) and the Public Company Accounting Oversight Board (PCAOB).
The SEC then talked about its Strategic Plan for 2018-2022 (see HERE) and the progress that has been made on the plan. The first goal in the plan is focusing on the interests of long-term Main Street investors, a group the SEC mentions in almost all public communications since the first publication of the Plan. In furtherance of this goal, the SEC holds town hall meetings and outreach tours, and uses digital tools and other outreach methods. The testimony cited several specific examples of town hall meetings.
The second goal of the Strategic Plan is recognizing significant developments, including technological developments, and trends in evolving capital markets and adjusting efforts to ensure the effective allocation of resources. The creation of the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) (see HERE) was in furtherance of this goal. FinHub is intended to serve as a public resource for fintech-related issues at the SEC, including matters dealing with distributed ledger technology (DLT), automated investment advice, digital marketplace financing and artificial intelligence/machine learning.
The third goal of the Strategic Plan is to elevate the SEC’s performance by enhancing analytical capabilities and human-capital development. The SEC did not site any specific performance parameters related to this goal.
Fiscal Year 2019 Initiatives
The SEC testimony then turns to its 2019 initiatives starting with enforcement proceedings. In FY 2018, the Commission brought 821 enforcement actions and obtained judgments and orders for $3.945 billion in penalties and disgorgement, while returning $794 million to harmed investors and awarding nearly $50 million in payments to whistleblowers. The actions have covered many topics including investment management, securities offerings, issuer reporting and accounting, market manipulation, insider trading, broker-dealer activities, cyber-related conduct and the Foreign Corrupt Practices Act, among many others.
In the enforcement arena the SEC has created (i) the Retail Strategy Task Force; (ii) the Cyber Unit; and (iii) the Share Class Selection Disclosure Initiative. The Retail Strategy Task Force has two primary objectives: (i) developing data-driven, analytical strategies for identifying practices in the securities markets that harm retail investors and generating enforcement matters in these areas; and (ii) collaborating with internal and external partners, such as OIEA and the Department of Justice, on retail investor advocacy and outreach. I notice that the SEC files multiple actions, almost daily, taking actions against defendants involved in fraud and other misconduct affecting retail investors.
In September 2017, the SEC created a specialized Cyber Unit within enforcement to combat cyber-related threats to investors focusing on potential violations involving distributed ledger technology (blockchain), digital assets, cyber-intrusions and hacking to obtain material, non-public information. The Cyber Unit has resulted in many actions for fraudulent or unregistered initial coin offerings (ICOs) and works closely with the SEC’s FinHub to monitor this area. In addition to an enforcement focus, the SEC has been focused on digital asset and distributed ledger technology in general, including their impact on capital markets and company disclosures.
Another area of 2019 initiatives has been monitory and addressing market developments and risks, including the potential impact of Brexit on U.S. capital markets and company disclosures related to Brexit risks. The SEC also has been focused on the transition away from LIBOR as a benchmark for short-term interest rates and the financial market risks that the transition may present. Earlier this year, Chairman Clayton created a new position, the Senior Policy Advisor for Market and Activities-Based Risk, to manage and coordinate a cross-disciplinary SEC staff committee that is responsible for identifying, monitoring and responding to market risks, including activities-based risks. Additionally, the SEC plays an active role and contributes to various domestic and international organizations that focus on market and systemic risks.
Cybersecurity risks at the SEC itself have also taken a front row. The topic of cybersecurity and improved technology in general was covered in depth in the testimony. After the SEC EDGAR system was hacked, the agency has dedicated resources to improving systems. For more on the hacking and cybersecurity issues in general, see HERE and HERE. The SEC has also reduced the collection of personal information such as Social Security numbers and dates of birth as unnecessary in light of the risks. A new Chief Data Officer will be put in place to ensure that the SEC only collects data it needs to fulfill its duties and that it can effectively manage and secure.
Regulatory and Policy Agenda
The SEC Commissioners highlighted some of the regulatory actions of the last year including the proposed amendments to the “accelerated filer” and “large accelerated filer” definitions (see HERE); adding test-the-waters for all companies (see HERE); proposed amendments to 15c2-11 (see HERE and the expansion of Regulation A for reporting companies (see HERE), among others. The SEC also highlighted its efforts to improve exempt offerings and private markets, including the concept release published this summer (see HERE).
As mentioned, the House Committee spent several hours questioning the SEC in what turned out to be a fairly expected bipartisan manner. The democratic Committee members criticized the SEC for not doing a great job as “Wall Street’s Cop” and expressing a need for additional regulations, including those related to ESG matters (see HERE). The Republicans were more complimentary and urged further efforts in improving capital formation…
The SEC has adopted final rules allowing all issuers to test the waters prior to the effectiveness of a registration statement in a public offering. The rule change is designed to encourage more companies to go public. Although it will help in this regard, a much larger expansion of testing the waters, allowing unlimited testing the waters (subject to anti-fraud of course) for all registered offerings under $50 million, would go far to improve the floundering small cap IPO market.
Prior to the rule change, only emerging growth companies (“EGCs”) (or companies engaging in a Regulation A offering) could test the waters in advance of a public offering of securities. The proposal implements a new Securities Act Rule 163B.
Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. The public offering process is divided into three periods: (1) the pre-filing period, (2) the waiting or pre-effective period, and (3) the post-effective period. Communications made by the company during any of these three periods may, depending on the mode and content, result in violations of Section 5 of the Securities Act of 1933 (the “Securities Act”). Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.”
All forms of communication could create “gun-jumping” issues (e.g., press releases, interviews, and use of social media). “Gun jumping” refers to written or oral offers of securities made before the filing of the registration statement and written offers made after the filing of the registration statement other than by means of a prospectus that meet the requirements of Section 10 of the Securities Act, a free writing prospectus or a communication falling within one of the several safe harbors from the gun-jumping provisions.
In April 2012, the JOBS Act established a new process and disclosures for public offerings by a new class of companies – i.e., emerging growth companies (“EGCs.”) An EGC is defined as a company with total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. In particular, Section 5(d) of the Securities Act of 1933 (“Securities Act”) allows EGCs to test the waters by engaging in communications with certain qualified investors. The SEC has now created new Securities Act Rule 163B allowing all companies intending to file, or who have filed, a registration statement.
Permitting companies to test the waters is intended to provide increased flexibility to such issuers with respect to their communications about contemplated registered securities offerings, as well as a cost-effective means for evaluating market interest before incurring the costs associated with such an offering. Since the enactment of the JOBS Act, 87% of all IPOs have been by EGCs, leaving non-EGC companies at a disadvantage where specific rules favor EGC status.
The current rule change is consistent with other SEC actions to extend benefits afforded to EGCs to other issuers.
Section 5(d) of the Securities Act – Testing the Waters; New Rule 163B
Section 5(d) of the Securities Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”) in order to gauge their interest in a proposed offering, whether prior to or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus. Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.
Prior to the new rule, “well-known seasoned issuers,” or WKSIs, could engage in similar test-the-waters communications, but smaller reporting companies that do not otherwise qualify as an EGC could not.
An EGC may utilize the test-the-waters provision with respect to any registered offerings that it conducts while qualifying for EGC status. Test-the-waters communications can be oral or written. An EGC may also engage in test-the-waters communications with QIBs and institutional accredited investors in connection with exchange offers and mergers. When doing so, an EGC would still be required to make filings under Sections 13 and 14 of the Exchange Act for pre-commencement tender offer communications and proxy soliciting materials in connection with a business combination transaction.
There are no form or content restrictions on these communications, and there is no requirement to file written communications with the SEC. During the first year or two following enactment of the JOBS Act, the SEC staff regularly asked to see any written test-the-waters materials during the course of the registration statement review process, but eventually these requests ceased. The SEC staff maintains the right to ask to review test-the-waters, or any, communications made by a company during the S-1 review process.
The new rules expand the test-the-waters provisions currently available to EGCs, to all companies. In particular, Securities Act Rule 163B permits any issuer, including investment companies, or any person authorized to act on its behalf, to engage in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or IAIs, either prior to or following the filing of a registration statement, to determine whether such investors might have an interest in a contemplated registered securities offering. The rule is a non-exclusive, and an issuer can rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate related to a contemplated securities offering.
The rule does not require a filing with the SEC or any particular legend on the communications. Like other communications during a registration process, the test-the-waters communications must be consistent with, and cannot conflict with, the information in a related registration statement. The communications are considered “offers” and accordingly anti-fraud provisions, such as Section 12(a)(2) and 10(b), still apply to such communications.
Companies that are subject to Regulation FD will need to be cognizant of whether any information in a test-the-waters communication would trigger a disclosure obligation under Regulation FD and make the required disclosure accordingly. As a reminder, Regulation FD requires that companies take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Regulation FD requires the filing of a Form 8-K immediately prior to or simultaneously with the issuance of the information. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day.
Thoughts on the Rule
The SEC believes that by allowing more test-the-waters communications, companies will be encouraged to participate in public markets which, in turn, promotes more investment opportunities for more investors and improves transparency and resiliency in the marketplace. Furthermore, added communication can enhance the ability of issuers to conduct successful offerings and lower the cost of capital. I agree, but it is not enough. Although the rule change is certainly welcome, I would advocate for a rule amendment that not only expands test-the-waters communications for all issuers but that broadens the category of potential investor that could be the subject of such communications, to include all accredited investors, and for offerings under $50 million, to include all investors analogous to Regulation A.
In its proposal release, the SEC noted that the 2015 modernization of Regulation A, which allows companies to test the waters with all potential investors, without restriction as to the type of investors, has helped modernize the Securities Act communication rules. I have trouble understanding why the SEC is comfortable with the unfettered Regulation A test-the-waters communications, but is limiting offerings registered under the Securities Act to qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”). Certainly the potential total investor loss is limited in a Regulation A offering (with the high end maxing out at $50 million for a Tier 2 offering) and Regulation A communications require specified disclaimers and filing with the SEC, but I still find it to be a disconnect.
In the final rule release, on several occasions, the SEC points out that QIBs and IAIs are sophisticated and do not need the protections of the Securities Act. I believe that the current change is in line with a conservative “incremental change” approach. A next-step middle ground could be to require any test-the-waters communications that are made available to potential investors that are not QIBs or IAIs to contain a specified legend and be filed with the SEC. That way, a company embarking on an offering could decide if it wants to take on the filing liability under Section 11 of the Securities Act or limit its test-the-waters communications to QIBs and IAIs.
Ultimately, I would like to see unlimited test the waters for any offering that is $50 Million or under, or whatever the Regulation A upper limit is at that time, if increased. An S-1 or other registered offering under the Securities Act has more robust disclosures than a Form 1-A and requires additional follow on disclosure obligations under the Exchange Act. The small cap IPO market, once active, is practically non-existent in today’s world and without it, our economy and Main Street investors will suffer. As a result of multiple factors including the devastating blow of large cap IPO failures like WeWork, Pelaton and Uber together with our shifting capital markets and the regulatory burdens for trading in lower priced securities small cap investment banking houses have no outlet for small cap IPO’s.
I firmly believe that if unlimited test the waters communications were allowed in a regular S-1 IPO, it would encourage bankers to work with small cap companies and help invigorate the market place. Although Regulation A is great, and a I am big advocate and fan, a Regulation A offering does not operate the same as a registered offering on the back-end such as closing through a clearing firm (T+2) or utilizing greenshoe overallotment options with market support. By limiting open test the waters for offerings up to $50 million, a small cap company could have the same benefits of a Regulation A offering with the additional investor protections associated with a standard registered IPO.
As anticipated, on September 26, 2019, the SEC published proposed amendments to Securities Exchange Act (“Exchange Act”) Rule 15c2-11. The purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities. The SEC release also includes a concept release regarding information repositories and a possible regulatory structure for such entities. The SEC believes the proposed amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors.
The proposed rules entail a complete overhaul of the rule and its exceptions are complicated and, if enacted, will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system. I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks.
Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent micro-cap fraud. The last substantive amendment was in 1991. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through.
I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA.
The specific information required to be maintained by the broker-dealer is delineated in Exchange Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv). In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.
The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.
The SEC’s proposed rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies. However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity). Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company.
The proposed rules: (i) require that information about the company and the security be current and publicly available; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; and (iv) streamline the rule and eliminate obsolete provisions.
The proposed rule release adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.
Current Public Information Requirements
The proposed rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed. In addition, the amendment will restructure and renumber paragraphs and subparagraphs.
The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the proposed rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.
The information that needs to be reviewed depends on the category of company and in particular (i) a company subject to the Exchange Act reporting requirements; (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer and (v) all others (catch-all category).
Regardless of the category of company, the broker-dealer, and OTC Markets if they are doing the review, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.
Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the only broker-dealer that actively submits Form 211 applications does complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. If the execution of the new rule matches its language, it will benefit the process greatly and possibly encourage more broker-dealers to offer OTC Markets’ quotations.
Information will be deemed publicly available if it is on the EDGAR database or posted on the OTC Markets (or other qualified IDQS), a national securities association (i.e., FINRA), or the company’s or a registered broker-dealer’s website. The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.
Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule will have a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.
The proposed rule will add specifics as to the date of financial statements. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.
The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify additional company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors. In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.
The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security.
Piggyback and Unsolicited Quote Exception Changes
There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception. The proposed rule will amend the piggyback exception to: (i) require that information be current and publicly available; (ii) limit the piggyback exception to priced bid and ask (two-way) quotations; (iii) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (iv) eliminate the piggyback exception for shell companies; and (v) revise the frequency of quotation requirement. To reduce some of the added burdens of the rule change, the SEC would allow a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of an exception have been met.
As discussed above, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme. The SEC proposes to only allow reliance on the piggyback exception when current public information is available. I think this will have a significant impact on micro-cap fraud.
The elimination of the piggyback exception for shell companies will likewise have a huge effect on the microcap space and instances of micro-cap fraud. The SEC intends this amendment to prevent shell companies from maintaining a quoted market. A broker-dealer will be prohibited from relying on the piggyback exception to publish or submit a quotation for a security of a company that meets the definition of a shell company. The proposed amendments will include a definition of a shell company which is the same as the definition in Rule 144: “any issuer, other than a business combination related shell company as defined in Rule 405 of Regulation C, or an asset-backed issuer, as defined in Item 1101(b) of Regulation AB, that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.”
The SEC notes that there are perfectly legal and valid reverse-merger transactions. My firm has worked on many reverse-merger transactions over the years. Obviously if passed, this rule change will have a significant effect on the reverse-merger market. I think the rule change sounds good on paper, and that a business engaged in a going public transaction should not bulk at either a Super 8-K or a 15c2-11 process. I do have concerns about the process and FINRA’s lengthy merit review of Form 211 filings, but perhaps these rule changes would give FINRA more confidence in its broker-dealer members and OTC Markets when they perform the review, making the process less arduous once submitted to FINRA.
A company would not be considered a shell simply because it is a start-up or has limited operating history. However, the onus will be on the broker-dealer to remain vigilant regarding whether they may rely on the piggyback exception if the company becomes a shell or falls into shell status. To help reduce the obvious burden on broker-dealers imposed by this proposed rule change, the rules will allow a broker-dealer to rely on a publicly available determination by a qualified IDQS (OTC Markets) or a national securities association (FINRA) that the securities are eligible for the piggyback exception. When up and running, I would hope that OTC Markets would add “piggyback qualified” or not, to each company’s quote page. I would hope the same for FINRA but do not foresee that occurring.
The SEC’s proposed rule only requires that companies that fall within the “catch-all” category have current public information for reliance on the piggyback exemption, since other categories of issuers have current public information by definition and thus adding the requirement to those categories would be redundant.
The requirement limiting the piggyback exception for the first 60 calendar days after a trading suspension will not likely have a market impact. A trading suspension over 5 days currently results in the loss of the piggyback exception and requirement to file a new Form 211. In practice, the SEC issues ten-day trading suspensions on OTC securities, and there is no broker-dealer willing to file a new 15c2-11 within 60 days thereafter in any event. In fact, in reality, it is a rarity for a company to regain an active Form 211 after a trading suspension. Perhaps that will change with implementation of the new rules.
The proposal would eliminate the 12-day requirement in the piggyback exception. Currently if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may rely on the piggyback exception. As proposed, for a broker-dealer to rely on the piggyback exception, the quoted OTC security would need to be the subject of two-way priced quotations within the previous 30 calendar days, with no more than four business days in succession without a quotation.
The existing rule excepts from the information review requirement the publication or submission of quotations by a broker-dealer where the quotations represent unsolicited customer orders. Under the proposed rule, a broker-dealer would need to determine that there is current publicly available information. If no current available information exists, the unsolicited quotation exception is not available for company insiders including officers, directors and 10%-or-greater shareholders.
The proposed rule requires that documentation be maintained that supports a broker-dealer’s reliance on any exception to the rule, including reliance on third-party determinations that an exception applies.
Lower Risk Securities; New Exceptions
The proposed rule amendments also add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception (see discussion under current information above); and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met.
The proposed rule provides an exception for companies that are well capitalized and whose securities are actively traded. In order to rely on this exception, the OTC security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”). The company must also have current public information to rely on the exception.
The ADTV test requires that the security have a worldwide ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation. To satisfy the proposed ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade).
The asset test requires that the company have at least $50 million in total assets and unaffiliated stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end. This would cover both domestic and foreign issuers.
The proposal would add an exception to the rule to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This proposal may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.
This exception requires that the broker-dealer have the 211 current information in its possession and has a reasonable basis for believing the information is accurate and the sources of information are reliable. Since FINRA issues a ticker symbol, this new exception will still require the filing of a Form 211 (or new form generated by FINRA to facilitate the exception). Whether the process for an exception review is quicker or less arduous will remain to be seen.
The proposed rule will also add a provision excepting broker-dealers from the 211 information review requirement where a qualified IDQS (OTC Markets) complies with the information review requirements and the broker-dealer relies on that review. The broker-dealer would need to publish a quotation within 3 business days after the qualified IDQS makes its determination of compliance publicly available. The proposed exception, however, would not be available if the issuer of the security to be quoted is a shell company, or 30 calendar days after a broker-dealer first publishes or submits such quotation, on OTC Markets, in reliance on this exception.
Once OTC Markets has complied with the rule’s information review requirement and made a publicly available determination that the requirements have been met, any broker-dealer could quote the security in the 30-day window. If the stock becomes frequently quoted during that 30-day window, the piggyback exception could then become available for continued quotation; otherwise, a new review or exception would need to be complied with. This is a win for OTC Markets, which included this as one of its suggestions in its comment letter to the SEC on the subject in January of 2018.
The SEC amendments also propose to allow a broker-dealer to rely on a determination by a qualified IDQS (OTC Markets) or national securities association (FINRA) that an exception to the rule is available as long as the broker-dealer determines that current public information is available or that they rely on OTC Markets’ or FINRA’s determination that such information is available. To facilitate a broker-dealer’s reliance, OTC Markets or FINRA must represent in a publicly available determination that it has reasonably designed written policies and procedures to determine whether information is current and publicly available, and that the conditions of an exception are met.
The proposed amendments require that the broker-dealer, OTC Markets and FINRA keep records regarding the basis of its reliance on, or determination of availability of, any exception to the rule.
Miscellaneous Amendments to Streamline
The SEC has also proposed numerous miscellaneous changes to streamline the rule and eliminate obsolete provisions. The miscellaneous changes include: (i) allowing a broker-dealer to provide an investor that requests company information with instructions on how to obtain the information electronically through publicly available information; (ii) updated definitions; and (iii) the elimination of historical provisions that are no longer applicable or relevant.
I’m happy that the SEC is reviewing the 211 process and attempting to improve the system, especially allowing the OTC Markets itself to conduct a review, submit a Form 211 directly to FINRA and determine the availability of an exception; however, I would like to see additional changes. In particular, the proposing release did not address the prohibition on broker-dealers, or now, OTC Markets, charging a fee for reviewing current information, confirming the existence of an exemption and otherwise meeting the requirements of Rule 15c2-11. The process of reviewing the information is time-consuming and the FINRA review process is arduous. Although not in the rule, FINRA in effect conducts a merit review of the information that is submitted with the Form 211 application and routinely drills down into due diligence by asking the basis for a reasonable belief that the information is accurate and from a reliable source. Most brokerage firms are unwilling to go through the internal time and expense to submit a Form 211 application. In fact, in reality, there is really only one that does so consistently. I believe the SEC needs to allow broker-dealers and OTC Markets to be reimbursed for the expense associated with the rule’s compliance.
On June 18, 2019, the SEC issued a 211-page concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework. The concept release seeks input on whether changes should be made to improve the consistency, accessibility, and effectiveness of the SEC’s exemptions for both companies and investors, including identifying potential overlap or gaps within the framework. See HERE for my blog on the release. As the topic of private exemptions becomes front and center, it is a good time to blog about the most commonly used of those exemptions, Rule 506.
Ever since the National Securities Markets Improvement Act of 1996 (“NSMIA”) amended Section 18 of the Securities Act to pre-empt state blue sky review of specified securities and offerings including offerings made in reliance on Rule 506 of Regulation D under the Securities Act of 1933 (“Securities Act), the vast majority of private capital raises are completed relying on Rule 506. For more information on the NSMIA, see HERE and HERE.
As I have repeated many times, all sales of securities must either be registered in accordance with the Securities Act or have an available exemption from registration. Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering, from the Act’s registration requirements. The Supreme Court case of SEC v. Ralston Purina Co. and its progeny Doran v. Petroleum Management Corp. and Hill York Corp. v. American Int’l Franchises, Inc. together with Securities Act Release No. 4552 set out the criteria for determining whether an offering is public or private and therefore the availability of Section 4(a)(2). In order to qualify as a private placement, the persons to whom the offer is made must be sophisticated and able to fend for themselves without the protection of the Securities Act and must be given access to the type of information normally provided in a prospectus.
Furthermore, all facts and circumstances must be considered including the relationship between the offerees and the issuer, and the nature, scope, size, type, and manner of the offering. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Purchasers receive restricted securities which can only be resold in accordance with a registration exemption. Regulation D itself does not provide for any resale exemptions and is only available for the issuance and sale of securities by the issuer. Historically a private offering always prohibited general solicitation or advertising.
Rule 506 is “safe harbor” promulgated under Section 4(a)(2). That is, if all of the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with. An issuer can rely directly on Section 4(a)(2) without regard to Rule 506; however, Section 4(a)(2) alone does not pre-empt state law and thus requires blue sky compliance.
Effective September 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors, provided however that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and this adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering.
At the same time, the SEC imposed bad actor disclosure and disqualification provisions to the rules. The bad actor provision disqualifies the use of Rule 506 as a result of certain convictions, cease and desist orders, suspensions and bars (“disqualifying events”) that occur on or after September 23, 2013, and adds disclosure obligation in Rule 506(e) for disqualifying events that occurred prior to September 23, 2013 (see HERE).
Offerings under both Rule 506(b) and 506(c) must satisfy the conditions of Rule 501 (definitions), 502(a) (integration), 502(d) (limitations on resale), and 506(d) (bad actor disqualifications). In addition, offerings under Rule 506(b) must satisfy the conditions of Rule 502(b) (type of information to be furnished) and 502(c) (limitation on the manner of offering). The offerings are also subject to the anti-fraud provisions of the federal securities laws. Furthermore, Rule 503 requires the filing of a Form D for all Rule 506 offerings, though an SEC C&DI has found that the failure to make such filing does not result in a loss of the offering exemption.
Rules Applicable to Both Rule 506(b) and 506(c) Offerings
Offerings under both Rule 506(b) and 506(c) must satisfy the conditions of Rule 501 (definitions), 502(a) (integration), 502(d) (limitations on resale), and 506(d) (bad actor disqualifications).
Rule 501 – Definitions
Rule 501 contains definitions application to all Regulation D offerings. The definitions most important to Rule 506 offerings include:
- Accredited Investor – see HERE for a summary of the definition of an accredited investor and the SEC concept release on same.
- Affiliate – An affiliate of, or person affiliated with, a specified person shall mean a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified.
- Purchaser representative. Purchaser representative shall mean any person who satisfies all of the following conditions or who the issuer reasonably believes satisfies all of the following conditions: (i) Is not an affiliate, director, officer or other employee of the company, or beneficial owner of 10% or more of the equity interest in the company, except where the purchaser is: (a) A relative of the purchaser representative by blood, marriage or adoption and not more remote than a first cousin; (b) A trust or estate in which the purchaser representative and any persons related to him collectively have more than 50% of the beneficial interest or of which the purchaser representative serves as trustee, executor, or in any similar capacity; or (c) A corporation or other organization of which the purchaser representative and any persons related to him collectively are the beneficial owners of more than 50%of the equity securities (excluding directors’ qualifying shares) or equity interests; (ii) Has such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment; (iii) Is acknowledged by the purchaser in writing, during the course of the transaction, to be his purchaser representative in connection with evaluating the merits and risks of the prospective investment; and (iv) Discloses to the purchaser in writing a reasonable time prior to the sale of securities to that purchaser any material relationship between himself or his affiliates and the issuer or its affiliates that then exists, that is mutually understood to be contemplated, or that has existed at any time during the previous two years, and any compensation received or to be received as a result of such relationship.
Rule 502(a) – Integration
All sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. Offers and sales that are made more than six months before the start of a Regulation D offering or are made more than six months after completion of a Regulation D offering will not be considered part of that Regulation D offering, so long as during those six month periods there are no offers or sales of securities by or for the issuer that are of the same or a similar class as those offered or sold under Regulation D, other than those offers or sales of securities under an employee benefit plan.
Unless there is a specific safe harbor or rule exemption, such as the six-month rule, the following five factors should be considered in making an integration analysis: (i) whether the sales are part of a single plan of financing; (ii) whether the sales involve issuance of the same class of securities; (iii) whether the sales have been made at or about the same time; (iv) whether the same type of consideration is being received; and (v) whether the sales are made for the same general purpose.
Rule 502(d) – Limitations on Resale
Securities issued in a Rule 506 offering are “restricted” and as such may only be resold if registered with the SEC or there is an available exemption from registration. The company relying on the Rule 506 exemption must exercise reasonable care to ensure that the purchasers of the securities are not underwriters planning to engage in a distribution of the securities. To satisfy their reasonable care requirement, a company can (i) make reasonable inquiry to determine if the purchaser is acquiring the securities for their own use or for other persons; (ii) require written disclosure to each purchaser prior to the sale that the securities have not been registered and, therefore, cannot be resold unless they are registered under the Securities Act or an exemption from registration is available; and (iii) place a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Securities Act and setting forth or referring to the restrictions on transferability and sale of the securities. In addition, the issuer in a Rule 506(b) offering is required to disclose the resale limitations to any non-accredited investors.
Rule 506(d) – Bad Actor Disqualifications
Rule 506 provides that disqualifying events committed by a list of specified “covered persons” affiliated with the issuer or the offering would result in disqualification from using Rule 506 or require disclosure to investors prior to their purchasing securities. It is a company’s obligation to determine whether it or any of the covered persons discussed below fall within the bad actor rules. In particular, covered persons include:
- The issuer and any predecessor of the issuer or affiliated issuer;
- Any director, general partner or managing member of the issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);
- Any beneficial owner of 20% or more of the outstanding equity securities of the issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting);
- Investment managers of Issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering; general partners and managing members of such investment managers; the directors and executive officers of such general partners; and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);
- Any promoter connected with the Issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);
- Any person who has been or will be paid, either directly or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
- Any director, officer, general partner, or managing member of any such compensated solicitor.
Disqualifying events include:
- Criminal convictions (felony or misdemeanor) within the last five years in the case of Issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Final orders issued by a state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, or the National Credit Union Administration that, at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
- Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203€ or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
- Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
- Suspension or expulsion from membership in, or suspension or bar from association with, a member of an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
- Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
- U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.
The rule includes an exception from disqualification for offerings in which the company establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a covered person. Moreover, the SEC can grant a waiver of disqualification if it determined that the issuer has shown good cause that disqualification is not necessary under the circumstances. For more on the bad actor rules, see HERE.
Filing Requirements/State Blue Sky Laws
Rule 503 requires the filing of a Form D for all Rule 506 offerings within 15 days of the first sale of securities. However, an SEC C&DI has found that the failure to make such filing does not result in a loss of the offering exemption.
As long as an offering meets the requirements of Rule 506, NSMIA pre-empts state law such that the company is not required to register or qualify the offering with state securities regulators. The offering does, however, remains subject to state law enforcement and anti-fraud authority. States may also require notice filings and the payment of a filing fee. See links to my blogs on NSMIA and state blue sky laws at the beginning of this blog.
Companies conducting an offering under Rule 506(b) can sell securities to an unlimited number of accredited investors with no limit on the amount of money that can be raised from each investor or in total. In addition to complying with all the criteria and conditions applicable to both 506(b) and 506(c) offerings, an offering under Rule 506(b): (i) prohibits general solicitation or advertising to market the offering; (ii) limits the number of unaccredited investor purchasers to no more than 35 and such investors must, either alone or with a purchaser representative, have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment; and (iii) requires the delivery of specified disclosures where even one unaccredited investor is included.
General Solicitation and Advertising
The Rules do not define “general solicitation” or “advertising” but do provide some examples, such as advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. Offering information posted on an unrestricted website or social media would also be considered a general solicitation.
A company may offer and sell securities to persons with whom it, or anyone acting on its behalf, has a pre-existing substantial relationship, without being deemed to have engaged in general solicitation or advertising. A “pre-existing” relationship is one that the company, or someone acting on the company’s behalf such as through a broker-dealer or investment adviser, has formed with the prospective investor prior to the commencement of the offering. The existence of a pre-existing relationship depends on facts and circumstances.
The absence of a pre-existing relationship does not automatically make a communication a general solicitation or advertisement under Regulation D. For example, a company may solicit prospective investors they are introduced to who are members of an informal, personal network of individuals or investors, such as angel investor groups. As a rule of thumb, if all members of the group or network are sophisticated and experienced in the type of investment being offered, members can be solicited without triggering the solicitation and advertisement rules under Regulation D. Moreover, the higher the number of persons without financial experience, sophistication, or prior personal or business relationships with the company that are solicited, the greater the chance that it will be deemed a general solicitation of the offering.
For a discussion on what constitutes a general solicitation including SEC guidance on the topic, see my blog HERE.
If a company plans to offer or sell securities to unaccredited investors in a 506(b) offering, it must provide the disclosures required by Rule 502(b). Although the rules only require that information be furnished to unaccredited investors, in light of the anti-fraud provisions, in practice, when a company puts together a disclosure package, it should be provided to all investors. Moreover, if any information is provided to accredited investors, even if not technically required by the disclosure obligations, it must also be provided to unaccredited investors. Like disclosures in SEC filings, only material information should be provided.
All information must be provided prior to the sale of securities. Specific disclosure must be made regarding resale limitations and other restrictions on transferability. The company must also make available to each purchaser at a reasonable time prior to his purchase of securities the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the company possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of information furnished under the rules.
If a company is subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), its SEC reports, including all reports, schedules and filings up to the date of the offering, will satisfy any information requirements. Foreign private issuers eligible to use Form 20-F can provide the information that would be required in that form. For business combinations and exchange offers, the information required by Form S-4 would satisfy the disclosure requirements.
The exhibits that would normally be filed with the SEC need not be included in the offering package, but they must be made available to an investor upon request, and the exhibits must be identified and described in the disclosure document.
If a company is not subject to the Exchange Act reporting requirements, it needs to provide:
Non-Financial Information – If the company is eligible to use Regulation A, the same kind of information as would be required in Part II of Form 1-A or if the company is not eligible to use Regulation A, the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the company would be entitled to use.
Part II of Form 1-A is similar to the prospectus in a registration statement. Part II requires disclosure of basic information about the company and the offering; material risks; dilution; plan of distribution; use of proceeds; description of the business operations; description of physical properties; discussion of financial condition and results of operations (MD&A); identification of and disclosure about directors, executives and key employees; executive compensation; beneficial security ownership information; related party transactions; description of offered securities; and two years of financial information.
The required information in Part II of Form 1-A is scaled down from the requirements in Regulation S-K applicable to Form S-1. Companies can complete Part II by either following the Form 1-A disclosure format or by including the information required by Part I of Form S-1 or Form S-11 as applicable. Part I of a registration statement requires the same categories and types of information but with more robust disclosures.
Financial Information – The financial statement requirements depend on the amount of the offering. All financial statements must be prepared in accordance with U.S. GAAP. For offerings up to $2,000,000, the same financial statements that are required of a smaller reporting company (Article 8 of Regulation S-X) are required except that only the balance sheet, which must be dated within 120 days of starting the offering, must be audited. Generally this means two years of financial statements (or from inception) and quarterly periods to date.
For offerings up to $7,500,000, the same financial statements that are required of a smaller reporting company (Article 8 of Regulation S-X) are required. This would include two years of audited financial statements (or from inception) and reviewed quarterly financial statements to date. However, if the company cannot obtain audited financial statements without unreasonable effort or expense, then only the company’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.
For offerings over $7,500,000, the full financial statements that would be required in a registration statement must be included. For a smaller reporting company, this would be the same financial statements as for offerings over $2,000,000 but below $7,500,000. As with other categories, if the company cannot obtain audited financial statements without unreasonable effort or expense, then only the company’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and this adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Companies conducting an offering under Rule 506(c) can sell securities to an unlimited number of accredited investors with no limit on the amount of money that can be raised from each investor or in total. I’ve written many times about Rule 506(c) including as the SEC came out with a fairly steady flow of guidance in the months after its first adoption. See this blog, which contains links to prior blogs on the subject HERE.
Accredited Investor Verification
Rule 506(c) provides a principles-based method for verification of accredited investor status as long as the steps are reasonable, as well as a non-exclusive list of verification methods. Whether the steps taken are reasonable would be an objective determination, based on the particular facts and circumstances of each transaction. Among the factors that companies should consider under the facts-and-circumstances analysis are:
- The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker-dealer registered with the SEC, verification could be a simple check on the FINRA website. The harder status to verify is a natural person claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements.
- The amount and type of information that the company has about the purchaser. Clearly, the more information, the better. The SEC lists the obvious (W-2; tax returns; letters from a bank or broker-dealer). Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.
- Nature and terms of the offering, such as type of solicitation and minimum investment requirements. For example, is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former. The greater the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.
After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.
Examples of the type of information that companies can review and rely upon include:
(i) Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages);
(ii) Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and
(iii) Third-party accredited investor verification service providers.
Moreover, non-exclusive methods of verification include:
- Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
- Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
- Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
- A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.
Related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property. The SEC has provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. However, if the evidence is at all questionable, further inquiry should be made.
Although the review of tax returns filed in a foreign country does not qualify under the verification safe harbors in the rule, a company could rely on foreign tax returns if the laws of that jurisdiction provide penalties similar to the laws of the IRS for making a false statement.
In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors. In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC 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, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with 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; 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 American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA 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 small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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