Monthly Archives: September 2020
Despite an unusual abundance of comments and push-back, on September 16, 2020, one year after issuing proposed rules (see HERE), the SEC has adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11. The primary purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities. The SEC believes the final amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors.
From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealer to rely on that confirmation. Importantly the new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer.
The final rule release contains an in-depth discussion of the numerous comments received (I was one of the many comment writers), especially related to the piggyback exception. As part of the comment process, the OTC Markets, and many of its supporters, suggested the creation of a new “expert market” which would allow the trading of securities with no or limited information, by institutions and other qualified individual traders. In rejecting the proposal, the SEC indicated that there was not enough detail and information around how such a market would operate, but that it was open to considering such a segregated expert qualified marketplace in the future following the appropriate groundwork.
The final rules entail a complete overhaul of the current rule structure and as such will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system. I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks.
The final rule release contains a section on guidance related to the rules implementation and use. The guidance includes information on determining the reliability of information sources, conducting information reviews, and red flags that may heighten a review requirement.
The effective date of the rule is 60 days following publication in the federal register. The rule will be published any day now. Compliance with the majority of the rule is required nine months after the effective date. However, compliance with the provision requiring a catch-all category of company to have current information for the preceding two years in order to qualify for the piggyback exception is not until two years from the effective date. As discussed more fully below, a catch-all company is generally an alternatively reporting company on OTC Markets.
Rule 15c2-11 was enacted in 1971 to ensure that proper information was available to a broker and its clients prior to quoting a security in an effort to prevent micro-cap fraud. The last substantive amendment was in 1991. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Since the enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through.
I’ve written about 15c2-11 many times, including HERE and HERE. In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange-traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange-traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA.
The specific information required to be maintained by the broker-dealer when it initiates a quotation is delineated in Exchange Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or Regulation A under wand quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv).
In addition, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. This reasonable basis requirement has altered the initial quotation process dramatically over the last ten years. In particular, FINRA uses this requirement to conduct a deep dive into the due diligence and background of a company when processing a 211 Application.
As discussed below, although the amended rule continues to require that a broker-dealer have a reasonable basis to believe information is accurate and from a reliable source, the revamped structure itself may help shift the burden back to the broker-dealer, where it belongs, and reduce FINRA’s overlapping merit review. Importantly as discussed, OTC Markets will not be required to submit a Form 211 but rather its determination of compliance with the rules will be self-effectuating, and a broker-dealer relying on OTC Markets review, will also not be required to submit a Form 211 to FINRA. This alone will make a tremendous difference in the process.
The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed by a market maker and approved by FINRA and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. The disparity is so extreme that a quotation can take on a life of its own and continue long after a company has ceased to exist or closed operations.
The SEC’s rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies. However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity). Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company.
The final rules: (i) require that information about the company and the security be current and publicly available in order to initiate or continue to quote a security; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; (iv) allow OTC Markets itself to evaluate and confirm eligibility to rely on the rule; and (v) streamline the rule and eliminate obsolete provisions.
The final rule adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security. The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout. In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA. However, if new IDQS platforms or national securities associations develop, they would also be covered by the rule.
OTC Markets Review
The new rule allows a qualified IDQS to comply with the information review requirements. As mentioned, in reality, the qualified IDQS is OTC Markets. In complying with the information review requirements under Rule 15c2-11, OTC Markets will be subject to the same review, responsibility and record keeping requirements of a broker-dealer and must have reasonably designed written policies and procedures associated with the rule’s compliance. OTC Markets would then “make known” to the public that it has completed a review and that a broker-dealer can quote or resume quoting the securities, and be in compliance with Rule 15c2-11. Likewise, OTC Markets can make a determination that a company qualifies for an exception to the 211 rule requirements and a broker-dealer can rely on that determination.
A broker-dealer can rely on the OTC Markets determination of the availability of the rule or an exception to quote a security without conducting an independent review. Keeping the rule’s current 3 business day requirement, a broker-dealer’s quotation must be published or submitted within three business days after the qualified IDQS (OTC Markets) makes a publicly available determination.
Importantly, the new rule specifically does not require that OTC Markets comply with FINRA Rule 6432 and does not require OTC Markets or broker-dealers relying on OTC Markets’ publicly available determination that an exception applies, to file Forms 211 with FINRA. I believe that the system will evolve such that OTC Markets completes the vast majority of 211 compliance reviews.
Current Public Information Requirements; Location of Information
The final rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed. In addition, the amendment will restructure and renumber paragraphs and subparagraphs.
To initiate or resume a quotation, a broker-dealer or OTC Markets, must review information up to three days prior to the quotation. The information that a broker-dealer needs to review depends on the category of company, and in particular: (i) a company subject to the periodic reporting requirements of the Exchange Act, Regulation A or Regulation Crowdfunding (Regulation Crowdfunding was not included in the proposed rule but was added in the final); (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer with information available under 12(g)3-2(b) and (v) all others (catch-all category) which information must be as of a date within 12 months prior to the publication or submission of a quotation.
The catch-all category encompasses companies that alternatively report on OTC Markets (see HERE for more information), as well as companies that are delinquent in their SEC reporting obligations. Provided however, that companies delinquent in their SEC reporting companies can only satisfy the catch-all requirements for a broker-dealer to quote an initial or resume quotation of its securities, not for the piggy-back exception.
For companies relying on the catch-all category, the information required to rely on Rule 15c2-11 includes the type of information that would be available for a reporting company, including financial information for the two preceding years that the company or its predecessor has been in existence. The information requirements were expanded from the proposed rule to also include (i) the address of the company’s principal place of business; (ii) state of incorporation of each of the company’s predecessors (if any); (iii) the ticker symbol (if assigned); (iv) the title of each “company insider” as defined in the rule; (v) a balance sheet as of a date less than 16 months before the publication or submission of a broker-dealers quotation; and (vi) a profit and loss and retained earnings statement for the 12 months preceding the date of the most recent balance sheet.
Certain supplemental information is also required in determining whether the information required by Rule 15c2-11 is satisfied. In particular, a broker-dealer or OTC Markets, must always determine the identity of the person on whose behalf a quotation is made, including whether that person is an insider of the company and whether the company has been subject to a recent trading suspension. The requirement to review this supplemental information only applies when a broker-dealer is initiating or resuming a quotation for a company, and not when relying on an exception, such as the piggy-back exception, for continued quotations.
Regardless of the category of company, the broker-dealer or OTC Markets, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source. In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information. Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications. I’ve included a brief discussion of red flags in the section titled guidance below.
The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available. Under the final rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available for a broker-dealer to initiate or resume a quotation in the security. The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.
Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present. Currently, the broker-dealer that submits the majority of Form 211 applications does a complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application. I suspect that upon implementation of the new rule, OTC Markets itself will complete the vast majority of 15c2-11 rule compliance reviews and broker-dealers will rely on that review rather than submitting a Form 211 application to FINRA and separately complying with the information review requirements.
Information will be deemed publicly available if it is posted on: (i) the EDGAR database; (ii) the OTC Markets (or other qualified IDQS) website; (iii) a national securities association (i.e., FINRA) website; (iv) the company’s website; (v) a registered broker-dealer’s website; (vi) a state or federal agency’s website; or (vii) an electronic delivery system that is generally available to the public in the primary trading market of a foreign private issuer . The posted information must not be password-protected or otherwise user-restricted. A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.
Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule has a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation. A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.
The final rule adds specifics as to the date of financial statements for all categories of companies, other than the “catch-all” category. A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet. However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation. A catch-all category company, including a company that is delinquent in its SEC reporting obligations, does not have the 6 month requirement for financial statements but a balance sheet must be dated no more than 16 months prior to quotation publication and the profit and loss must be for the 12 months preceding the date of the balance sheet.
The categories of information required to be reviewed will also expand. For instance, a broker-dealer or the OTC Markets will be required to identify company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors. In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder. As discussed below, the unsolicited quotation exception will no longer be available for officers, directors, affiliates or 10% or greater shareholders unless the company has current publicly available information.
The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets. In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system. If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security.
Exceptions in General
The final rule amendments add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception; and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met.
Piggyback and Unsolicited Quote Exception Changes
The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. As discussed, currently the piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade. Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme.
There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception. The final rule, which contains a 60 page discussion on the piggyback exception, will amend the exception to: (i) require that information be current and publicly available (see below chart); (ii) require at least a one-way priced quotation (either bid or ask) – which is a modification from the proposal which would have required a two-way quotation; (iii) eliminate the current 30 calendar day window before the exception can be relied upon but retain the requirement that that no more than 4 days in succession can elapse without a quotation; (iv) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (v) allow a period in which the exception can be relied upon for quotations of shell companies (modified from the rule proposal); and (vi) provide a conditional 15 day grace period to continue quotations when current information is no longer available (this provision was not in the rule proposal); and (vi) revise the frequency of quotation requirement.
Notably, the SEC does not include a delinquent reporting issuer in the “catch-all” category for purposes of qualification for the piggy-back exception, rather, the amended rule provides a grace period for Exchange Act reporting companies that are delinquent in their reporting obligations. In particular, a broker-dealer can continue to rely on the piggyback exception for quotations for a period of 180 days following the end of the reporting period. Since most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days from fiscal year end and for a quarterly Form 10-Q it is 45 days from quarter end. Accordingly, a company can be delinquent up to 90 days on the filing of its Form 10-K or 135 days on its Form 10-Q before losing piggyback eligibility. Regulation A and Regulation Crowdfunding reporting companies are not provided with a grace period, but rather must timely file their reports to maintain piggyback eligibility.
The following chart summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specified period, for purposes of piggyback eligibility:
|Category of Company||15c2-11 Current Information|
|Exchange Act reporting company||Filed within 180 days following end of the reporting period|
|Regulation A reporting company||Filed within 120 days of fiscal year end and 90 days of semi-annual period end|
|Regulation Crowdfunding filer||Filed within 120 days of fiscal year end|
|Foreign Private Issuer||Since first day of most recent completed fiscal year, information required to be filed by the laws of home country or principal exchange traded on|
|Catch-all company||Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet. Note that compliance with the requirement to include financial information for the 2 preceding years does not take effect until 2 years after the effective date (i.e. approximately 2 years and 2 months). A catch-all company would still need to provide all other current information set forth in the rule, to qualify for the piggyback exception, beginning on the compliance date – i.e. 9 months after the effective date.|
The amended rule adds a 15 day conditional grace period for a broker-dealer to continue to quote securities which no longer qualify for the piggyback exception as a result of a company no longer having current available public information upon expiration of the time periods in the above chart. In order to use the grace period, three conditions must be met: (i) OTC Markets or FINRA must make a public determination that current public information is no longer available within 4 business days of the information no longer being available (i.e. expiration of the time periods in the chart), this could be by, for example, a tag on the quote page or added letter to the ticker symbol; (ii) all other conditions for reliance on the piggyback exception must be effective (such as a one way quote); and (iii) the grace period ended on the earliest of the company once again making current information publicly available or the 14th calendar day after OTC Markets or FINRA makes the public determination in (i) above.
To reduce some of the added burdens of the rule change, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the piggyback exception have been met. To be able to properly keep track of piggyback exception eligibility, OTC Markets will need to establish, maintain, and enforce reasonably designed written policies and procedures to determine, on an ongoing basis, whether the documents and information are, depending on the type of company, filed within the prescribed time periods. I think the amendments, especially requiring ongoing current public information, will have a significant impact on micro-cap fraud.
The initial rule proposal contained a provision that would have eliminated the piggyback exception altogether for shell companies. This provision received significant push-back and would have had a huge chilling effect on reverse merger transactions in the OTC Markets. In its rule proposal the SEC admitted that there are perfectly legal and valid reverse-merger transactions. My firm has worked on many reverse-merger transactions over the years.
In response to the push back and the final rule allows for broker-dealers to rely on the piggyback exception to publish quotations for shell companies for a period of 18 months following the initial priced quotation on OTC Markets. In essence, a shell company is being granted 18 months to complete a reverse merger with an operating business, or in the alternative, to organically begin operations itself. To be clear, the amended rules only allow the piggyback exception for a period of 18 months following the initial quotation. Accordingly, if a company falls into shell status after it has been quoted for 18 months, a new 15c2-11 review would need to be completed by either a broker-dealer or OTC Markets under the initial quotation standards. Upon that new initial review, and assuming compliance with the requirements to initiate a quote, a new 18 month period would begin. If the company remained a shell at the end of the 18 month period, it would lose piggy back eligibility and a new 211 compliance review would be necessary. That is, either a broker-dealer would need to file a new Form 211, or OTC Markets would need to conduct the review upon which the broker-dealer could rely.
The amended rule adopts a definition of shell company that tracks Securities Act Rules 405 and 144 and Exchange Act Rule 12b-2, but also adds a “reasonable basis” qualifier to help broker-dealers and OTC Markets make determinations. In particular, a shell company is defined as any issuer, other than a business combination related shell company as defined in Rule 405 or asset backed issuer, that has: (i) no or nominal operations; and (ii) either no or nominal assets or assets consisting solely of cash or cash equivalents. A company will not be considered a shell simply because it is a start-up or has limited operating history. In order to have a reasonable basis for its determination, a broker-dealer or OTC Markets can review public filings, financial statements, business descriptions, etc.
The current 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. The amended rule eliminated both the 12 and 30 day frequency of quotation requirements but retains the four day requirement.
The piggyback exception rule change was the subject of a plethora of comments and push-back from the marketplace, including retail traders that were concerned they would in essence lose their livelihood, presumably this is one of the reasons the SEC devoted a full 60 pages to its discussion on this topic. In a sort of comprise, the SEC stated that it understands that market participants may have unique facts and circumstances as to how the amended Rule affects their activities, and the SEC will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule.
In a request for relief the SEC will consider all facts and circumstances including whether based on information provided, the issuer or securities are less susceptible to fraud or manipulation. The SEC may consider, among other things, securities that have an established prior history of regular quoting and trading activity; companies that do not have an adverse regulatory history; companies that have complied with any applicable state or local disclosure regulations that require that the company provide its financial information to its shareholders on a regular basis, such as annually; companies that have complied with any tax obligations as of the most recent tax year; companies that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors. Requests for relief should be submitted as soon as possible to prevent a quotation interruption prior to the rule’s implementation.
The requirement limiting the piggyback exception for the first 60 calendar days after a trading suspension will not likely have a market impact. A trading suspension over 5 days currently results in the loss of the piggyback exception and requirement to file a new Form 211. In practice, the SEC issues ten-day trading suspensions on OTC Securities, and there is no broker-dealer willing to file a new 15c2-11 within 60 days thereafter in any event. In fact, in reality, it is a rarity for a company to regain an active 211 after a trading suspension. Perhaps that will change with implementation of the new rules.
The existing rule excepts from the information review requirement the publication or submission of quotations by a broker-dealer where the quotations represent unsolicited customer orders. Under the final rule, a broker-dealer that is presented with an unsolicited quotation, would need to determine whether there is current publicly available information. If no current available information exists, the unsolicited quotation exception is not available for company insiders or affiliates including officers, directors and 10%-or-greater shareholders.
In the final rule, a broker-dealer may rely on a written representation from a customer’s broker that such customer is not a company insider or an affiliate. The written representation must be received before and on the day of a quotation. Also, the broker-dealer must have a reasonable basis for believing the customer’s broker is a reliable source including for example, obtaining information on what due diligence the broker conducted. Like the piggy-back exception, a broker-dealer will be able to rely on a qualified IDQS (OTC Markets) or a national securities association (FINRA) that there is current publicly available information.
Lower Risk Securities; New Exceptions
The final rule provides an exception for companies that are well capitalized and whose securities are actively traded. In order to rely on this exception, the security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”).
The ADTV test requires that the security have a worldwide reported ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation. To satisfy the final ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade).
The asset test requires that the company have at least $50 million in total assets and stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end. This would cover both domestic and foreign issuers. The proposed rule would have required that the $10 million of stockholder’s equity be from unaffiliated stockholders but that requirement was eliminated in the final rule.
The rule also creates an exception for a company who has another security concurrently being quoted on a national securities exchange. For example, some companies quote their warrants or rights on OTC Markets following a unit IPO offering onto a national exchange.
Like the piggyback exception, the SEC allows a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of the ADTV and asset test or the exchange-traded security exception have been met. Conversely if OTC Markets or FINRA is publishing the availability of an exception, they will also need to publish when such exception is no longer available.
The final rule adds an exception to the rule to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This change may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.
This exception requires that the broker-dealer have the 211 current information in its possession and have a reasonable basis for believing the information is accurate and the sources of information are reliable. Since FINRA issues a ticker symbol, this new exception will still require a broker-dealer to file a Form 211 (or new form generated by FINRA to facilitate the exception).
Miscellaneous Amendments to Streamline
The SEC has also made numerous miscellaneous changes to streamline the rule and eliminate obsolete provisions. The miscellaneous changes include: (i) allowing a broker-dealer to provide an investor that requests company information with instructions on how to obtain the information electronically through publicly available information; (ii) updated definitions; and (iii) the elimination of historical provisions that are no longer applicable or relevant.
As part of its rule release, the SEC eliminated the preliminary note that appeared with the former rule and adopted new guidance.
As discussed, a broker-dealer must have a reasonable basis under the circumstances to believe that 211 information is accurate in all material respects and from a reliable source. In its guidance, the SEC specifies that a deep-dive due diligence is not necessary in the absence of red flags and that FINRA, OTC Markets or a broker-dealer can rely on information provided by a another broker-dealer, company or its agents, including, officers, directors, attorneys or accountants and information that is publicly available. Where a source of information indicates it was prepared by a company or one of its agents, the broker-dealer should confirm with the company or the particular agent.
Upon reviewing all information in its possession and confirming that all information required by the rule has been received, the information review process can generally be completed. However, where a red flag presents itself such as a material inconsistency, a further review needs to be conducted. A reviewer either needs to resolve the red flag, or choose not to publish a quotation. This portion of the guidance stresses that investigations are not necessary beyond the specific information required in the rule, unless a red flag is present.
The guidance provides a non-exclusive list of red flags: (i) SEC or foreign trading suspensions; (ii) concentration of ownership of the majority of outstanding freely tradeable stock; (iii) large reverse stock splits; (iv) companies in which assets are large and revenue is minimal without explanation; (v) shell company’s acquisition of private company or other material business development; (vi) a registered or unregistered offering raises proceeds that are used to repay a bridge loan made or arranged by an underwriter where the loan is short term with a high interest rate, the underwriter received securities at below market prior to the offering and the company has no apparent business purpose for the loan; (vii) significant write-up of assets upon a company obtaining a patent or trademark; (viii) significant assets consist of substantial amounts of shares in other OTC companies; (ix) assets acquired for shares of stock when the stock has no market value; (x) unusual auditing issues; (xi) significant write-up of assets in a business combination of entities under common control; (xii) extraordinary items in notes to the financial statements; (xiii) suspicious documents; (xiv) a broker-dealer or qualified IDQS receives substantially similar offering documents from different issuers with certain characteristics; (xv) extraordinary gains in year to year operations; (xvi) reporting company fails to file an annual report; (xvi) disciplinary actions against a company’s officers, directors, general partners, promoters, auditors or control persons; (xvii) significant events involving a company or its predecessor or any majority subsidiaries; (xviii) request to publish both bid and offer quotes on behalf of a customer for the same stock; (xix) issuer or promoter offers to pay a fee; (xx) regulation S transactions of domestic companies; (xxi) Form S-8 stock; (xxii) “hot industry” OTC stocks; (xxiii) unusual activity in brokerage accounts of company affiliates, especially involving related shareholders; and (xxiv) companies that frequently change their names or lines of business.
In general I am happy with the rule changes. Allowing OTC Markets to separately review and make a determination as to initial compliance with Rule 15c2-11 or the availability of an exemption should improve the system dramatically. The existing rule was antiquated, simply did not meet its intended purpose, and provided unnecessary burdens on certain market-participants and none at all on others. However, I would like to see additional changes. In particular, the proposing release did not address the prohibition on broker-dealers, or now, OTC Markets, charging a fee for reviewing current information, confirming the existence of an exemption and otherwise meeting the requirements of Rule 15c2-11 (as set out in FINRA Rule 5250 – see here for more information HERE). The process of reviewing the information is time-consuming and the FINRA review process is arduous. Although not in the rule, FINRA in effect conducts a merit review of the information that is submitted with the Form 211 application and routinely drills down into due diligence by asking the basis for a reasonable belief that the information is accurate and from a reliable source. Most brokerage firms are unwilling to go through the internal time and expense to submit a Form 211 application. I believe the SEC needs to allow broker-dealers and OTC Markets to be reimbursed for the expense associated with the rule’s compliance.
Late last year, around the same time that the SEC approved Nasdaq rule changes related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market (see HERE), the SEC rejected proposed amendments by the NYSE big board which would allow a company to issue new shares and directly raise capital in conjunction with a direct listing process. Nasdaq had previously updated its direct listing rules for listing on the Market Global Select Market (see HERE).
The NYSE did not give up and in August of this year, after two more proposed amendments, the SEC finally approved new NYSE direct listing rules that allow companies to sell newly issued primary shares on its own behalf into the opening trade in a direct listing process. However, after receiving a notice of intent to petition to prevent the rule change, the SEC has stayed the approval until further notice. Still pushing forward, on September 4, the NYSE filed a motion with the SEC requesting that the stay be lifted and allowing the rule change to proceed. The NYSE argued that the objection to the rule change lacks merit and that the arguments raised were already fully vetted in the lengthy rule approval process.
Shortly after the August rule change approval, software unicorn Palantir Technologies filed an S-1 with the SEC to go public via direct listing on the NYSE. Although Palantir does not intend to sell securities under the new rule, but rather only filed for re-sale of existing shareholders’ equities, the much anticipated public transaction continues to be delayed. However, it is likely that the delay is not related to the stalled rule change, but rather normal market conditions.
Not wanting the NYSE to have a competitive edge, Nasdaq has filed a similar proposal with the SEC to allow for companies to sell shares directly in conjunction with direct listings onto the Exchange. I suspect that a ruling on that request will be delayed until the NYSE issue has been resolved.
Direct Listings in General
Traditionally, in a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A company would also not necessarily need a banker in the resale direct listing process. A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC. For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.
Most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering. For more on Rule 506, see HERE.
Early investors take a greater risk because there is no established secondary market or clear exit from the investment. Even where an investment is made in close proximity to an intended going public transaction, due to the higher risk, the private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.
Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk. For more on the accredited investor definition including the SEC’s recent amendments, see HERE.
The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.
In a direct listing there is a chance for an initial dip in trading price, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option. An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.
A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).
The new NYSE rule (and Nasdaq proposal) will change the direct listing process to allow a company to sell shares directly into the trading market and thus complete a capital raise at the same time as its going public transaction. In essence, this direct listing hybrid is an IPO without an underwriter.
Direct Listing with Company Share Sales
A company that seeks to list on the NYSE must meet all of the minimum initial listing requirements, including specified financial, liquidity and corporate governance criteria, a minimum of 400 round lot shareholders, 1.1 million publicly held outstanding shares and a $4.00 share price. Direct listings are subject to all initial listing requirements applicable to equity securities and as such, in a direct listing process, the rules must specify how the exchange will calculate compliance with the initial listing standards including related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
In order to qualify for the NYSE big board in a direct listing process, a company must have a minimum of $100 million aggregate market value of publicly held shares. In contrast, in an IPO, a company is only required to have a market value of publicly held shares of $40 million. The reason for the much higher standard in a direct listing process is a concern related to the liquidity and market support in an opening auction process without attached underwriters.
As indicated, the NYSE rule change allows a company to sell shares directly into the market, without an underwriter, as part of a direct listing process. In order to accomplish this, the NYSE created a new process dubbed an Issuer Direct Offering (IDO). To get the process across the finish line, the last amendment (i) deleted a provision that would provide additional time for companies completing a direct listing to meet the initial listing distribution standards; (ii) added specific provisions related to the concurrent selling security holder and IDO process; (iii) added provisions related to participation in the direct listing auction when completing an IDO; and (iv) removed references to direct listing auctions in the rule related to Exchange-Facilitated Auctions.
The material aspects of the final NYSE rule change (i) modifies the provisions relating to direct listings to permit a primary offering in connection with a direct listing and to specify how a direct listing qualifies for initial listing if it includes both sales of securities by the company and possible sales by selling shareholders; (ii) modifies the definition of “direct listing”; and (iii) adds a definition of “Issuer Direct Offering (IDO)” and describes how it participates in a direct listing auction.
To clarify the difference between an IDO and selling security holder process, the NYSE has defined a shareholder-resale process as a “Selling Shareholder Direct Floor Listing.” A pure Selling Shareholder Direct Floor Listing occurs where a company is listing without a related underwritten offering upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements.
The Selling Shareholder Direct Floor Listing process retains the existing standards for direct listing and how the NYSE determines company eligibility including the market value of publicly held shares. In particular, a company can meet the $100 million market value of publicly held shares requirement using the lesser of (i) an independent third-party valuation; and (ii) the most recent trading price of the company’s common stock in a trading system for unregistered securities that is operated by a national securities exchange or a registered broker-dealer (“Private Placement Market”). In order to satisfy the $100 million valuation, the NYSE requires that the independent valuation comes in at a market value of at least $250 million. In addition, the NYSE will only consider the Private Placement Market price if the equity trades on a consistent basis with a sustained history of several months, in excess of the market value requirement. Shares held by directors, officers or 10% or greater shareholders are excluded from the calculation.
An IDO listing is one in which a company that has not previously had its common equity securities registered under the Exchange Act, lists its common equity securities on the NYSE at the time of effectiveness of a registration statement pursuant to which the company would sell shares itself in the opening auction on the first day of trading on the Exchange in addition to, or instead of, facilitating sales by selling shareholders. This process is being called a “Primary Direct Floor Listing.” In a Primary Direct Floor Listing, a company can meet the $100 million market value of publicly held shares listing requirement if it sells at least $100 million in market value of shares in the NYSE’s opening auction on the first day of trading. Alternatively, where a company will sell less than $100 million of shares in the opening auction, the NYSE will determine that the company has met its market value of publicly held shares requirement if the aggregate market value of the shares the company will sell in the opening auction on the first day of trading and the shares that are publicly held immediately prior to the listing is at least $250 million. In that case the market value is calculated using a price per share equal to the lowest price of the price range established by the company in its registration statement.
In order to facilitate the direct sales by the company, the NYSE has created a new type of buy-sell order called an “Issuer Direct Offering Order (IDO Order)” which would be a limit order to sell that is to be traded only in a Direct Listing Auction for a Primary Direct Floor Listing. An IDO Order is subject to the following: (i) only one IDO Order may be entered on behalf of the company and only by one member organization; (ii) the limit price of the IDO Order must be equal to the lowest price of the price range in the effective registration statement; (iii) the IDO Order must be for the quantity of shares offered by the company as disclosed in the effective registration statement prospectus; (iv) an IDO Order may not be cancelled or modified; and (v) an IDO Order must be executed in full in the Direct Listing Auction.
A designated market maker effectuates the Direct Listing Auction manually and is responsible for setting the price (which involves many factors including working with the valuation financial advisor and the price set in the registration statement). The Direct Listing Auction and thus Primary Direct Floor Listing would not be completed if (i) the price is below the minimum or above the highest price in the range in the effective registration statement or (ii) there is not enough interest to fill both the IDO Order and all better priced sell orders in full. In other words, a Primary Direct Floor Listing can fail at the finish line. To provide a little help in this regard, the NYSE has provided that an IDO Order that is equal to the auction price, will receive priority over other buy (sell) orders.
The NYSE has also added provisions regarding the interaction with a company’s valuation or other financial advisors and the designated market maker to ensure compliance with all federal securities laws and regulations, including Regulation M. To provide an additional level of investor protection, and to satisfy the SEC, the NYSE retained FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of the federal securities laws and NYSE rules. Finally, the NYSE made several changes to align definitions and rule cross-references with the new provisions and direct listing process.
In passing the rule, the SEC noted that after its several modifications, they were satisfied that the final rule helped ensure that the listed companies would have a sufficient public float, investor base, and trading interest to provide the depth and liquidity necessary to promote fair and orderly markets.
The much anticipated amendments to the accredited investor definition and definition of qualified institutional buyer under Rule 144A were adopted by the SEC on August 26, 2020. The amendments come almost five years after the SEC published a report on the definition of “accredited investors” ( see HERE) and nine months after it published the proposed amendments (see HERE). The rule changes also took into account the input and comment letters received in response to the SEC’s concept release and request for public comment on ways to simplify, harmonize and improve the exempt offering framework (see HERE).
As a whole industry insiders, including myself, are pleased with the rule changes and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. As the SEC pointed out historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets. The amendments are meant to improve the definition to include institutional and individual investors with knowledge and expertise in the marketplace.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify with $5 million in assets and a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC has also amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
The amendments become effective 60 days after publication in the Federal Register.
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including Rules 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows an investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2019 the estimated capital raised in exempt offerings was $2.7 trillion compared to $1.2 trillion in registered offerings. The amended definition of accredited investor is part of the SEC’s larger effort to simplify, harmonize, and improve the exempt offering framework. Earlier this year the SEC published broader proposed rule changes to the exempt offering structure, which I broke down into a 5-part blog series. The first centered on the offering integration concept (see HERE); the second on offering communications, testing the waters and a new demo day exemption (see HERE); the third on Regulation D, Rule 504 and bad actor rules (see HERE); the fourth on Regulation A (see HERE); and the fifth on Regulation Crowdfunding (see HERE).
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
- Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
- Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
- Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
- Any entity in which all of the equity owners are accredited investors.
Summary of Amendments
The amendment to the accredited investor definition adds new categories of natural persons based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In particular, to start the amendment provides that a holder in good standing of a Series 7, 65 or 82 license qualifies as an accredited investor. The SEC further provides that it may add additional certifications, designations, or credentials in the future. In addition, a knowledgeable employee of a private fund will now be considered accredited. The amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test for natural persons.
The amendments also: (i) clarify that limited liability companies with $5 million in assets qualify as accredited and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify; (ii) add a new catch-all category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (iii) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (iv) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The amendments to the qualified institutional buyer definition in Rule 144A add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The amendments also add a catch-all category that permits institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
Noting that relying solely on financial thresholds as an indication of financial sophistication is suboptimal, including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth, the final amendment adds new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations. The final amendments track the proposed amendments in this area except that the final amendments require that any certification, license or designation be in good standing in order to qualify for accreditation.
The final amendment provides that the SEC may designate qualifying professional certifications, designations, and other credentials by order, with such designation to be based upon consideration of all the facts pertaining to a particular certification, designation, or credential. The final amendment includes a non-exclusive list of attributes the SEC will consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status will be posted on the SEC’s website.
Concurrent with adopting the final amendments, the SEC issued an order designating good standing holders of a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and would leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Requiring that a list of individuals that hold the certifications be publicly available will reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC has added a new category based on the person’s status as a “knowledgeable employee” of the fund. A knowledgeable employee is defined as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund who in connection with his or her regular functions or duties, participates in the investment activities of the fund and has been doing so for at least 12 months.
The private fund category is meant to encompass funds that rely on the investment company registration exemptions found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, prior to this amendment, if the knowledgeable employee does not qualify as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded.
The SEC has added a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent is defined as a cohabitant in a relationship generally equivalent to a spouse. The rule does not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules add the following entities to the accredited investor definition: (i) limited liability companies with total assets in excess of $5 million that were not formed for the specific purpose of making the investment; (ii) SEC and state registered investment advisers and exempt reporting advisors; (iii) rural business investment companies (RBICs); (iv) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (v) “family offices” with at least $5 million in assets under management, that were not formed for the purpose of making the investment, and their “family clients,” as each term is defined under the Investment Advisers Act as long as the prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.
These additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
Qualified Institutional Buyer – Rule 144A
The SEC has amended the definition of a “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. Rule 144A(a)(1)(i) specifies the types of institutions that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested threshold. The amendments expand the definition of qualified institutional buyer by adding RBICs, limited liability companies, and all entities, including Indian tribes that meet the $100 million threshold.
The amendments also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
In addition to the temporary rule changes and relief that Nasdaq has provided this year for companies affected by Covid-19 (see HERE and HERE), the exchange has enacted various rule amendments with varying degrees of impact and materiality.
In particular, over the last year Nasdaq has amended its delisting process for low-priced securities, updated its definition of a family member for the purpose of determining director independence and has clarified the term “closing price” for purposes of the 20% rule. This blog discusses each of these amendments.
In April 2020, the SEC approved Nasdaq rule changes to the delisting process for certain securities that fall below the minimum price for continued listing. The rule change modifies the delisting process for securities with a bid price at or below $0.10 for ten consecutive trading days during any bid-price compliance period and for securities that have had one or more reverse stock splits with a cumulative ratio of 250 shares or more to one over the prior two-year period.
Nasdaq’s rules require that primary equity securities, preferred stocks, and secondary classes of common stock maintain a minimum bid price of at least $1.00 per share for continued listing. Under Rule 5810(c)(3)(A), a security is considered deficient with this bid price requirement if its bid price closes below $1.00 for a period of 30 consecutive business days. Under Nasdaq Rule 5810(c)(3)(A), a company with a bid price deficiency has 180 calendar days from notification of the deficiency to regain compliance. A company generally can regain compliance with the bid-price requirement by maintaining a $1.00 closing bid price for a minimum of ten consecutive business days during the 180-day compliance period.
Also under the current rules, if a company is listed on or moves to the Nasdaq Capital Market, the lowest tier of Nasdaq, it may be eligible for a second 180-day period to regain compliance, provided that in the last half of the first compliance period, the company met the market value of publicly held shares requirement, as well as compliance with other Nasdaq rules. Accordingly, a company trading on the Nasdaq Capital Market could have up to 360 days to regain compliance with a deficient bid price.
However, where a company has a bid price below $.10 or has completed several reverse splits, it likely has more severe issues that will not be able to be corrected regardless of the allowable period to regain compliance.
The rule amendment allows Nasdaq to provide a notice of Staff Delisting Determination to a company that has traded below $1.00 for thirty consecutive business days (the time it would normally receive its deficiency notice) if the security has a closing bid price of $0.10 or less for a period of ten consecutive trading days. Likewise, instead of receiving a notice of deficiency, a company will receive a Staff Delisting Determination if it falls out of compliance with the $1.00 minimum bid price after completing one or more reverse stock splits resulting in a cumulative ratio of 250 shares or more to one over the two-year period immediately prior to such non-compliance.
A company could appeal the Staff Delisting Determination to a Nasdaq hearing panel which could grant a 180-day compliance period if it believes the company will be able to achieve and maintain compliance with the bid-price requirement.
The rule amendment was effective immediately and applied to all companies that received notice of noncompliance with the bid-price requirement after the date of its effectiveness. However, on May 14, 2020, Nasdaq extended the new rule such that it will be effective for companies that first receive notification of non-compliance on or after September 1, 2020. Nasdaq extended the rule effective date to provide relief for companies experiencing wide trading fluctuations as a result of Covid-19. The effective date extension is in addition to Nasdaq’s prior announcement that it would toll the 180-day period for companies that had already received a non-compliance notice, through June 30, 2020 (see HERE).
Although the new rule was extended, Nasdaq notes that it still may rely on its discretion to deny a second 180-day period to regain compliance for a company with a very low stock or that has completed multiple prior reverse splits. For a review of Nasdaq’s current initial listing standards, see HERE.
Definition of Family Member for Purposes of Determining Director Independence
Back in December, I wrote a blog drilling down on the Nasdaq board independence requirements (see HERE) and noted that a few months earlier, the SEC had declined to approve a Nasdaq rule change to the definition of “family member.”
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
For purposes of Rule 5605, “family member” was defined as a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule-change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The proposed language matched the NYSE definition. However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change believing that the rule release made an over-correction.
In February, Nasdaq submitted its third amendment to the proposed rule change, which was approved by the SEC. Although the definition of “family member” as approved by the SEC, is the same as proposed in June 2019, the rule release now states that Nasdaq intends to exclude domestic employees who share the director’s home, and stepchildren who do not share the director’s home, from the types of relationships that always preclude a finding that a director is independent. Rather, a company’s board of directors will need to examine all facts and circumstances to determine if a particular step-child relationship would be likely to interfere with the director’s exercise of independent judgment in carrying out his or her responsibilities
Clarification of “Closing Price” in 20% Rule
In January 2020, Nasdaq filed a rule change to clarify the meaning of the term “Closing Price” as used in Rule 5635(d), known as the 20% Rule. For more information on Rule 5635(d), see HERE. The rule change does not make any substantive changes but rather is meant to clarify the language to avoid any potential confusion.
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The rule amendment changes the term “closing price” to “Nasdaq Official Closing Price” in the definition of Minimum Price. The term Nasdaq Official Closing Price had been used in the September 2018 rule release when Nasdaq adopted the definition of Minimum Price. Aligning the language will add a layer of consistency and avoid any confusion for listed companies.