Monthly Archives: March 2020
As the whole world faces unprecedented personal and business challenges, our duty to continue to run our businesses, meet regulatory filing obligations and support our capital markets continues unabated. While we stay inside and practice social distancing, we also need to work each day navigating the new normal. Thankfully many in the capital markets, including our firm, were already set up to continue without any interruption, working virtually in our homes relying on the same technology we have relied on for years.
We all need to remember that the panic selling frenzy will end. Emotions with even out and the daily good news that comes with the bad (for example, the number of cases in China is falling dramatically; some drugs are working to help and the FDA is speeding up review times for others; early signs China’s economy is starting to recover already; scientists around the world are making breakthroughs on a vaccine; etc.) will begin to quell the fear. No one knows what the economic damage will be but we do know that new opportunities will appear, the buying opportunity is already being hinted at for capital markets, and entrepreneurs will continue.
In the meantime, besides the economic stimulus packages that have already passed in some states and that are fighting their way through the federal partisan political system, regulators have provided some relief for our clients and the capital markets participants.
Extension in SEC Reporting Filing Deadlines
The SEC has issued an exemptive order providing public companies with an additional 45 days to file certain disclosure reports that would otherwise be due between March 1 and April 30, 2020. The extension is only available under certain conditions. In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough. In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis. For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines
The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.
If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.
For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report. For more on S-3 eligibility, see HERE.
Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.
The extension actually changes the due date for the filing of the report. Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.
Disclosures Regarding Covid-19 Impact
The SEC press release regarding the exemptive Order reminds companies of the obligations to disclose information related to the impact of Covid-19 on their businesses. SEC Chair Jay Clayton stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”
Furthermore, the combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading). The exemptive order reminds all companies of its obligations. If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.
Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made. Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate. Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).
Furnishing of Proxy and Information Statements
The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible. The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.
Virtual Annual Meetings
Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law. Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not. New York has historically been one of the states that does not have easy provisions for virtual meetings. Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings. Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.
Relief for Registered Transfer Agents
The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020. The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.
The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists. The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.
To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The June concept release sought public comments on: (i) whether the exemptive framework as a whole is effective for both companies and investors; (ii) ways to improve, harmonize and streamline the exemptions; (iii) whether there are gaps in the regulations making it difficult for smaller companies to raise capital; (iv) whether the limitations on who can invest and amounts that can be invested (i.e., accredited investor status) pose enough investor protection and conversely create undue obstacles to capital formation; (v) integration and transitioning from one offering exemption to another; (vi) the use of pooled investment funds as a source of private capital and access to those funds by retail investors; and (vii) secondary trading and re-sale exemptions.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with this first blog focusing on integration.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
In recent years the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke up Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors and the Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the current most often used offering exemptions.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
The current Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. 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. That is, where two or more offerings are integrated, there is a danger that the exemptions for both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
The current integration rule (Securities Act Rule 502(a)) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Furthermore, yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
The amended rules would completely overhaul the integration concept such that each offering would be viewed as discrete regardless of whether it was completed close in time to a second offering. Under the new rules, where a regulatory safe harbor exists such safe harbor could be relied upon. For all other offerings, the new integration rules would look to the particular facts and circumstances of the offering, and focus the analysis on whether the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Of course, where exempt offerings allow general solicitation, they must include the regulatory legends required for such offering.
In making the analysis as to whether an offering complies with an exemption, where solicitation is not allowed, the company must have a reasonable belief that the investors were either not solicited or that such investor had a substantive relationship with the company prior to commencement of the offering. Generally a substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication and established accreditation. That is, a substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
Moreover, the SEC is proposing four new non-exclusive safe harbors from integration, including: (i) any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation (this 30-day test would replace the six-month test across the board); (ii) offerings under Rule 701, under an employee benefit plan or under Regulation S will not integrate with other offerings; (iii) a registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering that terminated more than 30 days before the registration statement was filed; and (iv) offerings that allow for general solicitation will not integrate with a prior completed or terminated offering.
The determination of whether an offering has been terminated or completed will vary depending on the type of offering. A Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering will be terminated or completed on the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities. As to Regulation A offerings, such will be terminated or completed when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering. Offerings under Regulation Crowdfunding will be terminated or completed upon the deadline of the offering set forth in the offering materials.
Registered offerings will be terminated or completed upon the (i) withdrawal of the registration statement; (ii) filing of an amendment or supplement indicating the offering is completed and withdrawing any unsold securities; (iii) entry of an order by the SEC; or (iv) three years after the filing of an S-3. Although the same termination and completion analysis for each offering would be preferred, the differing natures of the offering mechanics do not make that feasible.
To avoid an abuse of the 35 unaccredited limitation under Rule 506(b), where a company conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
To avoid abuse involving Regulation S offerings, where there is a concurrent Rule 506(c) offering, the company will need to prohibit resales to U.S. persons for a period of six months except for QIBs or IAIs.
The new integration principles and safe-harbors would be aggregated in Securities Act Rule 152. Moreover, Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions) will be amended to cross reference the new amended rule 152. Other rules (Rules 255(e), 147(h) and 147A(h)) will be eliminated as the provisions will be covered in Rule 152…
The SEC’s Office of Small Business Advocate launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat. The Office recently issued its first annual report (“Annual Report”).
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyzing the potential impact of regulatory changes on small businesses and their investors; (v) conducting outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
A highlight of the achievements of the office under the leadership of Martha Legg Miller include: (i) hosted and participated in various engagement events with entrepreneurs and investors; (ii) published its business plan; (iii) participated in National Small Business Week including the Small Business Roundtable and meeting of the Small Business Capital Formation Advisory Committee; (iv) launched explanatory videos on how to participate in and comment on rule making; and (v) hosted the annual Government-Business Forum on Small Business Capital Formation, a forum I have had the pleasure of attending in the past.
The Office’s Annual Report contains discussions on: (i) the state of small business capital formation; (ii) policy recommendations; and (iii) the Small Business Capital Formation Advisory Committee.
The State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in reliance on Rule 506(b) of Regulation D ($1.4 trillion for FYE June 30, 2019) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).
The industries raising the most capital include banking, technology, manufacturing, real estate, energy and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Florida and Texas are responsible for higher amounts of capital raised in aggregate.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited. The SEC recently proposed a change in the definition of accredited investor to open up investment opportunities to additional qualified investors (see HERE).
The Annual Report discusses costs for early-stage companies to raise capital, including attorneys’ fees. According to the report, attorneys’ fees are between $5,000 and $20,000 for very early-stage companies and from $20,000 to $40,000 for venture-stage entities. The Report is in line with fees in my firm.
Interestingly, the Annual Report notes a correlation between the increased availability of venture capital funding and job growth in metro areas. Generally, venture-capital or private-equity-backed companies enter the public markets – 44.8% of companies currently listed on the Nasdaq were formerly backed by a venture-capital or private-equity firm.
The Report contains information related to the much–talked-about growing delay in public offerings (see more information HERE and HERE.) According to the Annual Report, companies are going pubic later in their life cycle, which also results in less funds being raised in the public markets via follow-on offerings. The Annual Report indicates 204 IPO’s from July 1, 2018 through June 30, 2019 and 294 small public company follow-on offerings for the same period. Not surprisingly, 61% of exchange traded companies with less than a $100 million market cap have no research coverage.
Woman are founding more start-ups than previously, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. On the investor side, 29.5% of angel investors are women, 11% of VCs are women, and 71% of VC firms had no female partners.
There has also been a big uptick in minority-owned businesses. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. On the investor side, only 5.3% of angel investors and 1% of VCs are minorities.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.
Modernize, Clarify and Harmonize Exempt Offering Framework
Following up on the SEC’s June 2019 concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework (see HERE), the Office of Small Business Advocate recommends a simplification to the exempt offering structure. The securities laws, including exempt offering regulations, are complex and difficult to navigate. The fact is that without competent securities counsel, the chances that a capital raise will be compliant with the securities laws is nonexistent.
The Office of Small Business Advocate suggests the following guiding principles to consider in restructuring the current exempt offering framework: (i) the rules, including all guidance on compliance, should be readily accessible and written in plain English; (ii) the rules should allow a company to progressively raise money throughout its growth (meaning very easy structures for small start-up capital raises); (iii) consider the Internet and technology advancements in communication (perhaps allow more open solicitation and advertising); (iv) dollar caps should be flexible for future review and adjustment and consider factors such as industry, geography and life-cycle stage; and (v) the principles underlying the current regulatory structure for exempt offerings should be re-examined.
Investor Participation in Private Offerings (the Accredited Investor Definition)
Most offering exemptions limit participation to accredited investors or if unaccredited investors are allowed, the number of such investors may be limited (506(b)), the disclosures required much more robust, or the investment amounts limited. As a result, the question of a change to the hard-line-in–the-sand accredited investor definition has been debated for years and answering the call, in December 2019, the SEC published a proposed amendment (see HERE).
The Annual Report notes that the definition of an accredited investor is designed to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. However, the current definition results in eliminating opportunities for retail investors to diversify their portfolios and participate in the growth of companies in the private markets. Public mutual funds rarely invest in private companies and private-equity, hedge funds and venture-capital funds raise capital using the same offering exemptions as private businesses and thus have the same accredited investor limitations. Also, as a result of poor drafting, some sophisticated entities such as American Indian tribal corporations have been left out of the definition, regardless of their asset value.
The Office believes that although investor protections are important, the current definition prioritizes risk of loss over sophistication and creates too strong a barrier to capital for small and emerging-growth companies. Furthermore, the current accredited investor definition structure (and prohibitions on advertising and solicitation) makes it difficult and time-consuming for accredited investors to source investment opportunities even when they want to.
Supporting the proposed rule changes, the Office agrees that adding financial professional licenses and education goalposts to the current accredited investor definition would be beneficial. Likewise, they would not support an increase in the current financial thresholds. Rather than add to the list of entities that could qualify, the Office suggests that any entity, regardless of corporate form, should be able to qualify if it has over $5 million in assets. The Office recommends that the changes be easy to navigate, providing simplicity and certainty in ascertaining qualification to avoid increasing transaction costs. Although not included in any current rule proposal, the Office also suggests modifying the Investment Company Act rules to allow for more public mutual funds to invest in private companies.
As all capital markets practitioners know, one of the biggest challenges to raising capital is finding and being introduced to potential investors. Although larger companies engage the services of broker-dealers, there simply aren’t many options for smaller or early-stage entities. Because of the very big need, an industry of unlicensed finders has developed. This is a topic I’ve written about many times (see HERE). Some finders operate within the parameters of the law, such as by providing a multitude of valuable services such as creating pitch materials, consulting on capital structure, helping with general business goals and objectives and marketing materials, and importantly, not collecting a success or separate fee for capital introductions. However, many violate the law, causing a host of potential issues for both the finder and the company utilizing their services. Despite pleas from industry participants, the ABA, committees within the SEC and numerous other groups, the need for a workable regulatory structure remains unanswered.
The Office calls for a clear finder’s framework. In implementing a framework for finders to support emerging businesses’ capital needs and provide clarity to investors participating in the market, it is critical that the rules be clear for marketplace participants to reduce confusion, defining in plain English the activities that do not trigger registration and delineating when the scope of activities rises to the level that registration is appropriate. The framework should make clear what offering exemptions are eligible, whether the introduced investors must be accredited, the nature of compensation the finder may receive, the types of other incidental activities that the finder may engage in on behalf of the business, and the respective roles of federal and state regulators.
As I’ve mentioned several times, I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even support a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.
Since 2012, Regulation CF has provided a method for businesses to raise a small amount of capital (capped at $1,070,000) from numerous investors over the Internet utilizing the services of a funding portal. The Annual Report suggests that crowdfunding has been a success, helping many entrepreneurs that may otherwise not have been able to access capital. However, the Annual Report points out some issues with the process including the inability to properly advertise and market and thus drive investors to the opportunity and higher-than-necessary compliance costs. The Office reports that the system overseas is better, with companies raising more capital at a lower cost.
The Office suggests: (i) increase the $1,070,000 cap (no amount is suggested); (ii) remove the investment cap for accredited investors; (iii) revise the various disclosure obligations to reduce compliance costs; (iv) enable the use of special-purpose vehicles for investment; and (v) reduce the compliance burdens for funding portals.
Disclosure Requirements for Small Public Companies
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer, negatively impacting the U.S. public marketplace.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on recent proposed changes to the management’s discussion and analysis section of SEC reports, see HERE. That blog also contains a complete breakdown of the SEC’s ongoing disclosure effectiveness initiative. In addition to supporting the recent initiative, the Office advocates for further changes to reduce compliance costs for smaller reporting companies.
The Small Business Capital Formation Advisory Committee
The Small Business Advocate Act also created the Small Business Capital Formation Advisory Committee, which replaced the SEC’s voluntarily created Advisory Committee on Small and Emerging Companies. The new Advisory Committee is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters related to emerging, privately held small businesses to publicly traded companies with less than $250 million in public market capitalization; trading in securities of such companies; and public reporting and corporate governance of such companies.
The Advisory Committee has made two recommendations to the SEC. In particular, related to the recent SEC’s proposed rule changes to the reporting requirements for the acquisitions and dispositions of businesses (see HERE), the Advisory Committee suggests that the rule change provide differing treatment for Regulation A companies and make Management’s Adjustments optional or not required at all. Overall the Advisory Committee supports the rules changes but would make some tweaks.
The second recommendation relates to the SEC’s proposed amendment to the definitions of “accelerated filer” and “large accelerated filer” (see HERE ). Although the Advisory Committee supports the change, it would go further to add more companies that would qualify as a non-accelerated filers by raising the revenue threshold (currently proposed to be $100 million), increasing the time for such revenue (from the last year to three years) and considering whether all smaller reporting companies should be non-accelerated filers.
SEC Commissioner Hester M. Peirce, nicknamed “Crypto Mom,” has made a proposal for the temporary deregulation of digital assets to advance innovation and allow for unimpeded decentralization of blockchain networks. Ms. Peirce made the proposal in a speech on February 6, 2020.
The world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector with the SEC’s announcement that a cryptocurrency is a security in its Section 21(a) Report on the DAO investigation. Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
However, although capital raising seems clear, the breadth of the SEC’s jurisdiction and involvement are much less so. Not all token issuances and digital assets are used for capital raising, but rather these digital assets are fundamental to the operations of decentralized applications. Amazing new networks are being built and traditional applications are being disrupted at every turn. However, the ability to publicly issue the digital tokens that drive these networks continues to challenge the best practitioners, with all avenues leading back to some form of registration. The SEC’s temporary injunction against Telegram and its Grams digital token, the one token everyone firmly believed was a pure utility, together with the successful Regulation A offering of Blockstack’s token, has made Regulation A the clear choice for a public token issuance.
In theory, an S-1 would work as well, though to date no one has tried and likely will not do so in the short term. The issue with an S-1 is testing the waters and gun jumping (see HERE). Public communication in advance of an S-1 is strictly limited whereas most token offerings rely heavily on pre-marketing. Regulation A broadly allows pre-offering marketing, offers and communications (see HERE).
Currently, those who operate in the digital asset space must carefully navigate rough, uncharted waters while doing everything possible to comply with federal regulations. Although Regulation A+ works for the public issuance of a token, the issue of transitioning from a security to a utility a Hester Peirce Proposal For Treatment Oft this point requires a leap of faith. The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security. The question remains: how can a token that begins as a security, be utilized and traded freely in a network, in its utilitarian purpose, such to allow the network to grow in decentralization?
The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license (see, for example, HERE). Currently there is no active secondary trading market for digital asset securities in the U.S., though we are getting closer. However, secondary trading is different than use in a network for a token’s intended purpose.
Although there is no written guidance or pronouncement from the SEC Division of Trading and Markets, it appears that the SEC will allow a token that is a security to be used in a network without compliance with the registration or exemption provisions of the federal securities laws. The basis for this conclusion is the clearance of Blockstack’s Regulation A offering, which announces that the token can be used on the network and informal calls with FinHUB (see HERE) and digital asset legal practitioners. This does not provide the sort of comfort that a business investing millions of dollars into technology wants to rely upon.
That is one huge gap in the digital asset regulatory framework, but many more exist, leading Commissioner Peirce to throw out the first of what will probably be several proposals that hopefully bring us to a working structure.
Commissioner Peirce’s Proposal
Ms. Peirce begins by pointing out what I and every other practitioner have pointed out while trying to traverse the law’s application to digital assets, and that is that compliance with the law while furthering the meritorious digital asset technology is an unwinnable struggle. Ms. Peirce states, “[W]hether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin, providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, our securities laws stand in the way of innovation.”
Although the issues are widespread, Ms. Peirce focuses on the issue of getting tokens into the hands of potential network users without violating securities laws. Where a token is a security, the ability to grow a network and utilize a token within the network is unreasonably hampered.
Furthermore, although many tokens may be bundled in such a way as to create an investment contract under Howey, she thinks the SEC has gone too far in its analysis. The mere fact that a token is marketed as potentially increasing in value should not make it a security. If that were the case, quality handbags, designer sneakers, fine art and good wines would all be securities under the purview of the SEC.
The options available for digital asset technology innovators are limited. A network could simply open source the code and allow mining to create the initial tokens. A network could also take its chances and conclude that a token is not a security and proceed with the issuance, although that did not work out well for Telegram. The option most networks have chosen is to either avoid the U.S. altogether or rely on Regulation D and/or Regulation S for token issuances, and recently Regulation A for a more public issuance.
The safe harbor proposed by Commissioner Peirce is designed for projects looking to build a decentralized network. The safe harbor is admittedly in a draft form. Commissioner Peirce hopes for active public input as well as involvement within the SEC to help take her draft and formulate a workable plan that is either a rule or a no-action position, but that the market can rely on in moving forward.
The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempt from the federal securities laws as long as certain conditions are satisfied. In particular, (i) the offer and sale of tokens would be exempted from the provisions of the Securities Act of 1933 (“Securities Act”) other than the anti-fraud provisions; (ii) tokens would be exempt from registration under the Securities Exchange Act of 1934 (“Exchange Act”); and (iii) persons engaged in certain token transactions would be exempt from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.
In order to qualify for the safe harbor, several conditions must be met including: (i) the development team must intend the network to reach maturity, either through full decentralization or token functionality, within three years of the date of the first token sale, and act in good faith to meet that goal. I note that good faith is a hard standard to prove; (ii) the team must disclose key information on a freely accessible public website; (iii) the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network; (iv) the team must take reasonable efforts to create liquidity for users; and (v) the team would have to file a notice of reliance on the safe harbor on EDGAR within 15 days of the first token sale.
Determining decentralization requires an analysis of whether the network is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control. Functionality would be when holders can use the tokens for the transmission and storage of value or to participate in an application running on the network.
The key information that would need to be disclosed on a public website includes (i) the source code; (ii) transaction history; (iii) purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding); (iv) information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism; (v) the governance mechanisms for implementing changes to the protocol; (vi) the plan of development, including the current state and timeline for achieving maturity; (vii) financing plans, including prior token sales; (viii) the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team; (ix) the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future; (x) the sale by any member of 5% or more of his or her originally held tokens; and (xi) any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.
The requirement to make good-faith efforts to create liquidity for users could include a secondary trading market. In that case, the team would be required to utilize a trading platform that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection. Although I find this requirement perplexing, Commissioner Peirce believes it will help facilitate the distribution of the tokens such that they can flow back to a utility use on the network.
As mentioned, the safe harbor would not include the anti-fraud provisions of the securities laws. In addition, the safe harbor would be subject to the bad actor rules, such that it could not be used if any member of a team fell within the bad actor provisions (see HERE). The safe harbor would pre-empt state securities laws, but as with other pre-emptions, it would not include the state anti-fraud provisions.
The safe-harbor would be retroactive in that it would apply to tokens previously issued in registered or exempt offerings to allow for the free use of the token to build the network, and secondary sales.
Although as Commissioner Peirce notes, it has to start somewhere, it is a given in the industry that the proposal as written will not likely gain traction. It is simply too anti-regulation for any regulator’s and perhaps even industry participant’s liking. However, it does lay the framework to open the conversation and start towards a workable solution. Certainly, the current plan to let tokens registered as securities, be used as utilities, until we say otherwise, is not any better. The industry needs a workable solution, and I am glad an SEC Commissioner is taking a step forward.