Monthly Archives: January 2021
Like Nasdaq, I’ve written several times about the NYSE American listing requirements including the general listing requirements (see HERE) and annual compliance guidelines (see HERE). As an aside, although the Nasdaq recently enacted significant changes to its initial listing standards, the NYSE American has not done the same and no such changes are currently anticipated. I suspect that the NYSE American will see a large uptick in new company applicants as a result.
I recently drilled down on audit committee requirements and director independence standards for Nasdaq and in this and the next blog, I will do the same for the NYSE American. As required by SEC Rule 10A-3, all exchange listed companies are required to have an audit committee consisting of independent directors. NYSE American Company Guide Rule 803 delineates the requirements independent directors and audit committees. Rule 803 complies with SEC Rule 10A-3 related to audit committees for companies listed on a national securities exchange.
SEC Rule 10A-3
SEC Rule 10A-3 requires that each national securities exchange have initial listing and ongoing qualification rules requiring each listed company to have an audit committee comprised of independent directors. Although the NYSE American rule details its independence requirements, the SEC rule requires that at a minimum an independent director cannot directly or indirectly accept any consulting, advisory or other compensation or be affiliated with the company or any of its subsidiaries. The prohibition against compensation does not include a reasonable compensation for serving as a director.
Like the NYSE American rules, the SEC allows for different independence standards for foreign private issuers (FPI) following their home country rules and even allows for affiliation as long as the person is not an executive officer of the FPI.
The audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for auditing and audit-related services. Furthermore, the SEC requires that an executive officer of a listed company promptly notify the national exchange if he or she becomes aware of any material noncompliance with the audit committee requirements by that listed company.
Although charter requirements are detailed in the NYSE American rule, the SEC rule requires that the audit committee establish certain processes and procedures for handling complaints regarding accounting, internal financial controls and auditing matters, including for the confidential submission by employees. The SEC rule also requires that an audit committee be given the power, authority and funding to engage independent counsel and other advisors to carry out its tasks. Funding must also be provided to hire audit firms and pay administrative expenses.
The SEC allows for a phase-in for compliance when a company is completing an initial public offering. In particular, all but one director may be dependent for 90 days following the IPO and a minority of the audit committee may be dependent for one year from effectiveness of the registration statement. The SEC rule also contains general exemptions from the audit committee requirements including: (i) for consolidated subsidiaries that are listed on another exchange with similar audit committee requirements; (ii) FPI’s that follow home country rules and have a similar committee to an audit committee and satisfy certain additional conditions; and (iii) related to the listing of certain options, futures, asset-backed issuers, investment trusts, a passive trust or foreign governments. Specific disclosure is required when an exemption is being relied upon including an assessment of whether, and if so, how, such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of Rule 10A-3.
The SEC rule specifically requires that an exchange must give a listed company the opportunity to cure a defect in the audit committee requirements prior to delisting. Moreover, the SEC rule provides that if an independent director on the audit committee loses independence as a result of factors outside of their control, that person may remain on the audit committee until the next annual shareholders meeting or one year from the date of the occurrence that caused the board member to no longer be independent.
NYSE American Rule 803
Audit Committee Composition
One of the corporate-governance-related listing requirements is that a company have an audit committee consisting solely of independent directors (for more information on independence qualifications, see HERE) who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements including a balance sheet, income statement and cash flow statement. One member of the audit committee must have employment experience in finance or accounting, an accounting certification or other experience that results in the individual’s financial sophistication, including but not limited to being or having been a CEO, CFO or other senior officer with financial oversight.
The audit committee must have at least three members; however, a smaller reporting company is only required to have two members on its audit committee. For the current definition of a smaller reporting company, see HERE. Nasdaq does not have this carve-out for smaller reporting companies, though it does have it for compensation committees.
None of the committee members can have participated in the preparation of the financial statements of the company or any of its current subsidiaries for the prior three years. An individual will be considered to have participated in the preparation of the company’s financial statements if the individual has played any role in compiling or reviewing those financial statements, including a supervisory role. An interim officer who signed or certified the company’s financial statements will be deemed to have participated in the preparation of the company’s financial statements and, therefore, could not serve on the audit committee for three years.
The eligibility requirements to serve on the audit committee apply to all committee members whether or not such member is afforded non-voting status or other limitations on their participation with the committee. Lawyers that work at a law firm employed by the company cannot serve on the audit committee.
The NYSE American has a limited exception to the independence requirements where a director meets the independence standards in SEC Rule 10A-3 but not the more detailed requirements of the NYSE American company guide, is not currently an executive officer, employee or family member of an executive officer and exceptional circumstances makes the appointment of the person in the best interests of the company and its shareholders. Specific disclosures are required in the company’s next proxy statement or annual 10-K when relying on this exception including the nature of the relationship that makes the person non-independent and the reasons for the board’s determination. A committee member appointed under this exception may not serve for more than two years and cannot be chair of the audit committee.
Audit Committee Charter
NYSE American Company Guide Rule 803 requires that each company must certify that it has adopted a formal written committee charter and that the audit committee will review and reassess the charter on an annual basis. The certification is submitted one time and a copy of the actual charter does not need to be provided to the NYSE American. However, Item 407(d)(1) of Regulation S-K requires that companies report whether a current copy of its audit committee charter is available on its website and provide the website address. If the charter is not on the website, companies should include the charter as an appendix to its proxy statement at least once every three years or in any year in which the charter has been materially amended.
The charter must specify: (i) the scope of the audit committee’s responsibilities and how it carries out those responsibilities including structure, processes and membership requirements; (ii) the audit committee’s responsibility to ensure that it receives written statements from the outside auditor regarding relationships between the auditor and the company and actively taking steps for ensuring the independence of the auditor; (iii) the committee’s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company; and (iv) the specific audit committee responsibilities and authority.
Audit Committee Responsibilities and Authority
The audit committee is responsible for items delineated in SEC Rule 10A-3 and in particular related to: (i) registered public accounting firms, (ii) complaints relating to accounting, internal accounting controls or auditing matters, (iii) authority to engage advisers, and (iv) funding as determined by the audit committee.
The audit committee is required to meet on at least a quarterly basis. Nasdaq does not specify meeting requirements.
All noncompliance with audit committee requirements requires prompt notification to the NYSE American.
Consistent with SEC Rule 10A-3, if a member of the audit committee loses independent status for reasons outside the member’s reasonable control, the audit committee member may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement. A company relying on this provision must provide notice to the NYSE American immediately upon learning of the event or circumstance that caused the noncompliance.
If noncompliance is a result of a vacancy arising on the audit committee, the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement – provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the vacancy, the company shall instead have 180 days from such event to regain compliance. For a smaller reporting company, if the annual shareholders meeting occurs no later than 75 days following the event that caused the failure to comply with the audit composition requirement, a smaller reporting company shall instead have 75 days from such event to regain compliance. Nasdaq does not have a different compliance cure period for smaller reporting companies.
If a company has a class of equity securities listed on another exchange with SEC Rule 10A-3 audit committee requirements, they may list securities of a consolidated subsidiary on the NYSE American without having a separate audit committee for that subsidiary.
In a year of numerous regulatory amendments and proposals, Covid, newsworthy capital markets events, and endless related topics, and with only one blog a week, this one is a little behind, but with proxy season looming, it is timely nonetheless. In July 2020, the SEC adopted controversial final amendments to the rules governing proxy advisory firms. The proposed rules were published in November 2019 (see HERE). The final rules modified the proposed rules quite a bit to add more flexibility for proxy advisory businesses in complying with the underlying objectives of the rules.
The final rules, together with the amendments to Rule 14a-8 governing shareholder proposals in the proxy process, which were adopted in September 2020 (see HERE), will see a change in the landscape of this year’s proxy season for the first time in decades. However, certain aspects of the new rules are not required to be complied with until December 1, 2021.
The SEC has been considering the need for rule changes related to proxy advisors for years as retail investors increasingly invest through funds and investment advisors, in which the asset managers rely on the advice, services and reports of proxy voting advice businesses. It is estimated that between 70% and 80% of the market value of U.S. public companies is held by institutional investors, the majority of which use proxy advisory firms to manage the decision making and logistics of voting for thousands of proposals within a concentrated period of a few months. Proxy voting advice businesses provide a variety of services including research and analysis on matters to be voted upon; general voting guidelines that clients can adopt; giving specific voting recommendations on specific matters subject to a shareholder vote; and handling the administrative process of returning proxies and casting votes. The administrative tasks are usually electronic and, at times, can involve an automated completion of a ballot based on programed voting instructions.
The final vote was divided with the SEC Commissioners voting 3-1 in favor of the new rules. On the same day the SEC Commissioners, also in a 3-1 divided vote, endorsed guidance to investment advisors related to the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE.
In essence, the amendments condition the availability of two exemptions from the information and filing requirements of the federal proxy rules, which are often used by proxy voting advice businesses, on compliance with tailored and comprehensive conflicts of interest disclosure requirements. In addition, the exemptions are conditioned on the requirements that (i) companies that are the subject of proxy voting advice have that advice made available to them in a timely manner; and (ii) clients of proxy advice businesses are made aware of a company’s response to the advice in a timely manner.
The amendments codify the SEC’s longstanding view that proxy advice constitutes a solicitation under the proxy rules and is thus subject to the anti-fraud provisions. In particular, the amendment changes the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provides additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amends rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules.
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. The rules apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures. Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.
The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.“
The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.
On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request. For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts. The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).
The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.
The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9). A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions. In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters). The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.
New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021. Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while at the same time working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.
The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship. The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.
Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects. The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended. Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended. Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible. This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms such as ISS and Glass Lewis voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice. The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.
The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses. The time for review was set as a number of days based on the date of filing of the definitive proxy statement. However, commenters pushed back and the SEC listened.
The final rules allow proxy advisory businesses to take matters into their own hands. In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).
As adopted the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible. Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.
New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule. In particular:
(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.
(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).
The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company. Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice. Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.
It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule. The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does in fact meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Supplemental Guidance for Investment Advisors
On the same day as enacting the amended rules the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE. The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.
The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline. The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.
Following the SEC’s proposed conditional exemption for finders (see HERE), the topic of finders has been front and center. New York has recently adopted a new finder’s exemption, joining California and Texas, who were early in creating exemptions for intra-state offerings. Also, a question that has arisen several times recently is whether an unregistered person can assist a U.S. company in capital raising transactions outside the U.S. under Regulation S. This blog, the second in a three-part series, will discuss finders in the Regulation S context.
It is very clear that a person residing in the U.S. must be licensed to act as a finder and receive transaction-based compensation, regardless of where the investor is located. The SEC sent a poignant reminder of that when, in December 2015, it filed a series of enforcement proceedings against U.S. immigration lawyers for violating the broker-dealer registration rules by accepting commissions in connection with introducing investors to projects relying on the EB-5 Immigrant Investor Program. From a securities law perspective, EB-5 investments are generally completed by relying on the registration exemption found in Regulation S. For more on Regulation S, see HERE.
In a typical EB-5 investment, a company goes through a process of having their project approved by the United States Citizenship and Immigration Services (USCIS) after which they prepare private placement offering documents and solicit investors in qualifying foreign countries, including China. Due to language and cultural barriers, the U.S. company generally employs the services of marketing agents or finders in the foreign country to help locate and communicate with potential investors. Those finders are generally paid a success-based transaction fee. In addition, U.S. companies often establish a relationship with a U.S.-based immigration attorney that speaks the same language as the potential investors. The enforcement actions were part of a larger SEC investigation into securities law violations, including unregistered broker-dealer activity and sometimes fraud, in connection with the EB-5 program. It is interesting to note that no off-shore or non-U.S. finders were, or have since been, charged with unlicensed broker activity unless the action involved fraud.
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.
However, the Exchange Act generally does not apply to transactions outside the U.S. In particular, Section 30(b) of the Exchange Act specifically states that “The provisions of this chapter or of any rule or regulation thereunder shall not apply to any person insofar as he transacts a business in securities without the jurisdiction of the United States, unless he transacts such business in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate to prevent the evasion of this chapter.” Although this provision seems very broad, case law has narrowed the exemption such that the U.S. would still have jurisdiction, and the broker-dealer registration requirements in the Exchange Act would still apply, where (i) transactions occur in a U.S. securities market (such as Nasdaq or the NYSE); (ii) offers and sales were made abroad to U.S. persons (such as U.S. armed forces stationed abroad); or (iii) if the U.S. was used as a base for securities fraud perpetrated on foreigners.
Regulation S itself is a jurisdictional exemption. Rule 901 of Regulation S provides: “[F]or the purposes only of section 5 of the Act (15 U.S.C. §77e), the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed to include offers and sales that occur within the United States and shall be deemed not to include offers and sales that occur outside the United States.” Regulation S then continues to create a framework defining when an offer or sale is within the U.S. and preserves jurisdiction to protect foreign investors from offering fraud by U.S. persons.
Although not directly on point, SEC Rule 15a-6 provides a conditional exemption from the broker-dealer registration requirements for foreign broker-dealers that engage in certain specified activities involving U.S. investors. Rule 15a-6(b)(3) defines foreign broker-dealer to include “any non‑U.S. resident person (including any U.S. person engaged in business as a broker or dealer entirely outside the United States, except as otherwise permitted by this rule) that is not an office or branch of, or a natural person associated with, a registered broker or dealer, whose securities activities, if conducted in the United States, would be described by the definition of ‘broker’ or ‘dealer’ in sections 3(a)(4) or 3(a)(5) of the [Exchange] Act.” Notably, Rule 15a-6 does not include a requirement that a broker be licensed or registered in its foreign jurisdiction. Rather, the Rule only requires that the foreign broker be operating legally in its country of jurisdiction.
Rule 15a-6 allows certain transactions by foreign brokers with U.S. investors without registration. Regulation S, on the other hand, would only involve transactions with non-U.S. investors. Further in the Rule 15a-6 release, the SEC indicated that the exception in Rule 15a-6(a)(1) for unsolicited trades was designed to reflect the view that “U.S. persons seeking out unregistered foreign broker-dealers outside the U.S. cannot expect the protection of U.S. broker-dealer standards.” Again, in a Regulation S transaction, both the foreign finder and the investor would be outside the U.S.
Both Regulation S and Rule 15a-6 are based on the investors or brokers being outside the U.S. In determining whether such person is outside the U.S., the SEC will consider factors like whether the person physically visits the U.S., where a business has offices, where it has employees, where business is conducted and where bank accounts are located. Regulation S is very strict in its requirements that investors, and therefore finders, not have a connection to the U.S. at the time of an offer or sale of securities.
The bottom line is that I am comfortable that a foreign finder, operating exclusively outside the U.S. and exclusively soliciting non-U.S. investors, would be able to collect a transaction-based success fee without running afoul of the U.S. broker-dealer registration requirements.
The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time. The regulatory structure lays out governing principles and describes certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent. Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances. Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties. Rule 2-01(c) provides a non-exclusive list of circumstances which the SEC would consider inconsistent with independence.
The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company. The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets. Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.” However, under the old rules, technical violations that would not result in a lack of integrity were swept into the regulatory structure, causing unnecessary burdens and expenses associated with the client-auditor relationship.
The final amendments reflect updates based on recurring fact patterns that the SEC staff observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality. Accordingly, the new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time-consuming audit committee review of non-substantive matters.
The SEC adopting release provides examples of the types of concerns the new rules are designed to address, including one related to student loans and one related to a portfolio company. The student loan example is very straightforward, involving the technical independence violation where an auditor in an audit firm is still paying student loans to a large student loan lender and the audit firm audits the lender. Under the new rules, this would no longer create an independence violation.
The second example is more complicated but, in essence, involves a fund with multiple (could be hundreds) of portfolio companies and an audit firm with multiple global network affiliates. Under the prior rules, it was very complicated to sort out to make sure that the audit firm was not providing audit services to more than one portfolio company even though the only relationship between the companies was a common investor. Furthermore, a scenario could result where no qualified large audit firm could be independent due to the widespread investing activing of the fund.
Although the SEC doesn’t name names, this scenario could be fairly common. The three largest asset management firms, BlackRock, Vanguard and State Street, manage over $15 trillion in combined global assets, which is equivalent to more than three-quarters of the U.S. gross domestic product. Under the current rules, if one of their portfolio companies wanted to complete an IPO, it is very likely that the best audit firms would fail an independence test. The result would be that the company would be required to either: (i) replace their audit firm with another audit firm if one could be found; (ii) to wait to register with the SEC for up to three years after termination of the services provided to another portfolio company; or (iii) to make a determination, likely in consultation with SEC staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality. The amended rules would eliminate the need for a company’s audit committee and their auditors to seek SEC staff guidance in these scenarios.
The amendments will be effective 180 days after publication in the Federal Register, but voluntary compliance is permitted for new relationships once published in the Federal Register. However, auditors cannot retroactively apply the final amendments to relationships in existence prior to the effective date.
Definitions of Affiliate of the Audit Client and Investment Company Complex
The SEC has amended the definitions of an “affiliate of the audit client” and “investment company complex” with a focus on decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited. Currently an audit client includes not only the entity being audited but also affiliates of the audit client. Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities. Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also any investment company advised by a sister investment adviser or which has a sister sponsor.
The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies. In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.
Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality. In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.
The SEC has amended the definition of affiliate and ICC as relates to an audit client to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor. In reviewing materiality, the audit firm will need to consider both whether the sister entity and/or the audit client is material to the controlling entity. The amendment to the definition does not alter the general requirement that an auditor review all facts and circumstances to confirm independence. The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.
Audit and Professional Engagement Period
Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies. For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC. For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC. That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.
The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI. The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO. Accordingly, the SEC has amended the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.
Loans and Debtor-Creditor Relationships
Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client. The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.
The SEC has amended the rule to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions. In addition, the SEC has added language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.
The SEC has also revised the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.
Business Relationship Rule
The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders. The SEC has replaced the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”
As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.
Inadvertent Violations for Mergers and Acquisitions
An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction. The SEC has added a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner. Under the new rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances. Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.