Monthly Archives: March 2021
What a difference a year makes – or should I say – what a difference an administration makes! Back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s disclosure based regulatory regime. Enter Chair Allison Herron Lee and in a slew of activity over the past few weeks, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; Corp Fin has called for public comment on ESG disclosures and suggested a framework for discussion on the matter; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and the SEC issued a statement calling for public comment on climate related disclosures including a detailed list of questions to consider.
The ESG activity coming out of the SEC is so constant, I had to go back and add to this blog three times after I thought it was finished.
It seems that the SEC must answer the call from investors for valuable ESG disclosures. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
Net zero refers to operating such that global warming is limited to below 2o Celsius with net zero greenhouse gas emissions by 2050. But like all things ESG, there is a lot of disagreement on the best path forward. On March 10, 2021, the UK’s Institutional Investors Group on Climate Change, representing $35 trillion Euro in assets under management, published a Net Zero Investment Framework 1.0 specifically discouraging the use of carbon market offsets in achieving net zero goals. The problem is that many large companies use carbon offsets as an integral part of their stated net zero plans. Disclosure of plans may satisfy the SEC, but it is no guarantee that investors or stakeholders will approve of any course of action.
Back in 2010 the SEC issued guidance to public companies regarding disclosure requirements as they apply to climate change matters. Reviewing compliance with these guidelines is top of list for both Corp Fin and the Enforcement Taskforce. The Enforcement Task Force is also focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
In a series of blogs I will discuss ESG related matters including this first blog, which is focused on the climate change initiatives, a second discussing ESG investing, ratings and the role of a Chief Sustainability Officer and a third on ESG disclosures in general.
SEC Recent Climate Related Disclosure Initiative
As indicated, in the past 6 weeks, the SEC has issued a slew of statements and started numerous initiatives related to climate disclosures and environmental matters. Climate change is a top priority for the Biden administration. On February 1, 2021, the SEC announced that Satyan Khanna was named its first ever Senior Policy Advisor for Climate and ESG. Mr. Khanna was a former agency attorney and ex-adviser to Biden.
On February 24, 2021, acting SEC Chair Allison Herren Lee directed the Division of Corporation Finance to enhance its focus on climate related disclosures in public company filings. In her announcement, Chair Lee indicated that Corp Fin will review the extent to which public companies address the topics identified in the SEC’s 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The SEC staff has been directed to also update the 2010 guidance for present day efficacy. Then on March 15, 2021 the SEC solicited public comment on climate change disclosures with specific questions to consider.
The directive is not surprising as Chair Lee has always been vocal about her desire for increased climate and environment related disclosures. Stepping up initiatives for climate disclosure regulations, in March, Chair Lee, speaking at a virtual conference, stated that the SEC wants to implement a global framework for climate disclosures working in collaboration with global stakeholders and climate authorities. Certainly our markets are global and the SEC has made other recent disclosure changes to align with global practices, such as mining disclosure requirements (see HERE. New Corp Fin Director John Coates is fully on board. He is a former Harvard Law School professor who has pushed the SEC to update is corporate disclosures requirements on climate change and ESG matters.
On March 4, 2021, the SEC announced the creation of a Division of Enforcement Climate and ESG Task Force made up of 22 members from various offices. The task force will be focused on “ESG-related misconduct” including reviewing compliance with the 2010 climate disclosure guidelines and focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
I would also think that the Task Force will spend time reviewing the numerous ESG related financial products including high-yield debt instruments that have flooded the market. As one Wachtell Lipton memo pointed out, “[M]assive inflows into ESG-oriented investment funds and seemingly insatiable demand for ESG-related issuances have led to ‘greenium’ pricing (i.e., a lower cost of capital for issuers) of many ESG-related issuances. Moreover, credit rating agencies are increasingly factoring ESG risks – including related regulatory risks – into their ratings, as are credit committees at banks into their determinations.”
Also, on March 4, SECers Hester M. Peirce and Elad L. Roisman issued a joint statement questioning the practical meaning of the SEC’s climate and ESG related activities. As noted in the statement, Corp Fin has been reviewing companies’ disclosures, assessing their compliance with disclosure requirements under the federal securities laws, and engaging with them on climate change and a variety of issues that fall under the ESG umbrella, for decades. The concern is that the new initiative should be limited to reviewing public disclosures against the existing backdrop of regulation and not suddenly holding companies to a new undisclosed standard. The commissioners also questioned the timing of the enforcement task force, pointing out that it would be more prudent to wait until Corp Fin had completed its assessment on existing rules and until the Division of Examinations has completed this examination cycle. With that said, the statement concludes with a supportive call for adequate guidelines and rules resulting from input from SEC staff, investors, issuers and practitioners.
Request for Public Input on Climate Change Disclosure
On March 15, 2021, SEC Chair Allison Herren Lee issued a statement requesting public input on climate change disclosures. On the same day Ms. Lee gave a speech to the Center of American Progress outlining the SEC’s initiative on climate change matters. The request for public comment outlined specific questions for consideration and in particular:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant)? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)? Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
SEC 2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures. In 2010 and the few years prior, climate change was not only a global topic of discussion, but a regulatory hotspot as well. The EPA passed regulations requiring the reporting of and reduction of greenhouse gases by the largest pollutants; internationally the Kyoto Protocol was passed; the European Union Emissions Trading System became effective; international climate change conferences became the norm; official and un-official groups banded together on the subject; and the insurance industry revamped its actuarial and risk assessment system to account for climate change.
For some public companies, the regulatory changes could have a significant impact on operating and financial decisions including capital expenditures to reduce emissions and compliance with new laws, including those requiring reporting. Also, companies not directly impacted by the changes could be indirectly impacted by changes in costs for goods and services and impacts on their supply chain. The SEC release also notes that changes in weather patterns, increased storm intensity, sea level rise, melting of permafrost and temperature extremes at facilities could affect operations and financial disclosures. Likewise, changes in the availability or quality of water or other natural resources can have impacts on machinery, equipment and operations. Climate can also impact consumer demand such as reduced demand for heating fuels and warm clothing in warmer temperatures.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures HERE. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading).
The 2010 release delineated areas that could require such disclosure.
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business both historically and intended (see HERE for recent amendments to Item 101 including the addition of ESG related human capital disclosures). Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Like Item 101, Item 103 has recently been amended – see HERE.
Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 503 has also been amended – see HERE. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A- is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. Like the others, MD&A has been amended since 2010 – see HERE.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate related information.
Following the SEC’s proposed conditional exemption for finders (see HERE), I’ve been writing a series of blogs on the topic of finders. New York recently proposed, then failed to adopt a new finder’s regulatory regime. California and Texas remain the only two states with such allowing finders 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, which I addressed in the second blog in this series (see HERE). This blog will discuss the New York, California and Texas rules.
On December 1, 2020, the state of New York adopted an overhaul to some of its securities laws including modernizing registration and filing requirements with the Investor Protection Bureau and the Office of the Attorney General. Although the proposed rules would have adopted a new definition of “finder” and required licensing and examinations for such activity, the final rule release dropped the proposal without explanation.
Putting aside finders, an important aspect of the new rules is that companies conducting Rule 506 offering in New York will now need to file a completed Form D through the NASAA electronic filing depository. Prior to the new rules, New York’s Martin Act was very unclear on filing requirements and as a result, most practitioners simply did not file any notice documents or pay any fees where the offering pre-empted state law under the NSMIA (see HERE). This position was supported by an interpretive opinion published by the New York State Bar Association. Under the new rules, it is clear that a Form D is required, aligning New York with federal and other state notice provisions.
Historically, the Martin Act has not required the registration of securities, other than securities sold in real estate offerings, theatrical syndications or intra-state offerings. Instead, it requires that issuers register as dealers. In particular, the Martin Act requires that any person “engaged in the business of buying and selling securities from or to the public” register as a broker-dealer. New York exempted issuers from registering as dealers when they complete a firm commitment underwritten offering but not in other circumstances, including a best efforts underwritten offering or where no underwriter or placement agent is utilized.
The amended rules maintain this regulatory framework while expanding the definition of dealer and attempting to align, at least somewhat, the Martin Act with the federal framework involving covered securities. In particular, the new rules separate out dealers, and thus the forms necessary to file, into (i) Federal Regulation D Covered Securities Dealers; (ii) Federal Tier 2 Dealers; (iii) Federal Covered Investment Company Dealers; (iv) real estate dealers; and (v) all others.
In essence, the amended rules separate “dealers” that participate in federally covered transactions from those that do not. A Federal Regulation D Covered Securities Dealers must file a Form D. The new rules specify that the information in the Form D is all the information necessary to be filed by this category of dealer. A Federal Tier 2 Dealer must file a Uniform Notice Filing of Regulation A – Tier 2 Offering Form, which contains all the necessary information for that category of dealer. Finally, a Federal Covered Investment Company Dealer must file a Form N.
The New York rules did not proceed to provide a definition for “finders” but still require that “broker-dealers” that are not associated with a broker-dealer registered with the SEC or a member of FINRA be registered in New York to engage in broker-dealer activity. Of course, it still leaves the gaping question as to whether finder activity is broker-dealer activity requiring registration.
California Corporation’s Code Section 25206.1 permits the payment of a fee to finders for transactions involving intra-state offerings with California issuers subject to numerous conditions. In particular, a finder may be paid direct or indirect compensation if:
- The finder is a natural person;
- The finder only introduces accredited investors as defined by Rule 501 of the Securities Act (see HERE);
- The issuer and the transaction are in California exclusively (if an issuer is relying on a federal exemption other than one that nods to state law such as intra-state offering, the federal law would conflict);
- The securities purchase price cannot exceed $15,000,000 in the aggregate;
- The finder cannot participate in negotiating any of the terms of the offer or sale of securities;
- The finder cannot advise any party to the transaction regarding the value of the securities or the advisability of investing in, purchasing, or selling the securities;
- The finder cannot conduct any due diligence on the part of any party to the transaction;
- The finder cannot offer for sale any securities in which they own, directly or indirectly;
- The finder cannot receive, directly or indirectly, possession or custody of any funds;
- The securities transaction must be qualified or exempt from qualification under California law;
- The finder can only disclose (a) the name, address and contact information of the issuer; (b) the name, type, price, and aggregate amount of any securities being offered; and (c) the issuer’s industry, location and years in business;
- The finder must file in advance of taking any finder’s fees, a statement of information with the finder’s name and address, together with a $300 filing fee, with the California Bureau of Business Oversight, and thereafter file annual renewal statements with a $275 filing fee and representations that the finder has complied with the exemption conditions;
- Concurrently with each introduction, the finder shall obtain the informed, written consent of each person introduced or referred by the finder to an issuer, in a written agreement signed by the finder, the issuer, and the person introduced or referred, disclosing the following: (a) the type and amount of compensation that has been or will be paid to the finder; (b) the finder is not providing advice to the issuer or any person introduced or referred by the finder as to the value of the securities or as to the advisability of investing in, purchasing, or selling the securities; (c) whether the finder is also an owner, directly or indirectly, of the securities being offered or sold; (d) any actual or potential conflict of interest; (e) that the parties to the agreement have the right to pursue any available remedies for breach of the agreement; and (f) a representation that the person being introduced is accredited; and
- The finder must keep all records related to the transaction for five years.
Texas has a state finder’s registration process which is less onerous than full broker-dealer registration. A finder registers in Texas by filing a Form BD and Form U-4 with the state. A finder must be a natural person and cannot have agents working on their behalf.
Like California, even if registered, a finder’s activities are limited are subject to numerous conditions. Texas finders are strictly limited to dealing with accredited investors. Further, like California, a Texas finder would only be able to be compensated or operate in regard to Texas-based intra-state offerings or the activity would run afoul of federal securities laws.
Rule 115 of the Texas State Securities Board defines a “finder” as “[A]n individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor solely for the purpose of a potential investment in the securities of the issuer, but does not participate in negotiating any of the terms of an investment and does not give advice to any such parties regarding the advantages or disadvantages of entering into an investment, and conducts this activity in accordance with §115.11 of this title (relating to Finder Registration and Activities). Note that an individual registered as a finder is not permitted to register in any other capacity; however, a registered general dealer is allowed to engage in finder activity without separate registration as a finder.”
in turn prohibits a finder from: (i) participating in negotiating any terms of an investment; (ii) giving advice to an accredited investor or an issuer regarding the advantages or disadvantages of entering into an investment; (iii) conducting due diligence on behalf of a potential issuer or investor; (iv) providing a valuation or other analysis to an issuer or investor; (v) advertising to seek investors or issuers; (vi) having custody of an investor’s funds or securities; (vii) serving as escrow agent for the parties; or (viii) disclosing information to an investor or issuer other than as specified in parts (b) and (c) of the rule.
Rule 115.11(b) in turn requires that a finder disclose the following to each accredited investor: (i) that compensation will be paid to the finder; (ii) that the finder can neither recommend nor advise the investor with respect to the offering; and (iii) any potential conflict of interest in connection with the finder’s activity.
Rule 115.11(c) enumerates permitted finders’ disclosures, including: (i) the name, address and telephone number of the issuer; (ii) the name and a brief description of the security to be issued; (iii) the price of the security; (iv) a brief description of the business of the issuer in 25 words or less; (v) the type, number and aggregate amount of securities being offered; and (vi) the name, address, and telephone number of the person to contact for additional information.
Rule 115.11(d) contains specific detailed record-keeping requirements for finders. Records are required to be kept for five years and must be segregated from any other records the finder may maintain.
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this final blog discussing the changes to Regulation Crowdfunding. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE). The fourth blog in the series reviews the changes to Regulation A (see HERE).
Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions, including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation Crowdfunding – Background
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Although it took a while, Regulation Crowdfunding went into effect on May 16, 2016. The exemption allowed companies to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor could not exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. As written, regardless of the category, the total amount any investor could invest was limited to $100,000. For a summary of the provisions, see HERE.
In addition, all offerings must be conducted through a single offering portal and advertisements are limited to directing investors to that portal. Companies are required to provide specified information through the filing of a Form C with staggered information requirements based on the offering size. The financial statement requirements progressively increase based on increased offering size.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
On May 4, 2020, the SEC adopted temporary final rules under Regulation Crowdfunding for small businesses impacted by COVID-19, which include, among other things, an exemption from certain financial statement review requirements for companies offering $250,000 or less. These temporary rules were subsequently extended and apply to offerings initiated under Regulation Crowdfunding between May 4, 2020, and February 28, 2021 (see HERE).
The new rules increase the offering limits, adjusts the formula related to the maximum amount an unaccredited investor can invest, remove the investment limit for accredited investors, allow for investments through special purpose vehicles (SPVs), and align the bad actor provisions with those in Regulation A. The proposal to limit the type of securities that can be offered to align it with Regulation A was not adopted in the final rule amendments.
Increase in Offering Limit
The amendments increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding will become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The amendment rules increase the investment limits by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits no longer apply to accredited investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The amendment rules allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles can be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding offering. These special purpose entities may not have a separate business purpose beyond the crowdfunding investment and must not, in fact, conduct any business beyond the investment. The crowdfunding vehicle is a co-issuer in the offering and as such, investors in the crowdfunding vehicle will have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying company.
The rule benefits companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders. A cleaner cap table can make companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle will also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle will constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available, it is required to register if, as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Regulation Crowdfunding offerings have always meant to pre-empt state law; however, the language in the prior rule was somewhat ambiguous. To avoid any doubt, the SEC has amended Regulation Crowdfunding to specifically include crowdfunding investors in the definition of a “qualified purchaser” for purposes of Section 18 of the Securities Act, which section delineates federally covered securities and transactions (for more on federal pre-emption, see HERE).
The new rules also extend certain provisions of the Covid-related temporary relief for financial statements through August 28, 2022. That is, any offering under Regulation Crowdfunding, together with other Regulation Crowdfunding offerings in the last 12 months, where the target offering amount is between $107,000 and $250,000, may provide financial statements that are certified by the principal executive officer instead of reviewed by an independent public accountant. This temporary relief will apply only if reviewed or audited financial statements of the company are not otherwise available.
This year has marked a string of cases eroding the long history of Delaware’s board of director protections from breach of fiduciary duty claims. In Re Caremark International Inc. Derivative Litigation was a civil action in the Delaware Court of Chancery in 1996 which drilled down on a director’s duty of care in the oversight context. Caremark found that generally directors do not need to approve or exercise oversight over most company decisions, other than mergers (see HERE), changes in capital structure and fundamental changes in business.
Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” In other words – bad faith. Not surprisingly, these claims routinely fail at the pleading stage.
However, following Marchand v. Barnhill and In re Clovis Oncology Derivative Litigation which upheld claims against a board under Caremark last year, this year the Delaware Chancery Court also upheld claims in Hughes v. Hu and Teamsters Local 443 Health Services & Insurance Plan v. Chou. Whether these cases are actually a change in the law or just examples of how boards are utterly failing at their duties remains to be seen. Also, since these cases are all relatively new, we have yet to see whether Board of Director defendants will actually face personal liability.
Either way, they certainly act as a reminder of the importance of active, engaged board oversight of material risk and compliance issues. Clearly boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight. Part of those proactive steps include making a good faith effort to implement an oversight system and then actually monitoring it. Protocols need to be in place so that issues are brought to the board or relevant board committee promptly.
Likewise, boards should regularly review what key or mission critical risks exist (or potentially exist) for oversight. The board also needs to properly respond to risks or issues in a timely fashion and follow up with management. Board minutes should include notes on all actions taken.
Marchand v. Barnhill
In Marchand v. Barnhill the Delaware Supreme Court overruled the Chancery Court’s order granting a motion to dismiss on Caremark claims. Following the Caremark decision in 1996, almost all attempted negligent supervision causes of action were dismissed at the pleading stage. Marchand, which resulted from a listeria outbreak at Blue Bell Creameries, marked the first in what is now a series of cases that survived a motion to dismiss and continue to be litigated. In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company’s products, a complete production shutdown, and a layoff involving 1/3rd of its workforce.
In determining that the Plaintiff had properly pled a case under Caremark, the Supreme Court noted that bad faith can be established by showing that no good faith efforts had been made. In this case no board committee had considered food safety protocols; no procedures were in place that required management to inform the board of food safety compliance practices, risks or reports; there was no schedule for the board to consider food safety on any sort of regular basis (even annually); prior to the outbreak red flags were presented to management who did not disclose these matters to the board; and board minutes showed a complete lack of discussion related to food safety. The Court noted that government inspectors found food safety problems at the company’s plants that were so systemic that any reasonable monitoring system would have resulted in them being reported to the board.
In other words, even though management did not disclose issues to the board, the board’s lack of inquiry or development of a plan to learn about food safety issues, in a food production company, rose to the level of bad faith supporting a complaint for lack of oversight. The Marchand parties agreed to a $60 million settlement, ten days before trial was set to commence.
In re Clovis Oncology Derivative Litigation
In re Clovis Oncology Derivative Litigation the court found that the plaintiffs had adequately pled that the board breached its fiduciary duties by failing to oversee a clinical trial for the company’s experimental lung cancer drug and then allowing the company to mislead the market regarding the drug’s efficacy. Clovis eventually disclosed these failures, resulting in a $1 billion drop in market value, a federal securities action, an SEC complaint, and the Delaware derivative action. Here the judge stated that Delaware courts are more likely to find liability under Caremark for oversight failures involving compliance obligations under regulatory mandates than for those involving oversight of ordinary business risks.
The court indicated that Caremark rests on the presumption that corporate fiduciaries are afforded “great discretion to design context and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.” But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law—including regulatory mandates.
Caremark requires a plaintiff to establish that the board either “completely fail[ed] to implement any reporting or information system or controls” or failed to adequately monitor that system by ignoring “red flags” of non-compliance. Here the board’s governance committee was responsible for overseeing compliance with regulatory requirements applicable to the clinical trial, the judge held that the plaintiff adequately pled that it knowingly ignored red flags indicating that the company was not complying with those requirements. Accordingly, he declined to dismiss the case. The case remains pending.
Hughes v. Hu
In Hughes v. Hu the Chancery Court held that the plaintiff adequately pled that the director defendants, who served on the company’s audit committee, breached their fiduciary duties by failing to oversee the company’s financial statements and related party transactions. The audit committee only met when they needed to discuss its annual 10-K and the meeting was brief and perfunctory. The plaintiff alleged that the directors made a conscious choice to avoid their duties and followed management blindly even after being presented with evidence of improper financial reporting and a failure to adequately disclose related party transactions.
In 2014 the public company even disclosed material weaknesses in its internal controls and a lack of oversight by the audit committee as financial controls and related party transactions. In 2017 the company had not fixed any of its problems and had to restate three years of financial statements. Although the case survived the motion to dismiss, it is still ongoing and none of the defendants have been found liable as of yet.
Teamsters Local 443 Health Services & Insurance Plan v. Chou
In Teamsters Local 443 Health Services & Insurance Plan v. Chou the court found that the defendants ignored red flags of illegal activity. The illegal activity involved a subsidiary of AmerisourceBergen Corporation (ABC) that was pooling excess overfill medication from cancer vials into additional syringes, which led to contamination. ABC, through a subsidiary, is in the business of buying single-dose vials of oncology drugs from manufactures, putting the drugs in syringes and selling the syringes for use by cancer patients. The vials included an overfill amount to account for human error in filling syringes and to avoid air bubbles. The overfill amount is supposed to be discarded. Instead, the subsidiary was pooling the drugs and filling additional syringes.
The company faced corporate criminal and civil penalties and stockholders brought a Caremark case against the directors. In refusing to dismiss the case, the Court found that the directors ignored three red flags including: (i) a report from an outside law firm that the subsidiary was not integrated into ABC’s compliance and reporting function (and thus that compliance had substantial gaps); (ii) a former executive filed a lawsuit until seal in federal court alleging illegal activity and although the lawsuit was disclosed in the 10-K’s signed by the directors, they did not take any remedial action; and (iii) the subsidiary received a subpoena from federal prosecutors related to illegal activity and the board still did not take action.