Monthly Archives: December 2020
I’ve been at this for a long time and although some things do not change, the securities industry has been a roller coaster of change from rule amendments to guidance, to interpretation, and nuances big and small that can have tidal wave effects for market participants. On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. The proposed rule also updates the Form 144 filing requirements to mandate electronic filings, eliminate the requirement to file a Form 144 with respect to sales of securities issued by companies that are not subject to Exchange Act reporting, and amend the Form 144 filing deadline to coincide with the Form 4 filing deadline.
The last amendments to Rule 144 were in 2008 reducing the holding periods to six months for reporting issuers and one year for non-reporting issuers respectively, adding current information requirements and eliminating the use of the rule for shell companies and former shell companies unless certain preconditions were satisfied. For a summary of the current Rule 144, see HERE.
Currently, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. Under the amendments, the holding period for the underlying securities acquired upon conversion or exchange of “market-adjustable securities” would not begin until the conversion or exchange. Market adjustable securities usually take the form of convertible notes which had become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so – that is, until the SEC went on the attack starting a few years ago recently intensifying those efforts.
In a standard convertible note structure, an investor lends money in the form of a convertible promissory note. Generally the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer. As Rule 144 allows for tacking of the holding period, as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion. The notes generally convert at a discount to market price so if the converted securities are sold quickly, a profit is built in. The selling pressure from the converted shares has a tendency to push down the stock price of the issuer.
The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16 see HERE). As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock. Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a very large increase in the number of outstanding shares and a drastic decrease in the share price. Over the years this type of financing has often been referred to as “toxic” or “death spiral.”
Extreme dilution is really only possible in companies that do not trade on a national securities exchange. Both the NYSE and Nasdaq have provisions that prohibit the private issuance of more than 20% of total outstanding, of discounted securities without prior shareholder approval. For more on the 20% Rule, see HERE. In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed rule change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. The SEC also notes, correctly, that the exchanges do not look favorably on transactions involving market adjustable securities and as such, it is more difficult for an issuer to satisfy the listing criteria if they are or have been engaged in such transactions.
Although on first look it sounds like these transactions are risk-free for the investor, they are not. First, Rule 144 itself creates some hurdles. In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations. Also, if the company was formerly a shell company, it must always be current in its reporting obligations to rely on Rule 144. If a company becomes delinquent, the investor can no longer convert its debt and oftentimes such a company does not have the cash to pay back the obligation. Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers. Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.
The SEC recognizes these risks noting that a holder of market adjustable securities is subject to risk in the period from the issuance of the securities until the holding period is satisfied (such as a company going dark) but are not exposed to market risk associated with the underlying securities after conversion. In these circumstances, holders that convert and promptly resell the underlying security in order to secure a profit on the sale based on the built-in discount have not assumed the economic risks of investment of the underlying security. The SEC sees this as inconsistent with the purpose of Rule 144 to provide a safe harbor for transactions that are not distributions of securities.
The potential for profit attracted some unscrupulous market participants (especially in the early years), which together with the fact that the financing is expensive for companies, made the entire industry one that certain players in the small-cap world love to hate. From my viewpoint, the two sides of the coin became as polarized as partisan politics. An almost evangelical faction arose determined to stop these “predatory lenders,” likening them to the leg-breaking loan sharks of the 1960’s. On the other side, there are also higher-quality lenders that seek out a better-quality company to invest in and work to become long-term financial partners making multiple investments over the years mounting to millions of dollars helping companies grow. For many micro-cap companies, these lenders have become an indispensable source of capital where few or no other options exist.
I applaud every regulatory step in the direction of cleaning up the micro-cap space and giving OTC Markets respect as the venture marketplace it is, but in some cases the proverbial baby gets thrown out with the bath water. This isn’t the first time that the SEC has taken action to limit market adjusted financing. Back in 2006 the SEC altered its interpretation of Rule 415 limiting the amount of securities that could be registered as resale to 30% of a company’s public float (see HERE. Prior to that, big players like Cornell Capital and Dutchess Capital wrote ELOC’s for every micro-cap company in town.
Market adjusted investments dissipated for a little while but then the Rule 144 changes in 2008 (coupled with the allowance of tacking from 1997) brought it back to life. The 1997 Rule 144 proposing rule release proposed codifying the Division of Corporation Finance’s position that, if the securities to be sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms. However, investors still thought a two-year hold was too long. Then the 2008 rule changes shortened the holding period for restricted securities to six months for reporting companies and one year for non-reporting companies and overnight, the convertible note lending business blossomed.
The SEC certainly had visibility on the business as most of the issuers were publicly reporting and had to not only file an 8-K upon entering into a transaction but are required to report derivative liabilities on their balance sheets for the convertible overhang and to detail the transactions in the notes to financial statements. Back on September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the release of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and in particular to determine 8-K filing deficiencies. See HERE for my blog at the time.
At the time the SEC did not take aim at the investors and the only enforcement actions against investors’ involved fraud or market manipulation. Then in November 2017, the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act. Since that time the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer.
The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question. So far the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes. Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded.
Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly. Although the SEC has had some wins in the litigations, the issue is far from settled.
In that regard, the new Rule 144 proposal provides comfort in some respects. First, it is a step in regulating through rules and guidance as opposed to enforcement. Second, it seems to indicate that the SEC enforcement proceedings alleging unregistered dealer activities have specifically targeted market adjusted investment instruments that are not exchange traded as opposed to all private traders and investors.
After this long introduction, I’ll turn to the proposed rule.
Elimination of Tacking for Market Adjustable Securities
All offers and sales of securities in the US must either be registered or there must be an available exemption from registration. The Securities Act of 1933 (“Securities Act”) Rule 144 sets forth certain requirements for the use of the Section 4(a)(1) exemption for the resale of securities. Rule 144 is a non-exclusive safe harbor for reliance on Section 4(a)(1). Section 4(a)(1) of the Securities Act provides an exemption for a transaction “by a person other than an issuer, underwriter, or dealer.” Section 2(a)(11) in turn defines an underwriter as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security or participates or has a direct or indirect participation in any such undertaking.
Rule 144 sets forth objective criteria, including holding periods, public information, manner of sale, etc. on which selling security holders may rely to avoid being deemed to be engaged in a distribution and, therefore, to avoid acting as an underwriter under Section 2(a)(11) of the Securities Act. The holding period requirement is meant to ensure that the holder has assumed the economic risks of the investment and is not just acting as a conduit for the sale of unregistered securities to the public. When all of the conditions of Rule 144 are complied with, the purchaser of securities receives freely tradeable, unrestricted securities. Rule 144 only addresses the resale of restricted or control securities. Unrestricted securities (such as securities that have been registered under the Securities Act) may be sold without reference or regard to the Rule.
As discussed above, Rule 144 deems securities acquired solely in exchange for other securities of the same issuer to have been acquired at the same time as the securities surrendered for conversion or exchange. As a result, holders of market adjustable securities, such as a convertible note, may convert the note into common stock and immediately resell that common stock into the public marketplace, as long as the note has been held for the requisite Rule 144 holding period. Since the note is converted at a price below the market price, there is a built-in profit. Multiple conversions and sales can dramatically increase the amount of outstanding stock. This can be seen as a loophole in the rule’s structure resulting in distributions of securities, despite the compliance with Rule 144. The proposed rule change is intended to close this hole.
Currently Rule 144(d) sets out the holding period requirements to satisfy Rule 144. Rule 144(d)(3)(ii) provides “Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.” The proposed rule change would amend Rule 144(d)(3)(ii) to eliminate “tacking” for securities acquired upon the conversion or exchange of the market-adjustable securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange. As noted above, the rule change would not capture exchange traded securities as the exchanges already have rules to prevent distributions without prior shareholder approval (see the 20% rule – HERE.
The new proposed Rule 144(d)(3)(ii) language is as follows:
(ii) Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms, unless:
(A) the newly acquired securities were acquired from an issuer that, at the time of conversion or exchange, does not have a class of securities listed, or approved for listing, on a national securities exchange registered pursuant to Section 6 of the Exchange Act (15 U.S.C. 78f); and
(B) the convertible or exchangeable security contains terms, such as conversion rate or price adjustments, that offset, in whole or in part, declines in the market value of the underlying securities occurring prior to conversion or exchange, other than terms that adjust for stock splits, dividends or other issuer-initiated changes in its capitalization.
As a result, the holding period for the underlying securities, either six months for securities issued by a reporting company or one year for securities issued by a non-reporting company, would not begin until the conversion or exchange of the market-adjustable securities. The proposed rule change would not include convertible securities that have provisions for adjustments for splits, dividends, or other issuer initiated changes in capitalization but were not otherwise market adjustable.
Forms 4, 5, and 144 Filing Requirements
The rule proposal would: (i) mandate the electronic filing of Form 144; (ii) eliminate the Form 144 filing requirement related to the sale of securities of issuers that are not subject to the reporting requirements of the Exchange Act; (iii) amend the Form 144 filing deadline so that Form 144 may be filed concurrently with Form 4 by persons subject to both filing requirements; and (iv) amend Forms 4 and 5 to add an optional check box to indicate that a reported transaction was intended to satisfy Rule 10b5-1(c), which provides an affirmative defense for trading on the basis of material non-public information in insider trading cases.
The SEC plans to make an online fillable Form 144 available to simplify electronic filing and to streamline the electronic filing of Forms 4 and 144 reporting the same sale of securities.
The global and technologically interconnected nature of today’s business environment exposes companies to a wide array of evolving risks, which they must individually examine to determine proper disclosures using a principles-based approach. A company is required to conduct a continuing analysis on the materiality of risks in the ever-changing technological landscape to ensure proper reporting of risks. To assist management in making these determinations, the SEC has issued additional guidance.
The guidance, which is grounded in materiality and a principles-based approach, is meant to supplement prior guidance on technology and cybersecurity matters including the February 2018 SEC statement on public company cybersecurity disclosures (see my blog HERE); Director Hinman’s speech at the 18th Annual Institute on Securities Regulation in Europe in March, 2019; the SEC statement on LIBOR Transition in July 2019; and Chair Clayton’s remarks on LIBOR transition and cybersecurity risks from December 2018. The new guidance concentrates on risks resulting from conducting business outside the U.S. and particularly in jurisdictions that do not have comparable protections for corporate proprietary information.
Although there is no specific line-item requirement under the federal securities laws to disclose information related to the compromise or potential compromise of technology, data or intellectual property, the SEC has made clear that its disclosure requirements apply to a broad range of evolving business risks regardless of the absence of specific requirements. Also, the actual material theft or compromise of technology or intellectual property assets would generally require disclosure, including potentially in management’s discussion and analysis, the business section, legal proceedings, internal controls and procedures and/or financial statements.
The newest guidance is broken down by sources of risk associated with potential theft of technology and intellectual property and assessing and disclosing risks related to potential theft or compromise of technology and intellectual property.
Sources of Risk Associated with Potential Theft of Technology and Intellectual Property
There are many cybersecurity risks associated with technology and intellectual property. Cyber-incidents can take many forms, both intentional and unintentional, and commonly include the unauthorized access of information, including personal information related to customers’ accounts or credit information, data corruption, misappropriating assets or sensitive information or causing operational disruption. Attacks use increasingly complex methods, including malware, ransomware, phishing, structured query language injections and distributed denial-of-service attacks. A cyber-attack can be in the form of unauthorized access or a blocking of authorized access.
In the global context, the risk of theft includes through a direct intrusion by private parties or foreign actors, including those affiliated with or controlled by sovereign entities such as foreign states. The SEC guidance also warns of corporate espionage including the infiltration of moles and insiders.
In addition to direct intrusions, a theft or compromise can be accomplished using indirect attacks such as reverse engineering of technology and intellectual property. Patents together with reverse engineering can be used to assist in obtaining trade secrets and know-how.
Some foreign nations take a very direct route to obtain technology and intellectual property information by requiring companies to yield rights in order to conduct business in or access markets in their jurisdiction, either through formal written agreements or legal or administrative requirements. Companies need to be cognizant of the risks associated with these types of agreements or laws, including unintended consequences. Examples which require cautious risk assessment include: (i) patent license agreements which allow the foreign licensee to retain rights on improvements, including the ability to sever the improvements and receive a separate patent; (ii) patent license agreements which allow the foreign licensee to continue to use the technology or intellectual property after the patent or license term expires; (iii) foreign ownership and investment restrictions which can result in a loss of control over the foreign assets or entity holding the foreign assets; (iv) the use of unusual or idiosyncratic terms favoring foreign persons; (v) regulatory requirements which restrict the ability to conduct business in a foreign jurisdiction unless technology or data is stored locally; (vi) regulatory requirements which require the use of local service providers or technology in connection with international operations; and (vii) local licensing or administrative approvals that involve the sharing of intellectual property.
Assessing and Disclosing Risks Related to Potential Theft or Compromise of Technology and Intellectual Property
In addition to assessing the risks of a potential theft or compromise of technology, data or intellectual property in connection with international operations, companies must conduct an analysis as to how the realization of these risks may impact their business, including financial condition and results of operations, and any effects on their reputation, stock price and long-term value. As always, where the risks are material, they must be disclosed.
Where a company’s technology, data or intellectual property is being or previously was materially compromised, stolen or otherwise illicitly accessed, hypothetical disclosure of potential risks is not sufficient to satisfy a company’s reporting obligations.
The SEC guidance provides a list of questions for management to consider when assessing risks and related disclosure requirements involving international technology, data and intellectual property, including:
(i) Is there a heightened risk by virtue of conducting business, maintaining assets or earning revenue abroad;
(ii) Does the company have operations in a jurisdiction that is particularly susceptible to heightened risk;
(iii) Does the company have operations in a jurisdiction that requires entering into contracts related to technology as a condition to conducting business;
(iv) Has the company’s products been, or may they be, subject to counterfeit and sale through e-commerce;
(v) Has the company directly or indirectly transferred or licensed technology or intellectual property to a foreign entity or government, such as through the creation of a joint venture with a foreign entity;
(vi) Does the company store technology abroad;
(vii) Is the company required to use equipment or service providers in a foreign jurisdiction;
(viii) Has the company entered into a patent or technology license agreement with a foreign entity or government that provides such entity with rights to improvements on the underlying technology and/or rights to continued use of the technology following the licensing term, including in connection with a joint venture;
(ix) Is the company subject to foreign jurisdiction requirements which limit foreign ownership or investment and, in that vein, does the company have foreign subsidiaries where the majority ownership is held by governments or entities in that foreign jurisdiction;
(x) Has the company provided access to your technology or intellectual property to a state actor or regulator in connection with foreign regulatory or licensing procedures, including but not limited to local licensing and administrative procedures;
(xi) Has the company been required to yield rights to technology or intellectual property as a condition to conducting business in or accessing markets located in a foreign jurisdiction;
(xii) Does the company operate in a jurisdiction where the ability to enforce rights over intellectual property is limited as a statutory or practical matter;
(xiii) Does the company conduct business with local laws that limit or prohibit the export of data or financial documentation;
(xiv) Is the company readily able to produce data or other information that is housed internationally in response to regulatory requirements or inquiries;
(xv) Have conditions in a foreign jurisdiction caused the company to relocate or consider relocating operations to a different host nation and, if so, what are the related costs including material costs, training new employees, establishing new facilities and supply chains and the impact on import and export;
(xvi) Does the company have adequate controls and procedures in place to protect technology, data and intellectual property, and do these procedures include the ability to adequately respond to an actual or potential threat;
(xvii) Does the company have adequate controls and procedures in place to detect: (a) malfeasance by employees and others; (b) industrial or corporate espionage; (c) unauthorized intrusions into computer networks; and (d) other forms of cyber-theft and breaches; and
(xviii) What level of risk oversight and management does the board of directors and executive officers have with regard to the company’s data, technology and intellectual property and how these assets may be impacted by operations in foreign jurisdictions where they may be subject to additional risks.
The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. Companies trading on the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets have the option of reporting directly to OTC Markets under its Alternative Reporting Standards. The Alternative Reporting Standards are more robust for the OTCQB and OTCQX in that they require audited financial statements prepared in accordance with U.S. GAAP and audited by a PCAOB qualified auditor in the same format as would be included in SEC registration statements and reports.
As an aside, companies that report to the SEC under Regulation A and foreign companies that qualify for the SEC reporting exemption under Exchange Act Rule 12g3-2(b) may also qualify for the OTCQX, OTCQB and OTC Pink Current Information tiers of OTC Markets if they otherwise meet the listing qualifications. For more information on OTCQB and OTCQX listing requirements, see HERE, HERE, and HERE.
Effective October 1, 2020, the OTCQB Standards, Version 3.4, went into effect. To review the last amendments adopted in February 2020, see HERE. The new Version 3.4 modified the prior rules as follows:
Fees. Effective January 1, 2021, the OTCQB annual fee will increase from $12,000 to $14,000 and the application fee will increase from $2,500 to $5,000.
Corporate Governance Requirements. Companies that alternatively report to OTC Markets must meet certain corporate governance requirements to be eligible to trade on the OTCQB. In particular, such companies must have a board of directors that includes at least two independent directors and must have an audit committee the majority of which are independent directors. The new rules provide that trusts, funds, and other similar companies may be exempted from these corporate governance standards. A company wishing to be exempted must apply to OTC Markets in writing and such exemption will be granted in the sole and absolute discretion of OTC Markets.
Application Review/Reasons for Denial. Although OTC Markets has always had broad discretion to deny an application to trade on the OTCQB, the new rules specifically provide that OTC Markets may “[R]efuse the application for any reason, including but not limited to stock promotion, dilution risk, and use of “toxic” financiers if it determines, in its sole and absolute discretion, that the admission of the Company’s securities for trading on OTCQB, would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.”
Effective October 1, 2020, the OTCQX Standards, Version 8.6, went into effect. To review the last amendments adopted in December 2019, see HERE. The new Version 8.6 modified the prior rules as follows:
Fees. Effective January 1, 2021, the OTCQX annual fee will increase from $20,000 to $23,000. The application fee remains unchanged at $5,000.
International Company Upgrade to OTCQX. A Company with a class of securities currently quoted on the OTCQB market that chooses to upgrade to OTCQX may now be exempt from the requirement to select an OTCQX Sponsor or submit a Letter of Introduction.
Sponsor for International Companies. An OTCQX Sponsor who is an attorney or law firm is no longer required to be headquartered in the U.S. or Canada. Instead, each attorney who provides services as an OTCQX Sponsor must be licensed to practice law and in good standing in the U.S. As a reminder, I am a qualified OTCQX Sponsor.
It has been a very busy year for SEC rule making, guidance, executive actions and all matters capital markets. Continuing its ongoing disclosure effectiveness initiative on November 19, 2020, the SEC adopted amendments to the disclosures in Item 303 of Regulation S-K – Management’s Discussion & Analysis of Financial Conditions and Operations (MD&A). The proposed rule had been released on January 30, 2020 (see HERE). Like all recent disclosure effectiveness rule amendments and proposals, the rule changes are meant to modernize and take a more principles-based approach to disclosure requirements. In addition, the rule changes are intended to reduce repetition and disclosure of information that is not material.
The new rules eliminate Item 301 – Selected Financial Data – and amend Items 302(a) – Supplementary Financial Information and Item 303 – MD&A. In particular, the final rules revise Item 302(a) to replace the current tabular disclosure with a principles-based approach and revise MD&A to: (i) to state the principal objectives of the disclosure; (ii) update liquidity and capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iii) update the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (iv) update the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (v) replace the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion; (vi) eliminate the need for a tabular disclosure of contractual obligations as the information is already in the financial statements; and (vii) add a requirement to discuss critical accounting estimates and (viii) add the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The new rules also apply to foreign private issuers (FPIs). Finally, the amendments will make numerous cross-reference clean-up amendments including to various registration statement forms under the Securities Act and periodic reports and proxy statements under the Exchange Act.
Below the discussion of the rule changes is a chart of each of the amendments and its principal objective. The amendments take effect thirty days after publication in the federal register.
Detail on Final Rules
Elimination of Item 301 – Selected Financial Data
Item 301 generally requires a company to provide selected financial data in a comparative tabular form for the last five years. Smaller reporting companies (SRCs) are not required to provide this information, and emerging growth companies (EGCs) that are not also SRCs are not required to provide information for any period prior to the earliest audited financial statements in the company’s initial registration statement.
When Item 301 was developed, prior financial information was not available on EDGAR and financial statements were not tagged with XBRL. Also, the purpose behind Item 301 is to illustrate trends but Item 303 requires a discussion of material trends. Accordingly, Item 301 is not useful and the SEC has eliminated it.
Amendment to Item 302 – Supplementary Financial Information
Item 302 requires selected disclosures of quarterly results and variances in operating results including the effects of any discontinued operations and unusual or infrequently occurring items. SRCs and FPIs are not required to provide the information (note that FPIs are not required to report quarterly results or file quarterly reports at all). Also, Item 302 only applies to companies that are registered under the Exchange Act and accordingly does not apply to voluntary or Section 15(d) reporting companies (for more on voluntary and Section 15(d) reporting, see HERE).
The SEC had originally proposed eliminating this item altogether like Item 301. However, the SEC recognized that while most quarterly financial information could be found in prior filings, certain fourth quarter information was only captured in Item 302. Accordingly, the final rule release did not eliminate Item 302 but amended it such that it now only requires disclosure when there are one or more material changes for any of the quarters in the last two fiscal years for which financial statements are provided. Duplicative disclosures are not required.
Elimination of Item 303(a)(5) – Contractual Obligations Table
Under Item 303(a)(5) companies, other than SRCs, must disclose known contractual obligations in tabular format. There is no materiality threshold for the disclosure. The SEC has eliminated the table consistent with its objective of promoting a principals based MD&A disclosure and to streamline disclosures and reduce redundancy. Likewise, current Items 303(c) and (d) have been eliminated as these items have been picked up in amended 303(b).
Item 303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
Currently MD&A is broken down into 5 parts. Item 303(a) requires full-year disclosures on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations. Item 303(b) covers interim periods and requires a disclosure of any material changes to the Item 303(a) information. Item 303(c) acknowledges the application of a statutory safe harbor for forward-looking information provided in off-balance-sheet arrangements and contractual obligations disclosures. Item 303(d) provides scaled-back disclosure accommodations for SRCs. The amended rule substantially changes this structure.
The new Item 303 (i) adds a new Item 303(a) to state the principal objectives of MD&A including as to full fiscal years and interim periods and to provide instructions to guide the rest of the rule; (ii) eliminates unnecessary cross-references, clarifies and removes outdated and duplicative language; (iii) updates capital resource disclosures to require disclosure of material cash requirements including commitments for capital expenditures as of the latest fiscal period, the anticipated source of funds needed to satisfy cash requirements and the general purpose of such requirements; (iv) updates the results of operations disclosure to require disclosure of known events that are reasonably likely to cause a material change in the relationship between costs and revenues; (v) updates the results of operations disclosure to require a discussion of the reasons underlying material changes in net sales or revenues; (vi) eliminates the requirement to discuss the impact of inflation; (vii) replaces the specific requirement to disclose off-balance-sheet arrangements with a directive to disclose the arrangements in the broader context of the MD&A discussion, (viii) adds a requirement to discuss critical accounting estimates, and (ix) adds the flexibility to choose whether to compare the same quarter from the prior year, or the immediately preceding quarter.
The new Item 303(a) instruction paragraph has been revised to set forth the principal objectives of MD&A. The instructions codify guidance that requires a narrative explanation of financial statements to allow a reader to see a company “through the eyes of management.” The SEC stresses that MD&A should provide an analysis that encompasses short-term results as well as future prospects. The SEC does not want companies to merely recite the amounts of changes from year to year that are readily calculated from the financial statements, but rather to provide greater analysis as to the reasons for changes.
Also, the instructions emphasize providing disclosure on:
(i) Material information relevant to an assessment of the financial condition and results of operations of the company, including an evaluation of the amounts and certainty of cash flows from operations and outside sources;
(ii) The material financial and statistical data that the company believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations; and
(iii) Material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition, including descriptions and amounts of matters that (a) would have a material impact on future operations and have not had an impact in the past and (b) have had a material impact on reported operations and are not expected to have an impact on future operations.
Chart on Rule Changes
The following chart, copied from the SEC’s rule release, summarized the new rules.
|Current Item or Issue||Summary Description of Amended Rules||
|Item 301, Selected financial data||Registrants will no longer be required to provide 5 years of selected financial data.||Modernize disclosure requirement in light of technological developments and simplify disclosure requirements.|
Item 302(a), Supplementary financial information
|Registrants will no longer be required to provide 2 years of tabular selected quarterly financial data. The item will be replaced with a principles-based
requirement for material retrospective changes.
Reduce repetition and focus disclosure on material information. Modernize disclosure requirement in light of technological developments.
Item 303(a), MD&A
|Clarify the objective of MD&A and streamline the fourteen instructions.||Simplify and enhance the purpose of MD&A.|
|Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash
requirements, and the general purpose of such requirements.
Modernize and enhance disclosure requirements to account for capital expenditures that are not necessarily capital investments.
Results of operations
|Clarify that a discussion of material changes in net sales or revenue is required (rather than only material increases).||Clarify MD&A disclosure requirements by codifying existing Commission guidance.|
Results of operations
Instructions 8 and 9 (Inflation and price changes)
|The item and instructions will be eliminated. Registrants will still be required to discuss these matters if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations.||
Encourage registrants to focus on material information that is tailored to a registrant’s businesses, facts, and circumstances.
Item 303(a)(4), Off- balance sheet arrangements
|The item will be replaced by a new instruction to Item 303. Under the new instruction, registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on such registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidated
Prompt registrants to consider and integrate disclosure of off-balance sheet arrangements within the context of their MD&A.
|Registrants will no longer be required to provide a contractual obligations table. A discussion of material contractual obligations will remain required through an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cash
requirements from known contractual and other obligations.
|Promote the principles-based nature of MD&A and simplify disclosures.|
Instruction 4 to Item 303(a) (Material changes in line items)
|Incorporate a portion of the instruction into amended Item 303(b). Clarify in amended Item 303(b) that where there are material changes in a line item, including where material changes within a line item offset one another, disclosure of the underlying reasons for these material changes in quantitative and qualitative terms is
Enhance analysis in MD&A. Clarify MD&A disclosure requirements by codifying existing Commission guidance on the importance of analysis in MD&A.
Item 303(b), Interim periods
|Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter. Registrants subject to Rule 3-
03(b) of Regulation S-X will be afforded the same flexibility.
Allow for flexibility in comparison of interim periods to help registrants provide a more tailored and meaningful analysis relevant to their business cycles.
Critical Accounting Estimates
Registrants will be explicitly required to disclose critical accounting estimates.
|Facilitate compliance and improve resulting disclosure. Eliminate disclosure that duplicates the financial statement discussion of significant
policies. Promote meaningful analysis of measurement uncertainties.
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.
On November 19, 2020, as discussed in this blog, the SEC adopted 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 eliminated Item 301 – Selected Financial Data and revised Item 302 – Supplementary Financial Information. For my blog on the rules January 30, 2020 proposal, see HERE.
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 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 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.
In March 2019, the SEC adopted amendments to Regulation S-K as required by the Fixing America’s Surface Transportation Act (“FAST Act”) (see HERE). Among other changes, the amendments allow companies to redact confidential information from most exhibits without filing a confidential treatment request (“CTR”), including omitting schedules and exhibits to exhibits. Likewise, the amendments allow a company to redact information that is both (i) not material, and (ii) competitively harmful if disclosed without the need for a confidential treatment request. The enacted amendment only applies to material agreement exhibits under Item 601(b)(10) and not to other categories of exhibits, which would rarely contain competitively harmful information.
After the rule change, the SEC streamlined its procedures for granting CTR’s and for applying for extended confidential treatment on previously granted orders. The amendments to the CTR process became effective April 2, 2019. See HERE for a summary of confidential treatment requests. In December 2019, the SEC issued new guidance on confidential treatment applications submitted pursuant to Rules 406 and 24b-2.
Confidential Treatment Requests Under Rule 406 or 24b-2
Rule 406 of the Securities Act of 1933 (“Securities Act”) and Rule 24b-2 of the Securities Exchange Act of 1934 (“Exchange Act”) set forth the exclusive procedures for seeking confidential treatment for any information that may be required to be publicly filed under either Act and for which the streamlined procedures for confidential treatment of material contracts and their exhibits is not available. Furthermore, a company may voluntarily seek approval under Rules 406 and 24b-2 even if the self-executing procedure for omitting information is available. Later in this blog, I include a refresher on the streamlined, self-executing rules for omitting confidential information from material contract exhibits to SEC filings.
Like all CTR’s, requests under these rules must be made in paper format and not electronic. Also, like all CTR’s, if a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.
To make a CTR under Rule 406 or 24b-2, a person must omit the confidential information from the relevant EDGAR filing, noting that information has been omitted based on a CTR, and concurrently file the CTR with the SEC using the specific fax number and designated person for receiving such information. All documents and information must be marked “Confidential Treatment.”
The CTR must include one unredacted copy of the entire document for which confidential treatment is sought and a cover letter or memo containing (i) identification of the information sought to be kept confidential; (ii) a statement of the grounds for keeping the information confidential, including reference to particular provisions under FOIA and other SEC rules and regulations; (iii) the specific time period for which confidentiality is sought (year, month and date) and a justification for such period; (iv) a detailed explanation of why, based on the facts and circumstances of the particular case, disclosure of the information is unnecessary for the protection of investors; (v) a written consent to the furnishing of the confidential information to other government agencies, offices, or bodies and to the Congress; and (vi) the name, address and telephone number of the person to whom all notices and orders should be directed.
For an Exchange Act Rule 24b-2 CTR, the name of each exchange upon which the materials would be filed (or omitted) must also be included. Furthermore, the submission must include a statement that: (i) none of the confidential information has been disclosed to the public; (ii) disclosure of the information will cause substantial competitive harm to the company; and (iii) disclosure of the confidential information is not necessary for protection of investors.
As discussed below, the SEC will not grant confidential treatment to information that is material. Moreover, if information is omitted beyond what is customarily treated as private or confidential, the SEC will ask that an amendment be filed with fewer omissions and a new CTR filed.
If confidential treatment is granted, an order will be entered and filed on EDGAR. If confidential treatment is denied, the company will have an opportunity to withdraw the filing with the confidential information if withdrawal is otherwise allowable (such as a voluntary S-1 filing or Exchange Act report by a voluntary filer). A denial may also be appealed.
Application for Extension of Confidential Treatment
Companies that have previously obtained a confidential treatment order for a material contract must continue to file extension applications under Rules 406 or 24b-2 if they want to protect the confidential information from public release pursuant to a Freedom of Information Act request after the original order expires. The SEC has created a simple one-page form to apply for an extension of time for which a confidential treatment order had previously been granted. Rather than submitting a whole new application, with the confidential information included, a company seeking to extend a confidential treatment order previously granted can simply affirm that the facts and circumstances that supported the prior application continue to be true, complete and accurate.
The short-form application allows for an extension of confidential treatment for a period of three, five or ten years and requires a brief explanation to support the request. The request for extension must be filed prior to the original order’s expiration. If the applicant reduces the redactions from the previous version, the revised redacted version of the contract must be publicly filed when the short-form extension application is submitted. The short-form application cannot be used to add new exhibits to the application or make additional redactions. In that case, a full application under Rules 406 or 24b-2 would still be required.
The SEC has provided an email address (CTExtensions@sec.gov) for submittal of the new short-form application. The email address is exclusive to these short-form applications and, as such, should not be used in connection with any other type of confidential treatment or extension request. Upon approval, the SEC will post the order granting CTR on the applicant’s EDGAR page.
Confidential Treatment Requests for Material Contracts
Effective March 2019, Item 601(b)(10) of Regulation S-K allows a company to file redacted material contracts without applying for confidential treatment of the redacted information provided the redacted information (i) is not material and (ii) would be competitively harmful if publicly disclosed. If it does so, the company should mark the exhibit index to indicate that portions of the exhibit or exhibits have been omitted and include a prominent statement on the first page of the redacted exhibit that certain identified information has been excluded from the exhibit because it is both not material and would likely cause competitive harm to the registrant if publicly disclosed. The company also must indicate by brackets where the information is omitted from the filed version of the exhibit.
If requested by the SEC, the company must promptly provide an un-redacted copy of the exhibit on a supplemental basis. The SEC also may request the company to provide its materiality and competitive harm analyses on a supplemental basis. Any requested supplemental information must be provided in paper format and only to the designated email address provided by the SEC to protect and preserve its confidential nature. If the SEC does not agree with the analysis, it could request that the company amend its filing to include any previously redacted information. If a redacted exhibit is included with a registration statement, any questions regarding the confidential treatment will need to be fully resolved before the SEC will declare the registration statement effective.
The company may request confidential treatment of the supplemental material submitted to the SEC pursuant to Rule 83 while it is in the possession of the SEC. After completing its review of the supplemental information, the SEC will return or destroy the information at the request of the company if the company complies with the procedures outlined in Rules 418 or 12b-4. Rules 418 or 12b-4 require that a company request that the SEC either return or destroy the supplemental information, at the same time as it is first furnished to the SEC and that returning or destroying the information (i) is consistent with the protection of investors and (ii) is consistent with the Freedom of Information Act. Also, if information is electronically provided to the SEC, the SEC has no obligation to return or destroy same.
Although the letter requesting additional information, and the closing of the review letter, will both be made public on the EDGAR system, the SEC will not make public its comments regarding redacted exhibits, nor the company’s responses thereto.
The amendments are not meant to alter what information is deemed confidential or can be omitted, but rather to streamline the process by allowing a company to redact without the confidentiality treatment process. The w may still randomly review company filings and “scrutinize the appropriateness of a registrant’s omissions of information from its exhibits.”
What Information Qualifies for Confidential Treatment
Generally speaking, a company can seek confidential treatment for information which could adversely affect the company’s business and financial condition, usually because of competitive harm, if disclosed, as long as the information is not material to investors.
A CTR must include specific citations to an exemption from disclosure under FOIA. The FOIA specifies nine categories of information that may be exempted from the FOIA’s broad requirement to make information available to the general public. The most commonly used exemption for public companies allows for confidential treatment for “trade secrets and commercial or financial information obtained from a person and privileged or confidential.” The U.S. Supreme Court’s case Food Marketing Institute v. Argus Leader Media (October 2018) held that where commercial or financial information is both customarily and actually treated as private by its owner and provided to the government under an assurance of privacy, the information is “confidential” within the meaning of FOIA and that it is not necessary to show substantial competitive harm. The SEC’s new guidance refers CTA applicants to the Supreme Court case for assistance in crafting arguments for the CTA application.
Although FOIA may generally exempt trade secrets, not all trade secrets may be kept confidential by public companies. In essence, when a company determines to go public and files a registration statement under either the Securities Act or Exchange Act, and thus agrees to file reports with the SEC, the company is agreeing to make public the information required by Regulation S-K and S-X. A company cannot avoid these specific requirements by claiming confidentiality. Examples of information that a private company may deem confidential, but for which a public company will need to disclose, include: (i) the identity of 10% or greater customers; (ii) the identity of 5% or greater shareholders; (iii) the dollar amount of firm backlog orders; (iv) the duration and effect of all patents, trademarks, licenses and concessions held; (v) related party transactions; and (vi) executive compensation.
Assuming that information is not specifically required to be disclosed under the Securities Act or Exchange Act, a “trade secret” is “a secret, commercially valuable plan, formula, process or device that is used for the making, preparing, compounding or processing of trade commodities and that can be said to be the end product of either innovation or substantial effort.” Examples of information that a public company could successfully complete a CTR for include (i) pricing terms; (ii) technical specifications; (iii) payment terms; (iv) sensitive information regarding business strategy, or timing of research, development and commercialization efforts; (v) details of intellectual property (that isn’t already public, such as in a filed patent); (vi) details of cybersecurity procedures; and (vii) customer databases.
A company can never obtain confidential treatment for information that is already in the public domain or has been publicly disclosed, even if inadvertently. Accordingly, it is important that a company be very careful to ensure that any information for which it seeks confidential treatment is kept strictly confidential, including by third parties. For example, care should be given that a counterparty to a contract does not issue a press release or otherwise make provisions public.
Confidential Treatment Requests Under Rule 83
Rule 83 provides a procedure for requesting that information be kept confidential from Freedom of Information Act (“FOIA”) requests where no other procedure, such as Rules 406 or 24b-2, are available. Generally, Rule 83 is used in the context of requests for supplemental information, examinations, inspections and investigations. Under Rule 83, the submitter of information must mark each page with “Confidential Treatment Requested by [name]” and an identifying number and code, such as a Bates-stamped number. Also, the words “FOIA Confidential Treatment Request” must appear on the top of the first page of the request. Like all other CTR’s, the request must be via paper and not electronically. The SEC has provided a specific fax line and office (the FOIA Office) to receive Rule 83 CTR’s to maintain their confidentiality, even among SEC staff. A confidential treatment request will expire 10 years from the date the FOIA Office receives it unless that office receives a renewal request before it expires.
The requester may claim personal or business confidentiality, but need not substantiate his or her request until the FOIA Office notifies him or her of a FOIA request for the records. If a FOIA request is received for the records, the person that requested confidential treatment will be notified and given an opportunity to provide a legal and factual analysis supporting confidential treatment. A substantiation submittal must include: (i) the reasons that the information can be withheld under FOIA and referring to the specific provisions of FOIA supporting same; (ii) any other statutes or regulatory provisions that may govern the information; (iii) the existence and applicability of any prior determinations by the SEC, other federal agency or court relating to the confidential treatment of the information; (iv) the adverse consequences to a business enterprise, financial or otherwise, that would result from disclosure of confidential commercial or financial information, including any adverse effect on the business’ competitive position; (v) the measures taken to protect the confidentiality prior to and after submission to the SEC; (vi) the ease or difficulty of a competitor’s obtaining or compiling the commercial or financial information; (vii) whether the information was voluntarily submitted to the SEC; (viii) if the substantiation argument document itself should be kept confidential; and (ix) such additional facts and legal analysis as appropriate to support the request.
Where a Rule 83 CTR is being made in the course of live testimony or oral discussions, the request for confidential treatment must be made contemporaneously with providing the information and followed with a written request no later than 30 days later.
Rule 83 provides for an appeal process where an initial determination that confidential treatment is not warranted. Rule 83 appeals are reviewed and decided by the SEC’s Office of General Counsel. If the General Counsel decides the information does not need to be kept confidential, it will give the person 10 days’ notice during which time a person could file an action in federal court to continue to fight to maintain the confidentiality of the information. Likewise, if the SEC determines that information should be kept confidential, the person seeking the information can appeal by filing suit in federal court.
Rule 83 cannot be relied upon to request confidential treatment for information that would otherwise be required to be disclosed in SEC registration statements or reports. In that case, the person making the CTR would have to rely on the new procedures for redacting information in material contracts or make a CTR under Rules 406 or 24b-2.