Monthly Archives: November 2020
The recent amendments to Items 101, 103 and 105 of Regulation S-K (see HERE) went into effect on November 9, 2020, raising many questions as to the transition to the new requirements. In response to what I am sure were many inquiries to the Division of Corporation Finance, the SEC has issued three transitional FAQs.
The amendments made changes to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.
FAQ – Form S-3 Prospectus Supplement
The first question relates to the impact on Form S-3 and in particular the current use of prospectus supplements for an S-3 that went into effect prior to November 9, 2020. In general, a Form S-3 is used as a shelf registration statement and a company files a prospectus supplement each time it takes shares down off that shelf (see HERE).
The prospectus supplement must meet the requirements of Securities Act Rule 424 and includes specific information that was omitted from the base S-3 shelf registration. That information generally includes facts about a particular offering or shelf take-down such as the public offering price, description of securities or similar matters, and facts and events that constitute a substantive change from or addition to the information included in the base S-3.
The specific FAQ is “[A] registrant has a Registration Statement on Form S-3 that became effective before November 9, 2020. If the registrant files a prospectus supplement to the Form S-3 on or after November 9, 2020, must the prospectus supplement comply with the new rules?”
The SEC confirms that a prospectus supplement does not need to comply with new Items 101 and 103 because Form S-3 does not expressly require Item 101 or Item 103 disclosure but rather requires the incorporation by reference from Exchange Act reports containing that information. Further, the SEC confirms that a company does not need to amend its Form 10-K that is incorporated by reference into the Form S-3 to update for the new rules. For more on incorporation by reference including with respect to a Form S-3, see HERE.
On the other hand, Item 105 – risk factor disclosures – are required to be included in a prospectus supplement. In particular, Securities Act Rule 401(a) requires that the form and contents of a prospectus supplement conform to the applicable rules and forms as in effect on the initial filing date of the prospectus supplement. The SEC, however, has stated it will allow a company to continue to comply with the old Item 105 rules for prospectus supplements filed until the next update to the Registration Statement on Form S-3 for Section 10(a)(3) purposes.
A Form S-3 is updated for Section 10(a)(3) purposes each year when it files its Form 10-K, which is automatically incorporated by reference into the S-3. A company may also file a post-effective amendment to the Form S-3 as a result of fundamental changes, which post-effective amendment would act as a Section 10(a)(3) update.
FAQ – Form 10-K
Quickly following the passage of the new rules, practitioners noticed a disconnect between the new Item 101 requirements and the instructions on Form 10-K. In particular, Item 1 of Form 10-K requires the company to “[F]urnish the information required by Item 101 of Regulation S-K (§ 229.101 of this chapter) except that the discussion of the development of the registrant’s business need only include developments since the beginning of the fiscal year for which this report is filed.”
Amended Item 101(a) replaces the former prescriptive requirement to provide information related to the development of the company for the last 5 years (or 3 years for a smaller reporting company) with a principles-based materiality approach. Now, a company must provide information that is material to an understanding of the development of its business, irrespective of a specific time frame. The adopting rule release did not discuss the applicability to Form 10-K.
To clarify any confusion, the SEC issued an FAQ confirming that the new rules do not change Item 1 of Form 10-K, which only requires disclosures regarding the development of the registrant’s business for the fiscal year covered by the 10-K.
FAQ – Item 101 in Reports and Registration Statements
The third FAQ asks whether a company must always provide a full discussion of general development of its business pursuant to new Item 101(a) (or new Item 101(h) for a smaller reporting company) in an annual report or registration statement that requires Item 101 disclosure. The SEC’s response is “not necessarily.”
In particular, except in an initial registration statement, new Item 101 will permit a company to omit the full discussion of the general development of its business if the company: (1) provides an update to the general development of its business, disclosing all material developments that have occurred since the most recent registration statement or report that includes the full discussion; (2) includes one active hyperlink to the registration statement or report that includes the full discussion; and (3) incorporates the full discussion by reference to the registration statement or report. However, a company is not required to use this updating method. The SEC anticipates that the updating method will apply mainly to registration statements.
Over the years I have written many times about exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services (see, for example: HERE). Finally, after years of advocating for SEC guidance on the topic, the SEC has proposed a conditional exemption for finders assisting small businesses in capital raising. The proposed exemption will allow for the use of finders to assist small businesses in raising capital from accredited investors.
In its press release announcing the proposal, SEC Chair Clayton acknowledged the need for guidance, stating, “[T]here has been significant uncertainty for years, however, about finders’ regulatory status, leading to many calls for Commission action, including from small business advocates, SEC advisory committees and the Department of the Treasury. If adopted, the proposed relief will bring clarity to finders’ regulatory status in a tailored manner that addresses the capital formation needs of certain smaller issuers while preserving investor protections.”
Separately, New York has recently proposed a new finder’s exemption, joining California and Texas, who were early in creating exemptions for intra-state offerings. Also, I have received several inquiries lately on the topic of non-U.S. finders in the Regulation S context. This seems a good time to address it all. In Part I of this blog, I will review the new SEC proposal and in Part II the state law exemptions and Regulation S framework.
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders.
In its proposal the SEC recognizes this cottage industry, stating finders “often play an important and discrete role in bridging the gap between small businesses that need capital and investors who are interested in supporting emerging enterprises.” The SEC goes further recognizing that the lack of regulation makes it very difficult, noting that “companies that want to play by the rules struggle to know in what circumstances they can engage a ‘finder’ or a platform that is not registered as a broker-dealer.” The SEC gives a nod to the numerous calls for action over the years, including the ABA’s 2005 report, the SEC Advisory Committee on Small and Emerging Companies and the U.S. Treasury report (see links to discussions under Additional Reading on Finders).
I have advocated in the past for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. Although the exemptive order does have bad actor prohibitions it does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Although I think the proposal is a much needed step towards regulating finders, there are two aspects of the exemption that I have trouble with. The first is limiting the exemption to natural persons. Many natural persons operate through personal business entities such as an LLC or S corporation for valid business reasons including tax and estate planning.
The second is making the exemption unavailable for companies that are subject to the Exchange Act reporting requirements. The SEC reasons that once a company is able to file reports under the Exchange Act it is more likely able to attract a licensed broker dealer and would not need an unlicensed finder. The SEC indicates that non-reporting companies are more likely to experience difficulty obtaining the assistance of a broker-dealer, and are therefore most likely to need the assistance of a finder. I completely disagree with this reasoning as a basis for limiting the exemption.
Certainly the SEC reasoning may be true in some cases, but many broker-dealers will not work with small public companies, and many are simply prohibited from doing so. For instance Bank of America, and their brokerage, Merrill Lynch, will not transact business in the securities of companies with less than a $300 million market cap and less than a $5.00-per-share stock price (see HERE). Even many of the smaller tier brokerage firms that I deal with on a daily basis will not assist with a capital raise for an OTC Markets traded security unless the raise is a public offering in conjunction with an up-listing to a national exchange. Many of these brokerage firms clear through a clearing firm who in turn will not allow them to transact business with an OTC Markets issuer. Even those that will work with these smaller public companies, generally will not do so for a private capital raise, but rather will only work on public registered offerings.
If the SEC’s argument is based on need, then there is a large group of small public companies that have a palpable need for assistance with exempt offering capital raising efforts that will be left unfulfilled. Exempt offerings are smaller than registered offerings. Even if a small company can attract a broker-dealer for a private capital raise, the commissions, expense reimbursement and fees are generally extremely high and the agreements generally include strong rights of first refusal (ROFR rights) and other provisions that can make the cost of capital unfeasible. Further, knowing that by becoming subject to the SEC reporting requirements, the ability to use finder’s will be foreclosed, many of these companies may delay a going public transaction, which in and of itself is contrary to the SEC’s stated policies of encouraging public offerings and access to U.S. capital markets (see for example HERE).
Furthermore, one of the SEC’s core missions is the protection of investors. Companies that are subject to the Exchange Act reporting requirements are audited by independent auditors and required to comply with Sarbanes Oxley Act Rule 404(a) requiring the company to establish and maintain internal controls over financial reporting and disclosure control and procedures and have their management assess the effectiveness of each. These companies are subject to robust disclosure requirements delineated by Regulation S-K and financial disclosure requirements under Regulation S-X. Clearly, investors have much greater protections with the use of finders on behalf of a reporting company than a small private company.
Proposed Federal Finder’s Exemption
Registered broker-dealers are subject to comprehensive regulation under the Exchange Act and under the rules of each self-regulatory organization (“SRO”) of which the broker-dealer is a member, such as FINRA, the NYSE and Nasdaq. Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 15(a)(1) of the Exchange Act, in turn, makes it unlawful for any broker to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker is registered with the SEC. Accordingly, absent an available exception or exemption, a person engaged in the business of effecting transactions in securities is a broker required to register with the SEC.
Periodically the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. The Guide clearly includes “finders” and in particular:
Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):
- “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
- Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
- Finding investment banking clients for registered broker-dealers;
- Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
- Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
- Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flesh out, with inconsistent and uncertain results. Despite the inconsistent results, key considerations have included: (i) actively soliciting or recruiting investors; (ii) participating in negotiations between the issuer and the investor; (iii) advising investors as to the merits of an investment or opining on its merits; (iv) handling customer funds and securities; (v) having a history of selling securities of other issuers; and (vi) receiving commissions, transaction-based compensation or payment other than a salary for selling the investments.
The SEC has now proposed to issue an exemptive order, not a rule change, which would provide exemptive relief to allow a natural person to engage in certain defined activities without registration as a broker dealer. The exemption is in the form of a non-exclusive safe harbor and accordingly even if the parameters of the safe-harbor are not met, the traditional facts and circumstances analysis could still support that a person did not need to register as a broker dealer for specific activities.
The SEC proposal creates two classes of finders, both of which would allow a natural person (not an entity) to accept transaction-based fees for assisting with capital raising. A Tier I finder would be limited to providing contact information for potential investors and, as such, would not be able to have any direct contact with the investor. A Tier I finder could only assist a single company in a 12-month period.
A Tier II finder may (i) identify, screen and contact potential investors; (ii) distribute offering materials to investors; (iii) discuss company information including about the offering but may not provide advice on valuation or the advisability of making an investment; and (iv) arrange or participate in meetings with the company and investor. A Tier II finder is subject to certain disclosure requirements, including as to their role and compensation, and must obtain a written dated disclosure acknowledgement from the investor prior to any investment solicitation.
Regardless of the Tier, a finder could not (i) be involved in structuring the transaction or negotiating the terms of the offering; (ii) handle customer funds or securities or bind the issuer or investor; (iii) participate in the preparation of any sales materials; (iv) perform any independent analysis of the sale; (v) engage in any “due diligence” activities; (vi) assist or provide financing for such purchases; or (vii) provide advice as to the valuation or financial advisability of the investment.
Further, both Tiers of the proposed finder’s exemption are subject to the following conditions:
(i) the issuer cannot be required to file reports under the Exchange Act;
(ii) the issuer must be relying on a valid Securities Act registration exemption (such as Regulation D or Regulation A);
(iii) the finder cannot engage in general solicitation (the exemptive order does not specify if the issuer itself can engage in general solicitation but the finder cannot and in practice it may be difficult to maintain a clear line evidencing that the investors introduced by the finder did not learn of the offering through general solicitation if the issuer is doing so);
(iv) the investor must be accredited;
(v) the finder must have a written agreement with the issuer, including scope of services and compensation;
(vi) the finder cannot be associated with a broker-dealer;
(vii) the finder could not engage in other broker-dealer activities such as facilitating a registered offering or the resale of securities; and
(vii) the finder cannot be a “disqualified person” as defined in Section 3(a)(39) of the Exchange Act.
A “disqualified person” is similar to a bad actor under the exempt offering rules (see HERE) but regulates when a person is disqualified from being a member of FINRA (i.e., a broker-dealer) or associated with a member.
A person is disqualified from being a member or associated with a member of FINRA, and if the proposal is passed, from acting as a finder, if such person:
(a) has been expelled or suspended from membership, association with or participation in FINRA or foreign equivalent (the language is very broad in covering foreign contracts, markets, regulatory organizations and the like);
(b) is subject to an order of the SEC, other appropriate regulatory authority or foreign financial regulator denying, suspending for 12 months or less, revoking or otherwise limiting registration as a broker, dealer, municipal securities dealer, government securities broker, government securities dealer, security-based swap dealer, major security-based swap participant, or foreign equivalent of any of these or being an associated person of same;
(c) is subject to an order of the CFTC denying, suspending or revoking registration;
(d) is subject to an order of a foreign financial regulatory authority denying, suspending, or revoking the ability to engage in commodities, swaps or similar businesses;
(e) by his conduct while associated with a broker, dealer, municipal securities dealer, government securities broker or dealer, security-based swap dealer, or major security-based swap participant, or while associated with an entity or person required to be registered under the Commodity Exchange Act, has been found to be a cause of any effective suspension, expulsion, or order set forth in the above paragraphs, and in entering such a suspension, expulsion, or order, the SEC, an appropriate regulatory agency, or any self-regulatory organization (FINRA) shall have jurisdiction to find whether or not any person was a cause thereof;
(f) has associated (i.e., licensed with) any person that would be disqualified; or
(g) has committed or omitted any act, or is subject to an order or finding, of willful violation of any provision of the Securities Act, the Investment Advisors Act, the Investment Company Act, the Commodity Exchange Act or the rules of the Municipal Securities Rulemaking Board or has willfully aided, abetted, counseled, commanded, induced or procured such violation; is subject to a final order of a state securities or banking commission or similar agency or federal banking agency baring participation in the securities industry or finding a violation of any law or regulation which prohibits fraud, manipulative or deceptive conduct; has been convicted of any offense specified above or any other felony within ten years of the date of the filing of an application for membership or participation in, or to become associated with a member of, a self-regulatory organization; is enjoined from any action, conduct, or practice above; has willfully made or caused to be made in any application for membership or participation in, or to become associated with a member of, a self-regulatory organization, report required to be filed with a self-regulatory organization, proceeding before a self-regulatory organization, or any foreign equivalent any statement which was at the time, and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, or has omitted to state in any such application, report, or proceeding any material fact which is required to be stated therein (this paragraph is very similar to the Regulation D bad actor rules).
Additional Reading on Finders
For a general review on the law surrounding finder’s fees, including my recommendations for changes, see HERE.
For a review of the U.S. Department of the Treasury report recommending a regulatory structure for finder’s fees, see HERE.
For a review of the no-action-letter-based exemption for M&A brokers, see HERE.
For a review of the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer, see HERE.
To read about the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders, see HERE.
To learn about the exemption for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act, see HERE.
Following a tense period of debate and comments, on September 23, 2020, the SEC adopted amendments to Rule 14a-8 governing shareholder proposals in the proxy process. The proposed rule was published almost a year before in November 2019 (see HERE). The amendment increases the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954. The new rules represent significant changes to a shareholder’s rights to include matters on a company’s proxy statement.
Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years. The rules have not been amended in decades and during that time, shareholder activism has shifted. Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets. The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements. A study completed in 2018 found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.
The amendment alters the current ownership requirements for the submission of shareholder proposals to: (i) incorporate a tiered approach that provides for three options involving a combination of amount of securities owned and length of time held; (ii) specify documentation that must be provided when submitting a proposal; (iii) require shareholder proponents to specify dates and times they can meet with company management either in person or on the phone to discuss the submission; and (iv) provide that a person may only submit one proposal, either directly or indirectly, for the same shareholders meeting. The amendment also raise the current thresholds for the resubmission of proposals from 3, 6 and 10 percent to 5, 15 and 25 percent.
The final amendments go into effect 60 days after being published in the federal register and will apply to any proposal submitted for an annual or special meeting to be held on or after January 1, 2022.
Background – Current Rule 14a-8
The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.
All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.
Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors. Rule 14a-8 has been the source of considerable contention. Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that subject to substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.
State laws in general allow a shareholder to attend a meeting in person and at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process. By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost to themselves. It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.
The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so. Under the current Rule 14a-8 to qualify to submit a proposal, a shareholder must:
- Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
- If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
- If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
- Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
- Clearly state the proposal and course of action that the shareholder desires the company to follow;
- Submit no more than one proposal for a particular annual meeting;
- Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
- Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
- If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
- The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.
A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.
Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC. If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.
As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion. Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.
Substantive grounds for exclusion include:
- The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
- The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
- The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
- The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
- The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
- The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
- The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
- The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
- The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
- The proposal seeks to remove an existing director whose term is not completed;
- The proposal questions the competence, business judgment or character of one or more director nominees;
- The company has already substantially implemented the requested action;
- The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
- The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
- The proposal seeks to require the payment of a dividend; or
- The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.
Final Amended Rule
The need for a change in the rules has become increasingly apparent in recent years. As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and, as such, is susceptible to abuse. In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules. Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals. The SEC also conducted a Proxy Process Roundtable and invited public comments and input. The SEC continued its research, including reviewing a plethora of comment letters, after the rule proposals.
Submission Eligibility and Process
The final rule changes amend eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal. The amendments:
(i) Update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;
(ii) Investors who currently are eligible to submit proposals under the current $2,000 threshold/one-year minimum holding period, but currently do not satisfy the new requirements, will continue to be eligible to submit proposals through the expiration of the transition period that extends for all annual or special meetings held prior to January 1, 2023, provided they continue to hold at least $2,000 of a company’s securities;
(iii) Eliminate the 1% test as it historically is never used;
(iv) Eliminate the ability to aggregate ownership with other shareholders to meet the threshold for submittal. Shareholders can still co-file or co-sponsor proposals, but each one must meet the eligibility threshold;
(v) Require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal including a signed statement by the shareholder;
(vi) Require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal (regardless of prior communications on the subject), and provide contact information (of the shareholder, not its representative) as well as business days and specific times (i.e., more than one date and time) that the shareholder is available to discuss the proposal with the company.
One Proposal Requirement
The final amendments change the “one proposal” requirements in Rule 14a-8(c) to:
(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.
The final amendments also increase the resubmission thresholds. Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.”
The final amendments amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to increase the current resubmission thresholds of 3%, 6% and 10% of shareholder support related to matters voted on once, twice or three or more times in the last five years, respectively, to 5%, 15% and 25%.
The final amendments did not adopt an amendment from the proposed rule release that would have: (i) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote. Commenters strongly objected to this proposals and the SEC agreed with their reasoning.
As discussed above, a company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. In its proposing release, the SEC asked for comments on this process and how it might be improved upon, or whether the SEC should remove itself from the process altogether deferring to state law. After reviewing comments, the SEC declined to implement any changes to the process.
Just eight months following the rule proposal (see HERE), on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K. The amendments make a more principles-based approach to business descriptions and risk factors, recognizing the significant changes in business models since the rule was adopted 30 years ago. The amendments to disclosures related to legal proceedings continue the current prescriptive approach. In addition, the rule changes are intended to improve the readability of disclosure documents, as well as discourage repetition and disclosure of information that is not material.
The Item 101 and Item 103 amendments only apply to domestic companies and foreign private issuer that elect to file using domestic company forms. The forms generally used by foreign private issuers (F-1, F-3, 20-F, etc.) do not have references to Items 101 and 103 of Regulation S-K but rather refer to specific disclosure provisions in Form 20-F. However, the Item 105 (Risk Factor) amendments will apply across the board to both domestic and foreign issuers as the foreign issuer forms specifically refer to that section of Regulation S-K.
The effective date of the new rules is November 9, 2020 and as such, compliance with the new rules will need to be included in any filings made after 5:30 EST on Friday, November 6.
Item 101 – Description of Business
Item 101(a) of Regulation S-K requires a description of the general development of the business of the company during the past five years (or three years for smaller reporting companies) and lists five specific categories of information to include in the disclosure, including, for example, the year the company was formed and a description of any acquisitions or dispositions of businesses.
The SEC has amended Item 101(a) related to a company’s description of its business, to:
(i) Make it largely principles-based by providing a non-exclusive list of the types of information that could be disclosed and only requiring that disclosure to the extent it is material to an understanding of the general development of the business. The non-exclusive list includes: (a) material bankruptcy, receivership or similar proceeding; (b) nature and effects of any material reclassifications, merger or consolidation; (c) the acquisition or disposition of any material amount of assets otherwise than in the ordinary course of business; and (d) material changes to a company’s previously disclosed business strategy (note the proposed rule was more expansive on this topic but was determined to be repetitive to MD&A disclosures);
(ii) Eliminate a prescribed time frame for the disclosure. The SEC would rather require companies to focus on the information material to an understanding of the development of their business, irrespective of a specific time frame; and
(iii) Permit a company, in filings made after a its initial filing, to provide only an update of the general development of the business that focuses on material developments in the reporting period. A company must incorporate the previous discussion by reference and can only incorporate from a single previously filed document.
Item 101(c) of Regulation S-K requires a narrative description of the business done and intended to be done by the company, focusing on the segments that are reported in the company’s financial statements. Item 101(c) currently includes a list of 12 topics to cover. Like Item 101(a), the amendments make the rule largely principles-based and encourage a company to exercise judgment in evaluating what disclosure to provide. Only material information need be provided. The rule also provides a list of topics for a company to consider, and maintains the focus on providing company segment information.
The new list of topics include: (i) revenue generating activities, products or services, and any dependence on key products, services, product families, or customers, including governmental customers; (ii) status of development efforts for new or enhanced products, trends in market demand and competitive conditions; (iii) resources material to a company’s business, including raw materials; (iv) the duration and effect of all patents, trademarks, licenses, franchises, and concessions held; (v) a description of any material portion of the business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government; (vi) the extent to which the business is or may be seasonal; (vii) compliance with material government regulations, including environmental regulations (the prior list only included environmental regulations) to the extent they impact capital expenditures, earnings and competitive position; and (viii) human capital disclosure.
The human capital category is completely new and would include any material human capital measures or objectives that management focuses on in managing the business, and the attraction, development and retention of personnel (such as in a gig economy). The final rule includes non-exclusive examples of subjects that may be material, depending on the nature of the registrant’s business and workforce. The SEC declined to define “human capital” allowing a company to tailor the concept to its circumstances and objectives.
The human capital category is a win for advocates of environmental, social and governance (ESG) disclosures which have advocated for increased rule requirements related to these disclosure topics. For more on ESG, see HERE). It is unlikely we will see more than minor incremental increases in ESG disclosures beyond human capital under the current SEC regime. The SEC continues to review and study the issue, but is hesitant to spend other people’s money on matters that are personal and social, as opposed to clear material business metrics.
Item 103 – Legal Proceedings
requires disclosure of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or of which any of their property is the subject. Item 103 also requires disclosure of the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, and a description of the factual basis alleged to underlie the proceeding and the relief sought.
The SEC has amended Item 103 to: (i) expressly state that the required information about material legal proceedings may be provided by including hyperlinks or cross-references to legal proceedings disclosure located elsewhere in the document in an effort to encourage companies to avoid duplicative disclosure; and (ii) revise the $100,000 threshold for disclosure of environmental proceedings to which the government is a party to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Item 105 – Risk Factors
Item 105 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky and specifies that the discussion should be concise and organized logically. The disclosure of risk factors has always been principles-based with the SEC consistently discouraging the use of boilerplate items. However, despite this guidance, most companies include a lengthy laundry list of boilerplate risks.
The SEC has amended Item 105 to: (i) require summary risk factor disclosure of no more than two pages 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.
A company rarely requires more than 15 pages of risk factors, and as such, the new rule should be a good lesson in brevity and pointedness.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I have scaled down this recap from prior versions to focus on the most material items.
As discussed in this blog, on August 26, 2020, the SEC adopted final amendments to Item 101 – description of business, Item 103 – legal proceedings, and Item 105 – Risk Factors of Regulation S-K.
In May 2020, the SEC adopted amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses. See my blog HERE on the proposed amendments. My blog on the final amendments will be published after this blog.
In March 2020, the SEC adopted amendments to the definitions of an “accelerated filer” and “large accelerated filer” to enlarge the number of smaller reporting companies that can be exempt from those definitions and therefore not required to comply with SOX Rule 404(b) requiring auditor attestation of management’s assessment on internal controls. See HERE.
On January 30, 2020, the SEC proposed amendments to Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A) required by Item 303 of Regulation S-K. In addition, to eliminate duplicative disclosures, the SEC also proposed to eliminate Item 301 – Selected Financial Data and Item 302 – Supplementary Financial Information. See HERE.
On March 20, 2019, the SEC adopted amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The amendments: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See HERE. Some of the amendments had initially been discussed in an August 2016 request for comment – see HERE and the proposed rule changes were published in October 2017 – see HERE illustrating how lengthy rule change processes can be.
In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE .
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog here on the Item 601 rule changes HERE and HERE related to SEC guidance on same.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. In March 2020, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE
In early December 2015, the FAST Act was passed into law. The FAST Act required the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.