Monthly Archives: August 2020
On June 25, 2020, SEC Chair Jay Clayton gave testimony before the Investor Protection, Entrepreneurship and Capital Markets Subcommittee of the U.S. House Committee on Financial Services on the topic of capital markets and emergency lending in the Covid-19 era. The next day, on June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets issued a public statement on the same topic but expanded to include efforts to ensure the orderly function of U.S. capital markets.
Chair Clayton Testimony
Chair Clayton breaks down his testimony over five topics including: (i) market monitoring and regulatory coordination; (ii) guidance and targeted assistance and relief; (iii) investor protection, education and outreach efforts; (iv) ongoing mission-oriented work; and (v) the SEC’s fiscal-year 2021 budget request.
Market Monitoring and Regulatory Coordination
Despite the extraordinary volumes and volatility we have seen in the securities markets over the few months, at a high level, the “pipes and plumbing” of the securities markets have functioned largely as designed and as market participants would expect. The SEC has observed no systemically adverse operational issues with respect to key market infrastructure.
The SEC has also stepped up its market monitoring efforts establishing a cross-divisional Covid-19 Market Monitoring Group to manage and coordinate efforts to monitor markets and respond to issues. The Group has been continuously monitoring the market with respect to prices and price movements, capital flows and credit availability. The Group has also initiated work to: (i) identify, analyze and clarify interconnections across key segments of financial markets with increased specificity; and (ii) analyze the risks and potential pro-cyclical effects of investment strategies and mandates that include or are subject to mechanistic rules, guidelines or restrictions on holdings of assets—for instance, by reference to ratings and downgrades.
The SEC has also been in close contact with other domestic and international financial regulators regarding risks and impacts resulting from Covid-19 on investors, companies, state and local governments, issues and the financial system as a whole. Cybersecurity risks remain a top concern and priority. On the international level, attention is being paid to market impacts and increased risks with a focus on preserving orderly market functions.
Covid-19 Related Guidance and Targeted Regulatory Assistance and Relief
Chair Clayton highlights the various regulatory relief efforts of the SEC in response to Covid, for example temporary relief from filing deadlines, allowing virtual shareholder meetings, transfer agent relief (see HERE), and temporary expedited crowdfunding rules (see HERE). Chair Clayton testified about the SEC’s guidance on disclosures by public companies related to the impact of Covid on their businesses (see HERE) and the importance of those disclosures to the markets.
The SEC has also pursued many actions focused on operational issues, including facilitating the shift to business continuity plans that are consistent with health and safety directives and guidance and implementing a work-from-home system.
Investor Protection, Education and Outreach
Chair Clayton confirms that investor protection is as important as ever and that the SEC’s Office of Compliance Inspections and Examinations (OCIE) and Division of Enforcement remain fully operational and continue their robust efforts to protect investors. As all practitioners have noticed, Enforcement has been actively monitoring the markets for frauds, illicit schemes and other misconduct affecting U.S. investors relating to Covid and has dedicated significant resources to responding quickly to Covid-related misconduct. The SEC has issued over 30 trading suspensions on companies that have made claims related to access to testing materials, development of treatments or vaccines or access to personal protective equipment, and many of these have followed with enforcement actions.
The Office of Investor Education and Advocacy, along with Enforcement’s Retail Strategy Task Force, has issued investor alerts to inform and educate investors about concerns related to recent market volatility and Covid-related schemes. A separate alert warned investors of bad actors using CARES Act benefits to promote high-risk, high-fee investments and other inappropriate products and strategies.
Furthermore, Regulation Best Interest, establishing a new standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy to a retail customer, became effective on June 30, 2020. The SEC set up an investor-facing website explaining Regulation Best Interest and the Form CRS that broker-dealers are required to file.
Ongoing Mission-oriented Work
Despite the work-from-home status of the SEC, planned rulemaking and scheduling has continued unabated. Other initiatives, such as concerns with the risks associated with companies operating in emerging markets, have likewise continued. For more on that topic, see HERE.
Keeping with the national topic of the moment, Chair Clayton testified that the SEC is committed to diversity and inclusion. Over the last weeks, the topic has been brought to the forefront and the SEC recognizes it needs to make improvements and is working diligently with its Office of Minority and Women Inclusion on further initiatives. Chair Clayton also pointed out that in March 2020, the SEC released its first Diversity and Inclusion Strategic Plan to promote diversity and inclusion within the SEC and the entities the SEC regulates, the Office of the Advocate for Small Business Capital Formation recently held its Government-Business Forum on Small Business Capital Formation including a panel on minority- and woman-owned businesses, and the Asset Management Advisory Committee held a public meeting on diversity and inclusion in the asset management industry.
FY 2021 Budget Request
The SEC FY 2021 budget request of $1.895 billion, an increase of 4.4% over FY 2020, is hoped to provide the agency with resources to better execute its responsibilities. Key priorities include: (i) facilitating main street investor access to long-term, cost-effective investment opportunities and expanding outreach to small businesses; (ii) responding to continued evolution and innovation in the securities markets and meeting long-standing and emerging investor protection and oversight needs; and (iii) assessing and securing our data footprint with a focus on cybersecurity.
Public Statement on SEC’s Targeted Regulatory Relief Related to Covid-19
On June 26, Chair Clayton, William Hinman, Director of the Division of Corporation Finance, Dalia Blass, Director of the Division of Investment Management and Brett Redfearn, Director of the Division of Trading and Markets, issued a public statement on targeted regulatory relief and orderly markets amid the Covid-19 crisis. The statement reiterated much of Chair Jay Clayton’s testimony the day prior as summarized above. However, it also expanded to discuss continued changes and expansion to the relief as the virus crisis continues and is expected to continue to impact businesses and the public markets.
The SEC has reiterated many times that they are taking a health-first approach, prioritizing the health and safety of not only its employees and staff, but also making concessions for businesses to do so as well. All SEC staff is and will continue to work remotely and the SEC intends to extend relief it has provided to market participants to support a remote-work environment, such as virtual annual meetings. The SEC will also continue to provide relief related to the delivery of proxy materials in areas where mail cannot be delivered. Furthermore, the SEC will continue to allow the electronic submission of Form 144s and other documents that are still required to be delivered in paper form.
On the other hand, the SEC has no intention of offering further relief from filing deadlines for periodic reports such as 10-Qs and 10-Ks.
In May 2020 the SEC adopted temporary, conditional expedited crowdfunding access to small businesses using Regulation Crowdfunding (see HERE). The temporary rules provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief is scheduled to end on August 31, 2020. The SEC has not yet decided if it will extend this temporary rule.
In July 2020, 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 2020 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 decreased to 42 items as compared to 47 on the fall 2019 list.
Items on the Agenda can move from one category to the next or be dropped off altogether. New items can also pop up in any of the categories, including the final rule stage showing how priorities can change and shift within months. Portfolio margining harmonization was the only item listed in the pre-rule stage in the fall 2019 and remains so on the current list.
Nineteen items are included in the proposed rule stage, down from 31 on the fall list. Still on the proposed rule list is executive compensation clawback (HERE). Clawback rules would implement Section 954 of the Dodd-Frank Act and require that national securities exchanges require disclosure of policies regarding and mandating clawback of compensation under certain circumstances as a listing qualification.
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.
Earnings releases and quarterly reports were on the fall 2018 pre-rule list, moved to long-term on the spring 2019 list and up to proposed in fall 2019 where it remains. The SEC solicited comments on the subject in December 2018 (see HERE), but has yet to publish proposed rule changes.
Amendments to the transfer agent rules remain on the proposed rule list although it has been 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 suggested that it would finally be pushed over the finish line last year but so far it remains stalled (see, for example, HERE).
Other items that are still on the proposed rule list include amendments to Guide 5 on real estate offerings and Form S-11; amendments to the custody rules for investment advisors; investment company summary shareholder report; amendments to Form 13F filer thresholds; amendments to the family office rule; prohibition against fraud, manipulation, and deception in connection with security-based swaps; and broker-dealer reporting, audit and notifications requirements.
Items moved up from long-term to proposed-rule stage include mandated electronic filings increasing the number of filings that are required to be made electronically; additional proxy process amendments; 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; electronic filing of broker-dealer annual reports, financial information sent to customers, and risk-assessment reports; and amendments to the rules regarding the consolidated audit trail.
New to the list and appearing in the proposed rule stage is a rule regarding the valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company. Also new to the list and in the proposed rule stage is a potential amendment to Form PF, the form on which advisers to private funds report certain information about private funds to the SEC. Another new item that made it to the proposed stage is a proposal to amend Regulation ATS to increase operational transparency and foster oversight of ATSs that transact in government securities.
Twenty-one items are included in the final rule stage, increased from 16 on the fall list, including a few of which are new to the agenda. Amendments to certain provisions of the auditor independence rules (some amendments were adopted in June 2019 and additional amendments proposed on December 30, 2019 – see HERE) moved up from the proposed list to final rule stage.
Still in the final rule stage is the modernization and simplification of disclosures regarding the description of business, legal proceedings and risk factors which were proposed in August 2019 (see HERE). The SEC previously made some changes to risk factor disclosures in an amendment adopted in March 2019 (see HERE) but the newest proposals would go further to: (i) require summary risk factor disclosure if the risk factor section exceeds 15 pages; (ii) refine the principles-based approach of that rule by changing the disclosure standard from the “most significant” factors to the “material” factors required to be disclosed; and (iii) require risk factors to be organized under relevant headings, with any risk factors that may generally apply to an investment in securities disclosed at the end of the risk factor section under a separate caption.
Financial disclosures about acquired businesses are still listed in the final rule stage although final rules were adopted in May 2020, which are still on my list as a catch-up blog. The proposed amendments were published in May 2019 (see HERE). Similarly, amendments to address certain advisors’ reliance on the proxy solicitation exemptions in Rule 14a-2(b) (see HERE) still appear on the final rule list although final rules were adopted in July 2020 (also on my future blog list).
Jumping from a long-term action item to final rule stage is universal proxy process. Originally proposed in October 2016 (see HERE), the universal proxy is a proxy voting method meant to simplify the proxy process in a contested election and increase, as much as possible, the voting flexibility that is currently only afforded to shareholders who attend the meeting. Shareholders attending a meeting can select a director regardless of the slate the director’s name comes from, either the company’s or activist’s. The universal proxy card gives shareholders, who vote by proxy, the same flexibility.
Moving up from proposed rule to final rule stage are filing fee processing updates including changes to disclosures and payment methods (proposed rules published in October 2019); disclosure of payments by resource extraction issuers (proposed rules published in December 2019 – see HERE); proposals to amend the rules regarding the thresholds for shareholder proxy proposals under Rule 14a-8 (see HERE); procedures for investment company act applications; NMS Plan amendments; use of derivatives by registered investment companies and business development companies; market data infrastructure including market data distribution and market access (proposed rules published in February 2020); amendments to the SEC’s Rules of Practice; disclosure requirements for banking and savings and loan registrants, including statistical and other data; prohibitions and restrictions on proprietary trading and certain interests in, and relationships with, hedge funds and private equity funds; amendments to marketing rules under the Advisors Act; and amendments to modernize and simplify disclosures regarding Management’s Discussion & Analysis (MD&A), Selected Financial Data and Supplementary Financial Information. Some amendments to MD&A were adopted in March 2019 (see HERE)
The much-needed amendments to the accredited investor definition moved from the proposed list to the final 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.
Amendments to Rule 15c2-11, which first appeared on the agenda in spring 2019, moved from the proposed rule list to the final agenda. 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.
Other items remaining in the final rule stage include Fund of fund arrangements (proposed rules were issued in December 2018); customer margin requirements for securities futures (proposed rules published in July 2019); and amendments to the whistleblower program.
At least partially, new to the agenda and in the final rule stage is the harmonization of exempt offerings. In March 2020 the SEC proposed sweeping rule changes. For my five-part blog on the proposed rules, see HERE, HERE, HERE, HERE, and HERE. Regulation A and Regulation CF amendments were on the fall 2019 proposed rule list and although dropped off as separate items, are encompassed in the harmonization of exempt offerings proposed amendments.
Several items have dropped off the agenda as they have now been implemented and completed, including financial disclosures for registered debt security offerings. The proposed amendment was published during the summer in 2018 (see HERE) and the final rules adopted in March 2020 (see HERE). Amendments to the definition of an accelerated and large accelerated filer were finalized in March 2020 (see HERE) and thus removed from the list.
Items also completed and removed from the agenda include offering reform for business development companies (adopted in April 2020); amendments to Title VII cross-border rules (final rules adopted in September 2019); recordkeeping and reporting for security-based swap dealers (adopted in September 2019); disclosure for unit investment trusts and offering variable insurance products (adopted in May 2020); a new definition for covered clearing agency (adopted in April 2020); and risk mitigation techniques (adopted on December 2019).
Thirty items are listed as long-term actions (down from 37 in fall 2019 and 52 in spring 2019), 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 asset-backed securities disclosures (last amended in 2014); corporate board diversity (although nothing has been proposed, it is a hot topic); conflict minerals amendments (prior proposed rules were challenged in lengthy court proceedings on a constitutional First Amendment basis and yet another proposal was published in December 2019 – HERE); Regulation AB amendments; reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE); and stress testing for large asset managers.
Also still on the long-term action list is the modernization of investment company disclosures, including fee disclosures; custody rules for investment companies; 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; definitions of mortgage-related security and small-business-related security; broker-dealer liquidity stress testing, early warning, and account transfer requirements; covered broker-dealer provisions under Title II of Dodd-Frank; additional changes to exchange-traded products; short sale disclosure reforms; 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.
A few electronic filing matters remain on the long-term list including electronic filing of Form 1 by a prospective national securities exchange and amendments to Form 1 by national securities exchanges; and Form 19b-4(e) by SROs that list and trade new derivative securities products.
Several swap-based rules remain on the long-term 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.
New to the list are requests for comments on fund names; amendments to improve fund proxy systems; amendments to Rules 17a-25 and 13h-1 following creation of the consolidated audit trail (part of Regulation NMS reform); records to be preserved by certain exchange members, brokers and dealers; and proposed Rule 15 to Regulation S-T, administration of the EDGAR system.
Items that dropped from the agenda without action include amendments to the registration of alternative trading systems and clawbacks of incentive compensation at financial institutions. Sadly, completely dropped from the agenda is Regulation Finders. The topic of finders has been ongoing for many years, but unfortunately has not gained any traction. See here for more information HERE.
Writing a blog once a week during a time when almost daily events are publish-worthy means that some topics will be delayed, at least temporarily. Back in March, the SEC adopted final amendments to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed rule changes were published in the summer of 2018 (see HERE).
The amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The SEC also created a new Article 13 in Regulation S-X, renumbered Rules 3-10 and 3-16 to Rules 13-01 and 13-02, and made conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.
As stated in the SEC press release on the new rules, the amended rules focus on the provision of material, relevant, and decision-useful information regarding guarantees and other credit enhancements, and eliminate prescriptive requirements that have imposed unnecessary burdens and incentivized issuers of securities with guarantees and other credit enhancements to offer and sell those securities on an unregistered basis. The amendments are intended to improve disclosure and reduce the SEC registration-related compliance burdens for issuers. It is hoped that the rules will encourage registered debt offerings over unregistered offerings and thus improve disclosures and protections for investors.
The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.
Under the Securities Act, a guarantee of a debt is a separate security requiring either registration, with audited financial statement, or an exemption from registration upon its offer or sale. Rule 3-10 of Regulation S-X requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements and that the subsidiary be 100% owned. If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.
The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.
The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.
To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.
When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.
The amendments streamline the current structure, which has differing criteria depending on which exemption is being relied upon to unify all criteria. The amendments broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the eligibility requirements to rely on the exception are met and the parent company includes specific financial and non-financial disclosures about those subsidiaries.
The amended rule will:
(i) Allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned;
(ii) Replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis;
(iii) New non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities;
(iv) Permit disclosures to be provided outside the footnotes of the parent’s audited and interim unaudited financial statements in the registration statement covering the offering and in the Exchange Act reports thereafter;
(v) Eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers and guarantors, provided however, if the acquisition is significant, summarized financial information must be provided; and
(vi) Reduce the time in which additional Alternative Disclosure must be made to the period for which the issuer and guarantors have Exchange Act reporting obligations instead of the entire period that the guaranteed securities are outstanding.
To be eligible to rely on the exception, the following conditions must be met:
(i) The consolidated financial statements of the parent company have been filed;
(ii) The subsidiary or guarantor is a consolidated subsidiary of the parent;
(iii) The guaranteed security is debt or debt-like; and
(iv) One of the following issuer and guarantor structures is applicable: (a) the parent company issues the security or co-issues the security, jointly and severally, with one or more of its consolidated subsidiaries; or (b) a consolidated subsidiary issues the security or co-issues the security with one or more other consolidated subsidiaries of the parent company, and the security is guaranteed fully and unconditionally by the parent company.
Importantly, as noted, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subjects the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
The new rules include conforming amendments to also apply to the Rule 8-01 of Regulation S-X dealing with smaller reporting companies and Forms 1-A, 1-K and 1-SA to apply to Regulation A issuers.
Current Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.
The amendments replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security. The amended financial and non-financial disclosures are included in new Rule 13-02.
The level of disclosure is based on materiality and would include certain line items of the balance sheet and income statement of the affiliate. Where more than one affiliate provides collateral, financial information can be included on a consolidated rather than individual basis. However, when information is applicable to one or more, but not all, affiliates, it will need to be separated out. For example, when one or more affiliates separates trades, it would need to be clear which affiliate trading market information is being provided for.
In addition, the amendment changes the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements.
Furthermore, the amendments replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered, with a requirement to provide the financial and non-financial disclosures to the extent material, eliminating numerical thresholds. The rule leans towards materiality with the need to determine information is immaterial for it to be omitted.
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets (see HERE). Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
Following the public statements, in June 2020, Nasdaq issued new proposed rules which would make it more difficult for a company to list or continue to list based on the quality of its audit, which could have a direct effect on companies based in China.
Nasdaq Proposed Rule Changes
On June 2, 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The rule currently provides that Nasdaq may use its authority to deny listing or continued listing to a company when an individual with a history of regulatory misconduct is associated with that company. The rule sets out a variety of factors that may be considered by the exchange in making a determination. I’ve detailed the current rule below.
The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market.” The proposed rule change is meant to codify Nasdaq’s current interpretation of its discretionary authority to provide clarity to the marketplace on its position related to the importance of quality audits.
Nasdaq’s listing requirements are designed to ensure that a company is prepared for the reporting and administrative requirements of being a public company, to provide for transparency and the protection of investors, and to ensure sufficient investor interest to support a liquid market. Rule 5101 describes Nasdaq’s broad discretionary authority over the initial and continued listing of securities on Nasdaq in order to maintain the quality of and public confidence in the market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest.
Part of both the general federal securities laws and Nasdaq requirements relate to properly completed audits by an independent auditor. Investors need to be able to rely on the audit report to gain confidence that the financial statements are properly completed and free of material misstatements due to mistakes or fraud. For more on the requirements for an audit report, see HERE.
Auditors are subject to oversight by both the SEC and PCAOB. PCAOB inspections are designed to, among other things, identify deficiencies in audits and/or quality control procedures. Investigations can lead to the audited public company having to revise and refile its financial statements or its assessment of the effectiveness of its internal control over financial reporting. In addition, through the quality control remediation portion of the inspection process, inspected firms identify and implement practices and procedures to improve future audit quality. Accordingly, Nasdaq relies on auditors and the PCAOB oversight to maintain audit integrity.
Citing the recent joint public statement by SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III (see HERE), Nasdaq notes that audit work and the practices of auditors in certain countries, cannot be effectively reviewed or subject to the usual oversight. Those countries currently include Belgium, France, China and Hong Kong.
Currently, Nasdaq may rely upon its broad authority provided under Rule 5101 to deny initial or continued listing or to apply additional and more stringent criteria when the auditor of an applicant or a Nasdaq-listed company: (i) has not been subject to an inspection by the PCAOB, (ii) is an auditor that the PCAOB cannot inspect, or (iii) otherwise does not demonstrate sufficient resources, geographic reach or experience as it relates to the company’s audit, including in circumstances where a PCAOB inspection has uncovered significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls. The proposed rule change is meant to codify the existing rights of Nasdaq in that regard.
The proposed rule change would add a new paragraph (b) to IM-5101-1 detailing factors that Nasdaq will consider including:
(i) whether the auditor has been subject to PCAOB inspection including due to the audit firm being located in a jurisdiction that limits the PCAOB’s inspection ability;
(ii) if the auditor has been inspected, whether the results of the inspection indicate the auditor has failed to respond to inquiries or requests by the PCAOB or that the inspection revealed significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls;
(iii) whether the auditor can demonstrate that it has adequate personnel in offices participating in the audit with expertise in applying U.S. GAAP, GAAS or IFRS, in the company’s industry;
(iv) whether the auditor’s training program for personnel participating in the company’s audit is adequate;
(v) for non-U.S. auditors, whether the auditor is part of a global network or other affiliation of auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
(vi) whether the auditor can demonstrate to Nasdaq sufficient resources, geographic reach or experience as it relates to the company’s audit.
An auditor would not necessarily have to satisfy each of the factors but rather Nasdaq will consider all facts and circumstances, and may impose additional or more stringent criteria to mitigate concerns. Additional criteria could include: (i) higher equity, assets, earnings or liquidity measures; (ii) that an offering be completed on a firm commitment basis (as opposed to best efforts); (iii) lock-ups for officers, directors or other insiders; (iv) higher float percentage or market value of unrestricted publicly held shares; or (v) higher average OTC trading volume before an uplisting.
The proposed rule change would also add a new subparagraph (c) to IM-5101-1 to confirm Nasdaq’s ability to impose additional or more stringent criteria in other circumstances, including when a company’s business is principally administered in a jurisdiction that Nasdaq determines to have secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction (a “Restrictive Market”). In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s: (i) principal business segments, operations or assets; (ii) board and shareholders’ meetings; (iii) headquarters or principal executive offices; (iv) senior management and employees; and (v) books and records.
In the event that Nasdaq relies on its discretionary authority and determines to deny the initial or continued listing of a company, it would issue a denial or delisting letter to the company that will inform the company of the factual basis for the Nasdaq’s determination and its right for review of the decision.
Current Rule IM-5101-1
Nasdaq may use its authority under Rule 5101 to deny initial or continued listing to a company when an individual with a history of regulatory misconduct is associated with the company. Such individuals are typically an officer, director, substantial shareholder, or consultant to the company. In making this determination, Nasdaq will consider a variety of factors, including:
(i) the nature and severity of the conduct, taking into consideration the length of time since the conduct occurred;
(ii) whether the conduct involved fraud or dishonesty;
(iii) whether the conduct was securities-related;
(iv) whether the investing public was involved;
(v) how the individual has been employed since the violative conduct;
(vi) whether there are continuing sanctions (either criminal or civil) against the individual;
(vii) whether the individual made restitution;
(viii) whether the company has taken effective remedial action; and
(ix) the totality of the individual’s relationship with the company including their current or proposed position, current or proposed scope of authority, responsibility for financial accounting or reporting and equity interest.
Nasdaq may also exercise its discretionary authority with a company filed for bankruptcy, when its auditor issues a disclaimer opinion or when financial statements do not contain a required certification.
Where concerns are raised, Nasdaq will consider remedial measures by the company including the individual’s resignation, divestiture of stock holdings, termination of contractual arrangements or the creation of a voting trust to vote their shares. Nasdaq will also consider past corporate governance.
Nasdaq may impose restrictions or heightened listing requirements where concerns are raised, but may not allow for exceptions or lower standards to the listing rules. In the event that Nasdaq staff denies initial or continued listing based on such public interest considerations, the company may seek review of that determination through the procedures set forth in the Rule 5800 Series. On consideration of such appeal, a listing qualifications panel comprised of persons independent of Nasdaq may accept, reject or modify the staff’s recommendations by imposing conditions.