Monthly Archives: January 2020
In late 2019, the SEC published its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, and for several years I have blogged about each publication.
Like the prior Agendas, the spring 2019 Agenda is broken down by (i) “Pre-rule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame has increased with 47 items as compared to 40 on the spring 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. Only one item is listed in the fall 2019 pre-rule state and that is portfolio margining harmonization. The only item that had been on the spring 2019 agenda in the pre-rule category was the harmonization of exempt offerings which moved to the proposed rule stage after the SEC published a concept release in June 2019 (see HERE).
Thirty-one items are included in the proposed rule stage, up from 22 on the spring list. Items include amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019); broker-dealer reporting, audit and notifications requirements and three amendments to Regulation NMS.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, remains on the proposed rule list. The SEC proposed amendments to Rule 15c2-11 in late September (see HERE) after several speeches setting the stage for a change. 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, and in the latter I talked about SEC Chairman Jay Clayton’s and Director of the Division of Trading and Markets Brett Redfearn’s speeches on the subject. Comments and responses to the proposed rules have been voluminous and largely negative. The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. However, parts of the proposed rule changes are very good and would be hugely beneficial to this broken system. At this point it is unclear as to the future of these much-needed changes.
Other items that first appeared on the spring agenda and have been gaining some traction and that are listed on the proposed rule stage include: (i) proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); and (ii) amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE). Both proposed rules have been controversial but should proceed to final within the planned 12 months. Also first proposed in spring and still on the proposed rule list are amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendment to MD&A were adopted in March 2019 (see HERE)
Continuing the SEC’s disclosure effectiveness initiative, the proposed rules include modernization and simplification of disclosures regarding description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE).
Earnings releases and quarterly reports were on the fall 2018 pre-rule list and then moved to long-term on the spring 2019 list. The topic is back on the proposed rule list. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments to Rule 701 (the exemption from registration for securities issued by non-reporting companies pursuant to compensatory arrangements), and Form S-8 (the registration statement for compensatory offerings by reporting companies) remain on the proposed rule list. The SEC has recently amended the rules and issued a concept release (see HERE and HERE) and appears committed to enacting much-needed updates and improvements to the rules.
Highly debated and much needed, the amendments to the accredited investor definition moved from the long-term list to the proposed rule stage. The SEC published its report on the definition of accredited investors back in December 2015 (see HERE) and finally issued a proposed rule in December 2019 (see HERE). As mentioned in my blog on the subject, as a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections.
Other items moved up from long-term to proposed-rule stage include executive compensation clawback (see HERE) and clawbacks of incentive compensation at financial institutions. Clawback rules would implement Section 954 of the Dodd-Frank Act and technically require that national securities exchanges require clawback provisions as a listing qualification. Also moved up from the long-term list are amendments to Guide 5 on real estate offerings and Form S-11, Regulation Crowdfunding amendments, and Regulation A amendments.
New to the list, appearing in the proposed rule category are amendments to Form 13F filer thresholds, investment company summary shareholder report, and registration of investment advisers to rural business investment companies.
Remaining on the proposed rule list is bank holding company disclosures (proposed rules published in September 2019); filing fee processing updates (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019); use of derivatives by registered investment companies and business development companies; amendments to marketing rules under the Advisors Act; amendments to the custody rules for investment advisors; procedures for investment company act applications; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and market data distribution and market access.
Amendments to the transfer agent rules remains on the proposed rule list although it has been almost four years since the SEC published an advance notice of proposed rulemaking and concept release on new transfer agent rules (see HERE). SEC top brass speeches suggest that this will finally be pushed over the finish line this year (see HERE, for example).
Sixteen items are included in the final rule stage, reduced from 18 on the spring list. Financial disclosures about acquired businesses has moved to the final rule stage with amendments having been proposed in May 2019 (see HERE). The matter has been an open item for several years (see HERE).
Also included in the final rule stage are amendments to the financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE). Although still on the final rule list, the SEC adopted final amendments extending testing-the-waters provisions to non-emerging growth companies in October 2019 (see HERE)
Amendments to the definition of an accelerated filer has moved up from the proposed rule stage to final rule stage (see HERE for the proposed rule changes). Fund of fund arrangements (proposed rules were issued in December 2018), offering reform for business development companies (proposed rules published in March 2019), amendments to Title VII cross-border rules (final rules adopted in September 2019), and customer margin requirements for securities futures (proposed rules published in July 2019) have also moved up from proposed to the final rule stage.
Other items still in the final rule stage include rules related to exchange-traded funds (ETF) (for basic information on ETFs, see HERE), disclosure for unit investment trusts and offering variable insurance products, recordkeeping and reporting for security based swap dealers (new rules were adopted in September 2019), a new definition for covered clearing agency (last amended in September 2016), risk mitigation techniques (new rules were adopted on December 18, 2019), amendments to the whistleblower program, amendments to the SEC’s Rules of Practice and prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds (new rules adopted in November 2019).
Several items have dropped off the final rule list as they have now been implemented and completed, including implementation of FAST Act report recommendations (see HERE); the controversial Regulation Best Interest, which was adopted in June 2019; amendment to the single issuer exemption for broker-dealers which was adopted in June 2019; auditor independence with respect to loans or debtor-creditor relationships adopted in June 2019; amendments to the single issuer exemption for broker-dealers adopted in June 2019; amendments to the rule for nationally recognized statistical rating organizations adopted in August 2019; and amendments to the Volcker Rule which were implemented in August 2019.
Thirty-seven items are listed as long-term actions (down from 52), including many that have been sitting on the list for a long time now. Implementation of Dodd-Frank’s pay for performance (see HERE) has sat on the long-term list for several years now. Other items still on the long-term list include universal proxy (originally proposed in October 2016 – see HERE); and corporate board diversity (although nothing has been proposed, it is a hot topic); and the definitions of mortgage-related security and small-business-related security.
Also still on the long-term list (or added to the list) are numerous Dodd-Frank mandated provisions including additional proxy process amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); stress testing for large asset managers; prohibitions of conflicts of interest relating to certain securitizations; incentive-based compensation arrangements; removal of certain references to credit ratings under the Securities Exchange Act of 1934; conflict minerals amendments (being challenged in lengthy court proceedings on constitutional First Amendment basis); and covered broker-dealer provisions under Title II of Dodd-Frank.
New to the list are asset-backed securities disclosures (last amended in 2014); mandated electronic filings; Regulation AB amendments; modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; amendments to the Family Office Rule; amendments to Rule 17a-7 under the Investment Company Act concerning the exemption of certain purchase or sale transactions between an investment company and certain affiliated persons; broker-dealer liquidity stress testing, early warning, and account transfer requirements; additional changes to exchange-traded products; recordkeeping and risk controls specific to algorithmic trading; amendments to the rules regarding the consolidated audit trail; execution quality disclosure; credit rating agencies’ conflicts of interest; amendments to requirements for filer validation and access to the EDGAR filing system and simplification of EDGAR filings.
Also new to the list are a few electronic filing matters including electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports, and electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; Form 19b-4(e) by SROs that list and trade new derivative securities products; and Forms ATS and ATS-R regarding the initial, quarterly, and cessation of operation reports by ATSs.
Several swap-based rules remain on the long-term list or have been added to the list including ownership limitations and governance requirements for security-based swap clearing agencies, security-based swap execution facilities, and national exchanges; end user exception to mandatory clearing of security-based swaps; registration and regulation of security based swap execution facilities; and establishing the form and manner with which security-based swap data repositories must make security-based swap data available to the SEC.
Also remaining on the long-term action list are Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See HERE for more information.
Other interesting items on the long-term agenda are rule changes to short sale disclosure reforms and registration of alternative trading systems. Alternative trading systems have garnered interest for their potential use for securities token trading.
A public company with a class of securities registered under Section 12 or which is subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) must file Section 13 reports with the SEC (10-K, 10-Q and 8-K). A company becomes subject to Section 15(d) by filing a registration statement under the Securities Act of 1933, as amended (“Securities Act”) such as a Form S-1. A company registers securities under Section 12 by filing an Exchange Act registration statement such as on Form 10, Form 20-F or Form 8-A.
The Section 15(d) reporting requirements are scaled down from the Exchange Act reporting requirements for a company with a class of securities registered under Section 12. In particular, a company that is only subject to Section 15(d) need only comply with the Section 13 reporting obligations and need not comply with the federal proxy rules and third-party tender offer rules in Section 14, the officer/director and 10% shareholder reporting requirements in Section 16 or the 5% or greater shareholder reporting requirements in Sections 13(d), (g) and (f) of the Exchange Act.
This blog addresses suspending the duty to file reports under Section 15(d) and determining voluntary filer status. In a separate blog I will discuss the termination of registration under Section 12.
Suspension of Reporting Obligations
The duty to file reports under Section 15(d) can only be suspended and not terminated. To the contrary, registration under Section 12, and accordingly the requirement to file reports as a Section 12 registrant, can be terminated. However, even if a Section 12 reporting obligation is terminated, a Section 15(d) obligation remains, and even if temporarily suspended, can be resurrected when the fact basis for suspension changes.
The duty to file reports under Section 15(d) is automatically suspended: (i) If the company has a class of securities registered under Section 12 of the Exchange Act and is thus separately subject to the reporting requirements due to that registration; or (ii) on the first day of any fiscal year, other than the fiscal year in which a Securities Act registration statement became effective, in which the company has fewer than 300 record security holders.
Exchange Act Rule 15d-6 requires that a company whose duty to file reports is suspended because they have fewer than 300 shareholders as of the first day of their fiscal year-end, file a Form 15 within 30 days of the beginning of the fiscal year to inform the SEC of the suspension of the duty. SEC C&DI confirms that this notice is not a condition to the automatic suspension. In practice, very few companies actually file a Rule 15d-6 Form 15. Moreover, in practice, many companies voluntarily continue to file SEC reports even though the duty to do so has been statutorily suspended.
In addition, the duty to file reports may be voluntarily suspended, at any time, by the filing of a Form 15 upon meeting certain conditions. Exchange Act Rule 12h-3 provides that the duty to file reports under Section 15(d) is immediately suspended upon the filing of a Form 15 if the company has filed all SEC reports for the shorter of the prior three fiscal years and stub periods to date or since the company became SEC filing if the prerequisite conditions are met. If the Form 15 is subsequently withdrawn or denied, the company has 60 days to file any SEC reports not filed following the filing of the Form 15.
In addition to being current in SEC reporting at the time of filing a Form 15, in order to qualify to voluntarily suspend reporting obligations, the company must (i) have fewer than 300 shareholders of record or, if a bank holding company, have fewer than 1,200 shareholders of record; or (ii) have fewer than 500 shareholders of record and less than $10 million in assets on the last day of each of the company’s three most recent fiscal years.
A company may not voluntarily suspend Section 15(d) reporting obligations in reliance on Rule 12h-3 during a fiscal year in which a Securities Act registration statement goes effective or a company is required to file a Section 10(a)(3) prospectus update. Furthermore, a company cannot rely on the fewer than 500 shareholders and less than $10 million in assets provision if a Securities Act registration statement went effective or required a Section 10(a)(3) update in the succeeding two fiscal years. The rule specifically provides that these timing conditions do not apply for certain holding company restructures where the company has no significant assets and shares are issued pro rata. Moreover, the SEC has provided interpretative guidance with certain carve-outs to the rule.
A Section 10(a)(3) prospectus update is required to be filed to maintain the effectiveness of a Securities Act registration statement used for a continuous offering or under which securities may be offered from time to time. A Form S-3, Form S-8 and, in some instances, a Form S-1 can be used as shelf registrations that automatically forward incorporate Exchange Act reports by reference such that an annual Form 10-K acts as a post-effective amendment and Section 10(a)(3) update (for more on incorporation by reference, see HERE). If a company has an open Securities Act registration statement, it would not be able to file a Form 15 to voluntarily suspend reporting obligations unless it first filed a post-effective amendment to the registration statement to deregister any unsold shares or, if no shares had been sold, an application to withdraw the registration statement.
Analyzing the ability to file a Form 15 under Rule 12h-3 has resulted in the filing of numerous no-action letters, numerous compliance and disclosure interpretations, and the publication of SEC Staff Legal Bulletin No. 18 to provide guidance. The SEC has consistently found that a Rule 12h-3 Form 15 can be filed in a year in which a registration statement was declared effective or required to be updated under Section 10(a)(3) when all of the other conditions of Rule 12h-3 are met and where (i) a public offering is abandoned, no securities are sold under the effective registration statement and the company files a Rule 477 application to withdraw the registration statement; or (ii) the company is acquired resulting in the class of registered securities either being extinguished or held by only one record holder which is the acquiring entity. In both situations, the company has no public shareholders eliminating the purpose of requiring reporting. The SEC will not allow this concession to the rule where the company will continue to file SEC reports in any event such as voluntarily or as a result of a contractual obligation.
As an aside, when a Form 15 is filed to terminate registration under Section 12, only the duty to file reports under Section 13 is immediately terminated. The duty to file reports in accordance with the Section 14 proxy and tender offer rules, Section 16 officer/director and 10% shareholder and Section 13 5% or greater shareholder reporting does not terminate until 90 days after the filing of a Form 15. As noted above, a Section 15(d) company is not subject to those particular reporting obligations anyway.
The suspension of a duty to file reports is not a legal “termination” but rather is only a suspension. SEC Rule 12h-3 specifically provides that if a company no longer meets the legal requirements for an automatic suspension, or voluntary suspension, on the first day of its fiscal year, then the company must resume periodic reporting pursuant to Section 15(d) by filing an annual report on Form 10-K for its preceding year, not later than 120 days after the end of such fiscal year.
Determining Voluntary Filer Status
First, a company with a class of securities registered under Section 12 of the Exchange Act is never a voluntary filer. Assuming a company is not a Section 12 registrant, if the duty to file reports is automatically or voluntarily suspended and the company continues to file reports, that company is considered a voluntarily filer.
Securities Act Rule 144 sets forth certain requirements for the use of Section 4(a)(1) for the resale of securities. Rule 144 requires compliance with certain conditions, including a holding period. The length of the holding period is determined by whether the public company “has been for a period of at least 90 days immediately before the sale, subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act.” The holding period for a company that is subject to the reporting requirements is six months as opposed to one year for one that is not. A voluntary filer is not subject to the reporting requirements and therefore is subject to the longer one-year hold period. Accordingly, in order for a shareholder to calculate its required holding period under Rule 144, the shareholder (and any attorney writing a Rule 144 opinion letter) must determine whether the company is subject to the Exchange Act reporting requirements.
From a practical standpoint, there are some shortcuts for determining voluntary status. A company that files reports under Section 15(d) will have an SEC “File/Film Number” that begins with “333” (whereas a company that has a class of securities registered under Section 12 will have a number that begins with “000” or sometimes “001” or “005”). Upon quickly assessing if a company is a 15(d) filer, a practitioner should determine if a Securities Act registration statement was declared effective in the current fiscal year (not a voluntary filer) and if not, whether the company had fewer than 300 shareholders as of the first day of its current fiscal year (if less, voluntary). The latter answer generally must come from the company or the transfer agent.
If the company is not determined to be a voluntary filer based on the above, then it would only be a voluntary filer if it filed a Form 15 under Rule 12h-3. Even if a company meets the requirements and could voluntarily file a Form 15 at any time under Rule 12h-3, it would still be subject to the reporting requirements until it does so.
Determining Holder of Record
The calculation of shareholders of record for purposes of Section 15(d) and Rule 12h-3 is made in accordance with Exchange Act Rule 12g5-1. Generally each entity or custodian shareholder is counted as a single shareholder. That is, a broker, dealer, bank or nominee may be counted as a single shareholder, even if they hold shares on behalf of several different beneficial shareholders. In addition, persons that received the securities under an employee compensation plan that was exempt from U.S. registration may be excluded. Securities issued in a Regulation A, Tier 2 offering may also be excluded.
NYSE American Company Guide Rule 803 delineates the requirements independent directors and audit committees. NYSE American Company Guide Rule 802 requires that a majority of the board of directors of a listed company be “independent.” Rule 803 requires that all members of the audit committee be independent and defines independence and Rules 804 and 805 require that all directors on the nominating and compensation committees, if a company has such committees, be independent.
Under NYSE American Company Guide Rule 803, an “independent director” means a person other than an executive officer or employee of a company. The board of directors must make an affirmative finding that a director does not have a relationship which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director for that director to qualify as independent. However, the NYSE American rules specify certain relationships that would disqualify a person from being considered independent. Stock ownership is not on the list and is not enough, without more, to preclude independence.
Company Guide Rule 803 specifies that the following people cannot be considered independent:
(i) a director who is, or at any time during the past three years was, employed by the company, provided however, interim employment of less than one year would not be a disqualifier as long as such employment had since terminated. In addition, employment by an entity that was later acquired by the company would not disqualify a director from being independent provided the former officer was not employed by the company after the acquisition;
(ii) a director who accepted or who has a family member who accepted any compensation from the company in excess of $120,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than: (a) compensation for board or board committee service; (b) compensation paid to a family member who is an employee but not an executive of the company; (c) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (d) compensation received while acting as an interim officer as long as such employment lasted for less than a year and has since terminated. Options received for services should be valued using a commonly accepted option pricing formula, such as the Black-Scholes or binomial model at the time of grant. The option value is considered a payment upon grant even if the option does not immediately vest or if there are conditions to vesting or exercise. This prohibition is meant to capture any compensation that directly benefits the director or family member and as such would include political contributions to a campaign by either. However, it is not meant to capture ordinary course business transactions such as interest on an arm’s-length loan;
(iii) a director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer;
(iv) a director who is, or has a family member who is, a partner in (other than limited partner), or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (a) payments arising solely from investments in the company’s securities; or (b) payments under non-discretionary charitable contribution matching programs;
(v) a director of the company who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or
(vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.
Reference to the “company” includes parents and subsidiaries or any other entities that the company consolidates financial statements with, including variable interest entities. “Executive officer” refers to any person covered by SEC Rule 16a-1(f) and in particular the company’s president, principal financial officer, principal accounting officer, any vice-present in charge of a principal business unit, division or function or any officer or person who performs a policymaking function, which can include officers of a parent or subsidiary.
For purposes of Rule 803, “family member” means a person’s spouse, parents, children and siblings, mothers-in-law and fathers-in-law, sons-in-law and daughters-in-law, brothers-in-law and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home. This definition differs from the – see HERE.
Four years after issuing its report on the definition of “accredited investors” in December 2015, the SEC has published a proposed rule amendment to the definition. See HERE for my blog on the SEC’s report. The amendments were anticipated following an in-depth discussion on the definition contained in the SEC’s Concept Release on Private Offerings published in July 2019 (see HERE)
As a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. In the rule amendment release the SEC cites numerous comment letters suggesting and supporting many of the proposed amendments including one from the Crowdfunding Professionals Association (CfPA), Legislative & Regulatory Affairs Division, a committee I sit on and for which I participated in the preparation of the comment letter.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify including a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC is also proposing to amend the definition of a “qualified institutional buyer” under Rule 144a of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments would also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including rule 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows such investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2018 the estimated capital raised in rule 506 offerings was $1.7 trillion compared to $1.4 trillion in registered offerings. Of the $1.7 trillion, $1.5 trillion was raised by pooled investment funds and the balance directly by other businesses. The SEC has been talking about increasing access to this large and growing market sector for some time.
In November 2019 the topic was front and center at the Investor Advisory Committee meeting (see HERE). In my blog on the meeting, I suggested that access to private markets and private funds could be expanded by amending the definition of an “accredited investor” to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. The proposed amendments would do just that.
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
Any entity in which all of the equity owners are accredited investors.
The proposed amendments to the accredited investor definition would add new categories of natural persons based on professional knowledge, experience, or certifications. The proposed amendments would also add new categories of entities, including a catch-all category for any entity owning in excess of $5 million in investments. In particular, the proposed amendments would: (i) add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution; (ii) with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund; (iii) add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify; (iv) add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (v) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (vi) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The proposed amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test.
The proposed amendments to the qualified institutional buyer definition in Rule 144A would add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The proposed amendments would also add a catch-all category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
The proposed amendment would add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution. The added categories are intended to demonstrate an individual’s background and understanding in the areas of securities and investing and thus a reduced need for regulatory protection. The SEC believes that individuals with financial sophistication have the ability to balance risky investments, make risk assessments and avoid unsustainable losses.
The SEC proposes to include professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. The amendment would include a non-exclusive list of attributes the SEC would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
The SEC would issue an order designating professional certifications and designations or other credentials as qualifying for accredited investor status. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status would be posted on the SEC’s website.
The SEC also preliminarily anticipates including those that hold a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Also requiring that a list of individuals that hold the certifications be publicly available would reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC proposes to add a new category based on the person’s status as a “knowledgeable employee” of the fund. The private fund category is meant to encompass funds that rely on the exemptions found in Sections 3(c)(1) and 3(c)(7) from registration as an investment company under the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, if the knowledgeable employee does not qualified as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded. Accordingly, the SEC proposes to fill this gap and include knowledgeable employees of private funds in the amended definition of an accredited investor.
The SEC proposes to add a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent will be defined as a cohabitant in a relationship generally equivalent to a spouse. The rule will not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules would (i) add limited liability companies that were not formed for the specific purpose of making the investment, registered investment advisers and rural business investment companies (RBICs); (ii) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (iii) “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act, to the current list of entities that may qualify as accredited.
As mentioned above, these additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
Effective December 12, 2019, the OTC Markets has implemented changes to the initial and continued quotation requirements for companies listed on the OTCQX. The amendments (i) allow certain qualifying companies to use their regular securities counsel for a letter of introduction in place of an OTCQX sponsor; (ii) establish procedures for a company effecting a change of control; (iii) enhance corporate governance requirements, refine the definition of an “independent director,” and provide for a phase in for compliance with these new provisions; (iv) require Canadian companies to utilize a transfer agent participating in the Transfer Agent Verified Shares Program by April 1, 2020, and (iv) require U.S. companies to disclose all convertible debt.
Amended Rules for U.S. Companies
An SEC reporting company with a class of securities that has been publicly traded for at least one year may submit a written application to be exempted from the requirement to select an OTCQX sponsor. A company granted this exemption must submit a letter of introduction from their outside securities counsel in lieu of such a letter from an OTC Sponsor. Prior to adopting this rule amendment, only U.S. companies moving from a national exchange or with a separate class of securities trading on a national exchange qualified for the exemption.
A letter of introduction by outside securities counsel must state: (i) the securities counsel is licensed to practice law and in good standing in the U.S. and is not subject to any disciplinary actions within the last five years; (ii) the attorney is not currently subject to any sanctions resulting from disciplinary actions; (iii) the attorney is engaged by the company as its primary disclosure counsel and has assisted in the preparation of its most recent disclosure; (iv) other areas of engagement; (v) when engaged; (vi) that the attorney has reviewed information and made inquiries to satisfy itself that the company is in compliance with Exchange Act 12g3-2(b); (vii) the company is operating and is not a shell company; (viii) company is in good standing in each jurisdiction it conducts business; (ix) all of the company’s outstanding securities have been authorized and issued in accordance with the federal and state securities laws and are fully paid and non-assessable; (x) whether the company has been delisted, removed or suspended from a Qualifying Foreign Stock Exchange; and (xi) if the company is SEC or Regulation A reporting whether it is current in its reporting obligations.
Where outside securities counsel is used as a sponsor, the duties related to a sponsor and for the company to provide information to and seek input from such sponsor extend to the outside securities counsel.
Clarification of Penny Stock Exemption Eligibility Criteria
One of the qualifications to trade on the OTCQX is that a company must be exempt from the penny stock definition under Rule 3a51-1 of the Exchange Act by meeting one of the following criteria: (i) have a bid price of $5 or more as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application and, as of the most recent fiscal year-end, have at least one of the following: (a) net income of $500,000; (b) net tangible assets of $1,000,000; (c) revenues of $2,000,000; or (d) total assets of $5,000,000; or (ii) have net tangible assets of $2 million if the company has been in continuous operation for at least three years, or $5,000,000 if the company has been in continuous operation for less than three years, which qualification can be satisfied as of the end of a fiscal period or as a result of an interim capital raise; or (iii) have average revenue of at least $6,000,000 for the last three years. The amended rules clarify that the financial thresholds necessary to qualify for exemption must be based on audited financial reported dated within 15 months prior to the company’s application to the OTCQX.
Convertible Debt Disclosure
All OTCQX companies must now disclose all of their convertible debt arrangements and provide copies of all securities purchase or similar agreements, promissory notes, irrevocable transfer agent instruction letters and related deal documents. Generally, an SEC-reporting company files these documents as exhibits to a Form 8-K when completing the transaction, or with the subsequent Form 10-Q following the deal closure.
Change of Control
An OTCQX company must now promptly notify OTC Markets of a change of control of the company. Within 20 calendar days of the completion of the change of control, the company must submit a new OTCQX application and associated application fee. The OTCQB enacted a similar rule back in July 2017. In addition, OTC Markets may independently determine that a change of control has taken place and, in such case, will notify the company who must then complete the new application. The failure to submit the new application and fee is grounds for removal from the OTCQX.
Like the OTCQB rules, the OTCQX defines a change of control as any events resulting in:
(i) Any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) becoming the “beneficial owner” (as defined in Rule 13d-3 of the Exchange Act), directly or indirectly, of securities of the company representing fifty percent (50%) or more of the total voting power represented by the company’s then outstanding voting securities;
(ii) The consummation of the sale or disposition by the company of all or substantially all of the company’s assets;
(iii) A change in the composition of the board occurring within a two (2)-year period, as a result of which fewer than a majority of the directors are directors immediately prior to such change; or
(iv) The consummation of a merger or consolidation of the company with any other corporation, other than a merger or consolidation which would result in the voting securities of the company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity or its parent) at least fifty percent (50%) of the total voting power represented by the voting securities of the company or such surviving entity or its parent outstanding immediately after such merger or consolidation.
The new rules have amended the definition of an independent director to mean: “a Person other than an executive officer or employee of the Company or any other Person having a relationship which, in the opinion of the Company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following Persons shall not be considered independent: (A) a director who is, or at any time during the past three years was, employed by the Company; (B) a director who accepted or has a Family Member who accepted any compensation from the Company in excess of $120,000 during any fiscal year within the three years preceding the determination of independence, other than compensation for board or board committee service; compensation paid to a Family Member who is an employee (other than an executive officer) of the Company; or benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (C) A director who is the Family Member of a Person who is, or at any time during the past three years was, employed by the Company as an executive officer.”
Amended Rules for International Companies
A company with a class of securities that has been publicly traded on a Qualified Foreign Exchange, or that has been SEC reporting for at least one year, may submit a written application to be exempted from the requirement to select an OTCQX sponsor. A company granted this exemption must submit a letter of introduction from their outside securities counsel in lieu of such a letter from an OTC sponsor. Prior to adopting this rule amendment, only international companies moving from the OTCQB to the OTCQX qualified for the exemption. Where outside securities counsel is used as a sponsor, the duties related to a sponsor and for the company to provide information to and seek input from such sponsor extend to the outside securities counsel.
The outside securities counsel sponsor letter is in substantially the same form as required for U.S. companies.
Change of Control
The same provisions as discussed above for U.S. companies also apply for international companies.
Transfer Agent Verified Shares Program
The new rules require Canadian companies to utilize a transfer agent participating in the Transfer Agent Verified Shares Program by April 1, 2020.
Clarification of Penny Stock Exemption Eligibility Criteria
The same provisions as discussed above for U.S. companies also apply for international companies.
Corporate Governance Standards
International companies that are not listed on a Qualified Foreign Stock Exchange must meet additional corporate governance standards including: (i) have at least two independent directors on its board of directors (companies listed prior to the rule change will have until January 1, 2021 to comply); (ii) have an audit committee comprised of a majority of independent directors; (iii) conduct an annual shareholders’ meeting and make annual financial reports available to its shareholders at least 15 calendar days prior to the meeting. Trusts, funds and similar entities may apply for an exemption to these new corporate governance requirements.
A company that fails to meet the requirements must notify OTC Markets immediately upon learning of the event or circumstance that cause the non-compliance and must regain compliance by the earlier of its next annual meeting or one year from the date of the non-compliance.
The amended rules add the requirement that a company provide a current shareholder list from its transfer agent as part of its application package. In addition, OTC Markets will now require a background check authorization form as part of its application process.
The amended rules have increased the period for which a company, that is not SEC reporting or Regulation A reporting, must post information on the OTC Website from 24 months to three years, as part of its initial disclosure obligations. All information must be posted in English.