Laura Anthony

    • Member Type(s): Expert
    • Title:Founding Partner
    • Organization:Legal & Compliance, LLC
    • Area of Expertise:Securities Law

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    The OTCQB Has Added Additional Quantitative Listing Standards

    Tuesday, August 14, 2018, 8:43 AM [General]
    0 (0 Ratings)

    On May 20, 2018, the OTC Markets Group published the OTCQB Standards version 3.0 incorporating amendments to the OTCQB initial and ongoing listing standards to add further quantitative shareholder and public float requirements. The new standards went into effect on May 20, 2018 for new listing applications. Existing OTCQB traded companies have until May 20, 2020 to comply with the new requirements.

    The amended listing standards now require that an applicant company:

    1. Have at least 50 beneficial shareholders holding at least one round lot (100 shares) each;
    2. Have a freely tradeable public float of at least 10% of the total issued and outstanding shares of the tradeable class of securities. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion.

    Previously in October 2017, OTC Markets amended its OTCQB rules to increase the annual listing fee from $10,000 to $12,000. Prior to that on July 31, 2017, the OTC Markets Group enacted amendments to the OTCQB standards related to the processing and reporting of change in control events. For a review of the change of control standards, see HERE.

    A review of OTCQB Listing Standards

    The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. The OTCQB is considered the venture-market tier designed for entrepreneurial and development-stage U.S. and international companies. To apply to the OTCQB, a company must submit a completed application and quotation agreement and pay the application fee.

    Eligibility Requirements

    To be eligible to be quoted on the OTCQB, all companies will be required to:

    • Meet a minimum closing bid price on OTC Markets of $0.01 for each of the last 30 calendar days and as of the day the OTCQB application is approved;
    • In the event that there is no prior public market and a 15c2-11 application has recently been approved by FINRA allowing a quotation at $0.01 or greater, or if the company is traded on a Qualified Foreign Exchange at a price greater than $0.01, OTC Markets can waive the bid requirement at its sole discretion. In this case, the company’s stock must trade above the $0.01 for each of the 30 calendar days immediately subsequent to the company first being quoted on the OTCQB;
    • Have at least 50 beneficial shareholders, each owning at least 100 shares;
    • Have a freely tradeable public float of at least 10% of the total shares issued and outstanding of the class of security to be traded on the OTCQB. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion;
    • Have current disclosure by meeting one of the following: (a) being subject to the reporting requirements of the Securities Exchange Act of 1934 and be current in such reporting obligations; (b) being a Regulation A reporting company and be current in such reporting obligations; (c) if an international issuer, be eligible to rely on the registration exemption found in Exchange Act Rule 12g-2(b) and be current and compliant in such requirements; (d) be a bank current in its reporting obligations to its bank regulator; or (e) be current in the OTC Markets Alternative Reporting Standards;
    • Have U.S. GAAP audited financials prepared by a PCAOB qualified auditor, including an audit opinion that is not adverse, disclaimed or qualified. International reporting companies or companies trading on a qualified foreign exchange may have audited financial statements prepared in accordance with IFRS.  Regulation A reporting companies are exempt from the requirement that the initial audits be prepared by a PCAOB auditor; however, subsequent financial statements are required to have a PCAOPB audit;
    • Be duly organized, validly existing and in good standing under the laws of each jurisdiction in which it is organized and does business;
    • Not be subject to any bankruptcy or reorganization proceedings;
    • Submit an application and pay an application and annual fee;
    • Maintain a current and accurate company profile on the OTC Markets website;
    • Use an SEC registered transfer agent and authorize the transfer agent to provide information to OTC Markets about the company’s securities, including but not limited to shares authorized, shares issued and outstanding, and share issuance history; and
    • Submit an OTCQB Annual Certification confirming the accuracy of the current company profile and providing information on officers, directors and controlling shareholders.
    • For companies that are relying on the Alternative Reporting Standard (i.e., not reporting to the SEC), meet minimum corporate governance requirements, including (i) have a board of directors that includes at least two independent directors; and (ii) have an audit committee comprised of a majority of independent directors. A company may request the ability to phase in compliance with this requirement if: (a) at least one member of the board of directors and audit committee are independent at the time of the application; and (b) at least two members of the board and a majority of the audit committee are independent within the later of 90 days after the company begins trading on the OTCQB or by the time of the company’s next annual meeting and in no event later than one year from joining the OTCQB.

    All companies are required to post their initial disclosure on the OTC Markets website and make an initial certification.  The initial disclosure includes:

    • Confirmation that the company is current in its SEC reporting obligations, whether subject to the Exchange Act reporting requirements or Regulation A reporting requirements, and has filed all reports with the SEC on the EDGAR system that all financial statements have been prepared in accordance with U.S. GAAP, and that the auditor opinion is not adverse, disclaimed or qualified;
    • Bank Reporting Companies must have filed all financial reports required to be filed with their banking regulator for the prior two years, including audited financial statements;
    • International Companies – (i) Companies subject to the Exchange Act reporting requirements must be current in such reports; (ii) A company that is not an SEC Reporting company must be current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and shall have posted in English through the OTC Disclosure & News Service or an Integrated Newswire, the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b) for the preceding 24 months (or from inception if less than 24 months); and all financial statements have been prepared in accordance with U.S. GAAP and that the auditor opinion is not adverse, disclaimed or qualified;
    • Alternative Reporting Companies must have filed, through the OTC Disclosure and News Services, an information and disclosure statement meeting the requirements of the OTCQX and OTCQB disclosure guidelines. If the company was an SEC Reporting Company immediately prior to joining OTCQB and has a current 10-K or 20-F on file with the SEC, or was a Regulation A Reporting Company immediately prior to joining OTCQB and has a current 1-K on file with the SEC, the company is not required to file an information statement through the OTC Disclosure & News Service, but subsequent to joining OTCQB must file all annual, quarterly, interim and current reports required pursuant to the OTCQX and OTCQB Disclosure Guidelines; and
    • Verified Company Profile – verification that the company profile is current, complete and accurate.

    In addition, all companies will be required to file an initial and annual certification on the OTC Markets website, signed by the CEO and/or CFO, stating:

    • The company’s reporting standing (i.e., whether SEC reporting, Regulation A reporting, Alternative Standards Reporting, bank reporting or international reporting) and briefly describing the registration status or the applicable exemption from SEC registration of the company;
    • If the company is an international company and relying on 12g3-2(b), that it is current in such obligations;
    • That the company is current in its reporting obligations as of the most recent fiscal year end and any subsequent reporting periods and that such information has been filed either on EDGAR or the OTC Disclosure & News Service, as applicable;
    • That the company profile on the OTC Markets website is current and complete and includes the total shares outstanding, authorized and in the public float as of that date;
    • The number of beneficial shareholders holding at least 100 shares and the number of shares in the public float as of the least practicable date;
    • That the company is duly organized, validly existing and in good standing under the laws of each state or jurisdiction in which the company is organized and conducts business;
    • Identifies the law firm and/or attorneys that assist the company in preparing its annual report or 10-K. Include the firm and attorney name if outside counsel, or name and title if internal counsel. If no attorney assisted in putting together the disclosure, the company must identify the person or persons who prepared the disclosure and their relationship to the company;
    • Identifies any third-party providers engaged by the company, its officers, directors or controlling shareholders, during the prior fiscal year and up to the date of the certification, to provide investor relations services, public relations services, stock promotion services or related services;
    • Names and shareholdings of all officers and directors and shareholders that beneficially own 5% or more of the total outstanding shares, including beneficial ownership of entity shareholders.

    An application to OTCQB can be delayed or denied at OTC Markets’ sole discretion if they determine that admission would be likely to impair the reputation or integrity of OTC Markets group or be detrimental to the interests of investors.

    Requirements for Bank Reporting Companies

    Bank reporting companies must meet all the same requirements as all other OTCQB companies except for the SEC reporting requirements.  Instead, bank reporting companies are required to post their previous two years’ and ongoing yearly disclosures that were and are filed with the company’s bank regulator, on the OTC Markets website.

    International Companies

    In addition to the same requirements for all issuers as set forth above, foreign issuers must be listed on a Qualified Foreign Exchange and be compliant with SEC Rule 12g3-2(b). Moreover, a foreign entity must submit a letter of introduction from a qualified OTCQB Sponsor which states that the OTCQB Sponsor has a reasonable belief that the company is in compliance with SEC Rule 12g3-2(b), is listed on a Qualified Foreign Exchange, and has posted required disclosure on the OTC Markets website. A foreign entity must post two years’ historical and ongoing quarterly and annual reports, in English, on the OTC Markets website which comply with SEC Rule 12g3-2(b). I am a qualified OTCQB Sponsor and assist multiple international companies with this process.

    Application Review Process

    OTC Markets will review all applications and may request additional information on any of the information submitted. In addition, OTC Markets can require that a company provide a further undertaking, such as submission of personal information forms for any executive officer, director or 5%-or-greater beneficial owner. OTC Markets can request that third parties provide confirmations or information as well.  OTC Markets can, and likely will, conduct independent due diligence including through the review of publicly available information.

    OTC Markets can deny an application if it determines, upon its sole and absolute discretion, that the admission of the company would be likely to impair the reputation or integrity of OTC Markets or be detrimental to the interests of investors.

    Upon approval of an application, the company’s securities will be designated as OTCQB on the OTC Markets websites, market data products and broker-dealer platforms.

    Ongoing Requirements

    • All companies are required to remain in compliance with the OTCQB standards, including the ongoing disclosure obligations;
    • S. OTCQB companies will be required to remain current and timely in their SEC reporting obligations, including either Exchange Act reports, Regulation A+ reports or Alternative Reporting Standard and including all audited financial statement requirements;
    • A foreign company that is not an SEC Reporting Company must remain current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and in any event shall, on an ongoing basis, post in English through the OTC Disclosure & News Service or an Integrated Newswire the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b);
    • Audited financial statements must be prepared in accordance with U.S. GAAP or, for international reporting companies or alternative reporting companies listed on a qualified foreign exchange, IFRS and all must contain an audit opinion that is not adverse, disclaimed or qualified. Audits must be completed by a PCAOB qualified auditor.
    • Banks must remain current in their banking reporting requirements and file copies of their reports on the OTC Markets website no later than 45 days following the end of a quarter or 90 days following the end of the fiscal year;
    • All OTC Markets postings and reports must be filed within 45 days following the end of a quarter or 90 days following the end of the fiscal year for US Exchange Act issuers and Alternative Reporting Standard filers, as required by Regulation A+ for Regulation A+ reporting issuers, and immediately after their submission to their primary regulator for international companies; where applicable, file a notice of late filing allowing for 5 extra days on a quarterly report and 15 extra days on an annual or semiannual report;
    • All OTCQB companies will be required to post annual certifications on the OTC Markets website signed by either the CEO or CFO no later than 30 days following the company’s annual report due date;
    • All companies are required to comply with all federal, state, and international securities laws and must cooperate with all securities regulatory agencies;
    • Must pay the annual fee within 30 days of prior to the beginning of each new annual service period;
    • All companies must respond to OTC Markets inquiries and requests;
    • All companies must maintain an updated verified company profile on the OTC Markets website and must submit a Company Update Form at least once every six months;
    • OTCQB is a recognized securities manual for purposes of blue sky secondary market exceptions. A precondition to relying upon the manual’s exemption is the maintenance of current updated disclosure information as required by OTC Markets;
    • All companies must make a press release and possibly other public disclosure (such as a Form 8-K) to inform the public of any news or information which might be reasonably expected to materially affect the market of its securities;
    • An OTCQB company must act promptly to dispel unfounded rumors which result in unusual market activity or price variations;
    • All companies must file interim disclosures in the event the company undergoes a reverse merger or change of control and make new updated certifications and disclosure related to the new business and control persons;
    • All OTCQB companies are subject to the OTC Markets Stock Promotion Policy, as such policy may be amended from time to time. In the event that OTC Markets determines, upon its sole discretion, that a company is the subject of promotional activities that encourage trading, OTC Markets may require the company to provide additional public information related to shareholdings of officers, directors and control persons and confirmation of shares outstanding, and any share issuance in the prior two years. OTC Markets may also require submission of a Personal Information Form for any executive officer, director or 5%-or-greater shareholder;
    • OTCQB companies must quickly issue press releases to the public to disclose any news or information which might reasonably be expected to materially affect the market for its securities.
    • Not be subject to bankruptcy or reorganization proceedings;
    • Be duly organized and in good standing under the laws of each jurisdiction in which the company is organized or does business;
    • Have at least 50 beneficial shareholders, each owning at least 100 shares;
    • Have a freely tradeable public float of at least 10% of the total shares issued and outstanding of the class of security to be traded on the OTCQB. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion;
    • Companies relying on the Alternative Reporting Standard must comply with the ongoing corporate governance requirements subject to a notice and one-year grace period if the company falls into noncompliance;
    • All OTCQB companies must meet the minimum bid price of $.01 per share at the close of business of at least one of the previous thirty (30) consecutive calendar days; in the event that the price falls below $.01, the company will begin a grace period of 90 calendar days to maintain a closing bid price of $.01 for ten consecutive trading days; and
    • Use an SEC registered transfer agent and authorize the transfer agent to provide information to OTC Markets about the company’s securities, including but not limited to shares authorized, shares issued and outstanding, and share issuance history.

    Officers and directors of the company are responsible for compliance with the ongoing requirements and the content of all information.  Entities that do not meet the requirements of either OTCQX or OTCQB will be quoted on the OTC Pink.

    Procedures for Change in Control Events

    A “change in control event” is defined to mean a transaction resulting in: (i) a change in the majority ownership or effective control of a company; (ii) material changes to the company’s management team or board of directors; or (iii) in conjunction with either of the above, a material change in the nature of the company’s business operations.

    Under Section 2.4, a company will be responsible for notifying OTC Markets upon the completion of a transaction resulting in a change of control. Regardless of notification, OTC Markets may also make a discretionary determination that a change of control event has occurred.

    Upon a change of control event, a company will be required to submit a OTCQB Change in Control Notification together with a new OTCQB Application and application fee ($2,500) within 20 calendar days. OTC Markets will review the notice and application and may request additional information. The failure to respond or fully comply with such requests may result in removal from the OTCQB.

    Furthermore, immediately following a change in control event, a company would be required to file a new OTCQB Certification and updated company profile page.


    Newly applying entities must pay an initial application fee of $2,500, which fee is waived for existing OTCQB entities. All OTCQB companies will be required to pay an annual fee of $12,000. Companies may opt to make two semiannual installments of $6,500. Fees are nonrefundable.

    Removal/Suspension from OTCQB

    A company may be removed from the OTCQB if, at any time, it fails to meet the eligibility and continued quotation requirements subject to a notice and opportunity to cure. Companies that are delinquent in filing and reporting requirements are subject to a 45-day cure period.  Companies with a bid price deficiency shall have a 90-day cure period. However, in the event the company’s bid price falls below $0.001 at any time for five consecutive trading days, the company will be immediately removed from the OTCQB. All other deficiencies are subject to a 30-day cure period. OTC Markets may provide additional cure periods, but in no event may audited financial statements be older than 18 months.

    Companies are granted a cure period of 30 calendar days for failure to maintain the minimum ongoing beneficial shareholder amount and public float requirements. A company may apply in writing to OTC Markets Group for an extension of the 30-day cure period by submitting a plan to cure the deficiency, which extension may be granted by OTC Markets Group in its sole and absolute discretion.

    In addition, OTC Markets Group may remove the company’s securities from trading on OTCQB immediately and at any time, without notice, if OTC Markets Group, upon its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.

    In addition, OTC Markets can temporarily suspend trading on the OTCQB pending investigation or further due diligence review.

    A company may voluntarily withdraw from the OTCQB with 24 hours’ notice...

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    SEC Issues Additional C&DI On Use Of Non-GAAP Measures

    Tuesday, August 7, 2018, 8:45 AM [General]
    0 (0 Ratings)

    On April 4, 2018, the SEC issued two new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies in connection with business combinations. The two new C&DI follow two other C&DI which were issued on October 17, 2017 (see HERE).

    The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

    My prior two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE  and HERE.

    GAAP continues to be and has consistently been criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number.

    On the flip side, the plaintiff’s bar has habitually used Regulation G and Item 10(e) of Regulation S-K, and in particular the GAAP reconciliation disclosure requirements, to pursue frivolous lawsuits in the context of business combinations. Business combinations as a whole are one of the most frequent targets for such litigation.

    The fall 2017 C&DI was an effort by the SEC to provide some clarity on the requirements. CD&I 101.01 addressed whether forecasts provided to a financial advisor in relation to a business combination transaction would be considered non-GAAP financial measures requiring compliance with applicable rules. In particular, the SEC confirmed that providing forecasts to a financial advisor in connection with a business combination transaction would not be considered non-GAAP financial measures.

    Item 10(e)(5) of Regulation S-K and Rule 101(a)(3) of Regulation G provide that a non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, SEC rules, or pursuant to specific government regulations or SRO rules that are applicable to a company. Accordingly, financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (i) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (ii) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

    Although the disclosure of projections to a financial advisor in a business combination transaction does not implicate rules related to non-GAAP financial measures, that same disclosure in a registration statement, proxy statement or tender offer statement would need to comply with Regulation G and Item 10(e) of Regulation S-K.

    In the second C&DI issued in the fall, the SEC addressed the limited exemptions from the non-GAAP rules for communications relating to business combination transactions. In particular, Rule 425 of the Securities Act requires that certain business combination communications, that would not be considered solicitation materials in other contexts, be filed with the SEC, generally as part of a registration statement on Form S-4, proxy statement or tender offer statement. Likewise, limited solicitations under Exchange Act Rule 14a-12 and 14d-2(b)(2) that are made prior to filing a proxy statement are exempted from the non-GAAP measure requirements.

    Other than the limited exemptions set forth in the rules listed above, and communications to a financial advisor, business combination communications must comply with Regulation G and Item 10(e) of Regulation S-K related to non-GAAP financial measures, including a reconciliation to comparable GAAP numbers and the reasons for presenting the non-GAAP numbers.

    Following the issuance of those C&DI, some plaintiffs’ lawyers took advantage of a perceived lack of clarity and suggested that projections disclosed to bidders or a board of directors did require GAAP reconciliation and when none was provided, a violation had occurred.

    Accordingly, on April 4, 2018, the SEC provided further clarity. New C&DI 101.02 is direct and to the point, providing:

    Question: Can the registrant rely on the Answer to Question 101.01 if the same forecasts provided to its financial advisor are also provided to its board of directors or board committee?

    Answer: Yes.

    New question 101.03 likewise provides:

    Question: A registrant provides forecasts to bidders in a business combination transaction. To avoid anti-fraud concerns under the federal securities laws or ensure that the other disclosures in the document are not misleading, it determines that such forecasts should be disclosed. Are the financial measures contained in forecasts disclosed for this purpose considered non-GAAP financial measures?

    Answer: If a registrant determines that forecasts exchanged between the parties in a business combination transaction are material and that disclosure of such forecasts is required to comply with the anti-fraud and other liability provisions of the federal securities laws, the financial measures included in such forecasts would be excluded from the definition of non-GAAP financial measures and therefore not subject to Item 10(e) of Regulation S-K and Regulation G.

    Refresher on Regulation G and Item 10(e) of Regulation S-K

    Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K.

    Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

    Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X.  Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

    Definition of non-GAAP financial measure and exclusions

    A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

    Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

    Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

    Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

    Regulation G and Item 10(e) requirements

    Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

    As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading.

    As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

    Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP.  I made several additions to the original chart created by Skadden...

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    Wyoming’s Blockchain Legislation

    Thursday, August 2, 2018, 9:43 AM [General]
    0 (0 Ratings)

    Wyoming continues to position itself as a business-friendly state most recently by passing groundbreaking blockchain legislation defining cryptocurrency coins or tokens as a whole new asset class separate from securities and commodities.  While it is unlikely that Wyoming’s new statutes will impact the SEC’s view that most, if not all, cryptocurrencies, or at least those issued to investors or used for capital raising, are securities, or the CFTC’s view that cryptocurrencies that are used as a medium of exchange, are a commodity, Wyoming has done what federal lawmakers have not yet endeavored – created comprehensive blockchain legislation.

    In March 2018, Wyoming passed five separate bills addressing securities, corporate, banking and tax matters which could entice cryptocurrency and blockchain businesses to locate within the state. The statutes are part of an initiative in Wyoming called ENDOW – Economically Needed Diversity Options for Wyoming.

    HB 19

    Wyoming House Bill 19 provides an exemption for virtual currency, including bitcoin and ethereum, used within Wyoming from money transmitter laws and regulations subject to providing certain specified verification authority to the Wyoming Secretary of State and Wyoming Banking Commissioner.  The specified verification authority includes representations, warranties and undertakings by the issuer of “utility tokens” to confirm beneficial ownership of the token and to prevent unauthorized or fraudulent duplication of the token by third parties.

    HB 19 defines a “virtual currency” as “any type of digital representation of value that: (i) is used as a medium of exchange, unit of account or store of value; and (ii) is not recognized as legal tender by the United States government.”

    As a reminder, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce.  Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing.  Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

    However, despite the Wyoming state law exemption, businesses which issue or exchange these tokens would still be subject to FinCEN’s regulations and the requirements to comply with the Bank Secrecy Act (BSA).  The BSA requires virtual currency exchangers and administrators, including those businesses that issue a virtual currency in exchange for other virtual currencies, fiat currency or types of value, to complete anti-money laundering (AML), know your customer (KYC) and other procedures to combat the financing of terrorism and prevent or detect the abuse of virtual currency to facilitate cyber-crime, money laundering, terrorist financing, black market sales of illegal or illicit products and services and other high-tech crimes. For more on FinCEN and the BSA, see HERE.

    HB 70

    Wyoming House Bill 70 removes utility tokens from specified securities and money transmission laws.  In particular, any person that develops, sells or facilitates the exchange of an open blockchain utility token would not be required to comply with specified securities and money transmission laws subject to providing specified verification authority.  The purpose of the statute is to make clear that utility tokens issued for non-investment purposes, are exempt from the Wyoming securities laws including registration and exemption provisions and broker-dealer registration requirements.

    HB 70 defines an “open blockchain token” as a digital unit which is: (i) created (a) in response to the verification or collection of a specified number of transactions relating to a digital ledger or database, (b) by deploying computer code to a blockchain network that allows for the creation of digital tokens or other units, or (c) using any combination of (a) and (b); (ii) recorded in a digital ledger or database that is chronological, consensus-based, decentralized and mathematically verified, especially related to the supply of units and their distributions; and (iii) capable of being traded or transferred between persons without an intermediary or custodian of value.

    HB 70 provides that the purpose of the token must be for “a consumptive purpose, which shall only be exchangeable for, or provided for the receipt of, goods, services or content, including rights of access to goods, services or content.”

    Furthermore, HB 70 would not apply where the developer or seller of the token sold the token to the initial buyer as a financial investment.  The requirement that the token not be an investment can only be satisfied if: (i) the developer or seller does not market the token as a financial investment; and (ii) at least one of the following is true: (a) the developer or seller reasonably believed that it sold the token for a consumptive purpose; (b) the token has a consumptive purpose that is available at the time of sale and can be used at or near the time of sale; (c) if the token does not have a consumptive purpose at the time of sale, the token is prevented from being resold until the consumptive purpose is available; or (d) the developer or seller takes other reasonable precautions to prevent the buyers from purchasing the token as a financial investment.

    The SEC has been clear in numerous statements that it believes that tokens that are issued for the purpose of capital raising and an increase in value, are securities offerings that must comply with the federal securities laws.  The SEC’s position relates to factors such as the method of issuance and sale of the tokens, use of proceeds, investment intent and expectation of profit, ability to increase value, whether the “utility” has been built out or established, and ability for secondary trading.  The SEC has specifically not taken into account the ultimate utility value of the token, nor directly answered the oft asked question of whether a token that is issued in a securities offering, can then morph into a commodity or other asset class, not subject to the securities laws.  It is my view, and the general view of the marketplace, that “utility tokens” can be sold in a “securities offering.”

    Although the Wyoming statute attempts to address the investment intent, and even appears to attempt to address the SEC main criteria, I would suggest that issuers of any tokens should continue to comply with the federal securities laws until there is further guidance and certainty at the federal level.

    SF 111

    SF 111 provides that virtual currency is not subject to taxation as “property” in Wyoming.  That is, virtual currency would be treated as personal property, not subject to Wyoming property taxes.  SF 111 amends a prior statute that exempted money and cash on hand, currency, gold, silver and related items by adding virtual currencies.  Like HB 19, SF 111 defines a “virtual currency” as “any type of digital representation of value that: (i) is used as a medium of exchange, unit of account or store of value; and (ii) is not recognized as legal tender by the United States government.”

    HB 101

    HB 101 allows for the maintenance of corporate records of Wyoming entities via blockchain that utilizes electronic keys, network signatures and digital receipts.  In particular, the Act authorizes the use of electronic networks or databases for the creation or maintenance of corporate records, authorizes the use of a data address to identify shareholders, authorizes the acceptance of shareholder votes if signed by a network signature that corresponds to a data address and specifies the requirements for the use of electronic networks and databases.  In addition, the Act requires the secretary of state to review and update its rules for consistency.

    HB 126

    HB 126 allows the creation and use of “series LLC’s.”  Delaware is well known for its series LLC statute.  Series LLC have become popular in the blockchain space and accordingly it is thought that this will attract blockchain-based businesses...

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    Proposed SPAC Rule Changes

    Tuesday, July 24, 2018, 8:08 AM [General]
    0 (0 Ratings)

    With the growing popularity of special purpose acquisition companies (SPACs), both the Nasdaq and NYSE have proposed rule changes that would make listings easier, although on June 1, 2018, the Nasdaq withdrew its proposal. SPACs raised more money last year than any year since the financial crisis. The SEC has been delaying action on the proposed rule changes, now pushing off a decision until at least August 2018.

    A company that registers securities as a blank check company and whose securities are deemed a “penny stock” must comply with Rule 419 and thus are not eligible to trade. A brief discussion of Rule 419 is below. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of the SPAC, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule. For more on penny stocks, see HERE.

    For purposes of this blog, the discussion of “SPACs” refers to trading SPACs and thus those that are not required to comply with the provisions of Rule 419. However, I have included information on the protections afforded through Rule 419, and thus not included in a SPAC, and a brief summary of the Rule 419 requirements.

    What is a SPAC?

    A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.

    The sponsor of a SPAC contributes 10% of the total post initial public offering (IPO) capital of the company. The sponsor’s 10% capital is used to cover the IPO and ongoing SEC reporting and administration expenses. Although a sponsor will invest 10% of the capital, they typically receive founder’s shares in the SPAC that results in approximately 20% ownership in the post IPO company. Sponsors do not make money unless a successful business combination is completed and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.

    When a SPAC completes its IPO, usually 100%, but in no event less than 90%, of the funds raised are held in escrow to be released either upon completion of a business combination transaction, or back to shareholders in the event a transaction is not completed within a set period of time. A SPAC business combination must have a market value of at least 80% of the value of the amount held in escrow at the time of the agreement to enter into the transaction. Shareholders that object to the business combination have the right to convert their shares into a pro rata share of the funds held in escrow.

    A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.

    SPAC IPOs are usually structured as unit offerings with both stock and warrants to entice investors to bet on the unknown future opportunity. The number of warrants and exercise price can vary and usually have a direct correlation to the prominence and track record of the sponsors and underwriters. That is, the more prominent the sponsor and underwriter, the fewer warrants and higher the strike price. As an alternative to warrants, some SPAC sponsors agree to over-fund the IPO trust account by some multiple to the investment amount, which over-funded amount would be distributed to the SPAC investors if a business combination is not completed.

    The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will either have applied for a listing on a national exchange or, following the closing of the offering, will work with a market maker who will file a Form 211 application with FINRA to receive a trading symbol to trade on the OTCQX.

    At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO registration statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to an IPO process in general; HERE related to testing the waters and public communications during the IPO process; and HERE related to a Form 211 application.

    When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.

    Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements.

    Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction. As will be discussed further below, the exchanges all require that the newly combined company satisfy their particular continued listing requirements.

    SPACs are, by nature, “shell companies” as defined by the federal securities laws. Accordingly, SPACs have all the same limitations as other shell companies, including, but not limited to:

    • A SPAC is an ineligible issuer that is not entitled to use a free writing prospectus in its IPO or subsequent offerings within three years of completing a business combination.
    • After completing the IPO and until it completes a business combination, the SPAC must identify its shell company status on the cover of its Exchange Act periodic reports.
    • A SPAC cannot use a Form S­8 to register any management equity plans until 60 days after completing a business combination.
    • Holders of SPAC securities may not rely on Rule 144 for resales of their securities after the SPAC completes a business combination until one year after the company has filed current “Form 10” information (i.e., the information that would be required if the company were filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company and so long as the SPAC remains current in its SEC reporting obligations.

    OTCQX SPAC Eligibility

    The OTCQX tier of OTC markets allows for the listing and trading of SPACs and is the only tier of OTC Markets that does so. OTC Markets Group will consider on a case-by-case basis the listing of a SPAC that satisfies all of the eligibility requirements for the OTCQX other than the general prohibition against shell and blank check companies (for a full list of requirements, see HERE), and in addition must satisfy the following requirements:

    1. a) As of the most recent annual or quarterly period end, have $25 million in net tangible assets;
    2. b) Have a minimum bid price of $5.00 per share as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX; and
    3. c) Be an SEC Reporting Company or a Regulation A Reporting Company.

    Nasdaq Proposed Rule Changes

    Nasdaq had proposed rule changes to its SPAC listing requirements reducing the number of required round lot shareholders (i.e., shareholders that own at least 100 shares) from 300 to 150 and to likewise eliminate the 300-round lot shareholder continued listing requirement. Round-lot requirements are meant to assure that public companies have a deep enough investor base to encourage stable trading and limit price volatility. However, Nasdaq asserts that price volatility is less of a concern with a SPAC as it has no operations and at least 90% of the cash that a SPAC raises in an IPO must be held in escrow until a business combination is completed.

    Nasdaq also wanted to require that a SPAC listed on the Nasdaq Capital Market maintain at least $5 million in net tangible assets to ensure that the SPAC does not fall within the definition of a penny stock. The proposed rules would have imposed a 30-day deadline for SPACs listed on any of its three markets to demonstrate compliance with initial listing requirements following a merger.  However, on June 1, 2018 Nasdaq withdrew its proposal without further explanation.

    NYSE Proposed Rule Change

    The NYSE has effectuated a series of rule changes related to SPACs throughout 2017. In particular, the NYSE now requires a majority of the SPAC’s independent directors to approve the business combination. In addition, the NYSE as changed the continued listing distribution standard from a requirement of 300 total stockholders to a requirement of 300 public stockholders. The NYSE also now specifically allows a company to follow the tender offer rules under Section 14 of the Exchange Act in lieu of the proxy rules under the same section, to solicit shareholder approval and redemptions related to business combinations.

    The more recent November 2017 proposed changes are more substantial, mirroring the Nasdaq proposed rule changes. Like Nasdaq, the NYSE has proposed cutting the minimum number of required odd lot shareholders in half from 300 to 150. The NYSE has also proposed adding a $5 million minimum capital requirement to ensure that SPAC securities could not be deemed a penny stock. Upon completion of a business acquisition, the new combined company would have a 30-day grace period to prove continued listing eligibility.

    Rule 419

    The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company that is issuing securities which fall within the definition of a penny stock. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of this Rule 419 discussion, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

    Rule 419 requires that a blank check company filing a registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger. The securities of a blank check company which is required to comply with Rule 419 are not eligible to trade, but rather must remain in escrow.

    Rule 419 of the Securities Act imposes certain obligations and restrictions upon issuers that are deemed to be “blank check” companies under applicable rules and regulations. Blank check companies generally lack any revenues, assets, operating history or plan of operations. Among other things, Rule 419 requires that nearly all of a “blank check” issuer’s offering proceeds be placed in escrow until the issuer has completed a business combination. All of a “blank check” company’s securities must also be placed in escrow until after the completion of a business combination, and no trading may occur until the issuer’s securities have been released from escrow. Notably, the definition of a “blank check” company set forth in Rule 419 excludes issuers whose outstanding shares are not deemed to be “penny stock.” In turn, the definition of “penny stock” set forth in Rule 3a51-1 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), provides an exception for issuers with less than three years of operations who have a minimum of $5 million in net assets.

    The staff of the SEC has previously determined through interpretive guidance that, to the extent an issuer files a current report on Form 8-K promptly upon consummation of an IPO indicating that net assets are in excess of $5 million, the staff will not deem the issuer to be a blank check company subject to the requirements of Rule 419. As a result, SPACs generally file such a current report on Form 8-K once the IPO is consummated, thereby avoiding the restrictions imposed by the requirements of Rule 419.

    Companies subject to Rule 419 are required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement on the target company. The post-effective amendment must be filed upon the execution of an agreement for an acquisition or merger. The Rule provides procedures for the release of the offering funds held in escrow in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and re-sale or secondary offerings.

    Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected to not remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon having enough funds remaining in escrow to close the transaction.

    For purposes of Rule 419, the term “blank check company” means a company that:

    1. Is a development stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
    2. Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.

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    SEC Amends Definition of “A Smaller Reporting Company”

    Tuesday, July 17, 2018, 8:16 AM [General]
    0 (0 Ratings)

    by Laura Anthony, Esq.

    SEC Amends Definition of “A Smaller Reporting Company”

    On June 28, 2018, the SEC adopted the much-anticipated amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. The amendments come almost two years to the day since the initial publication of proposed rule changes (see HERE).

    Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.

    As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

    Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.

    The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

    Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

    The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton as directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.


    The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) have come to the forefront over the past couple of years. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.

    A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Over the years Regulation S-K has not been kept current with other Rule changes, the arduous reporting requirements for smaller companies has resulted in stifled capital formation and fewer smaller IPOs, and investors have questioned the quality and relevancy of information required to be included in reports.

    The SEC disclosure requirements are scaled based on company size. The SEC established the smaller reporting company category in 2007 to provide general regulatory relief to these entities. Prior to this rule change, a “smaller reporting company” was defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K, as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

    The following table, copied from the SEC rule release, summarizes the scaled disclosure accommodations available to smaller reporting companies...

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    FinCEN’S Role In Cryptocurrency Offerings

    Tuesday, July 10, 2018, 8:04 AM [General]
    0 (0 Ratings)

    In the continuing dilemma over determining just what kind of asset a cryptocurrency is, multiple regulators have expressed opinions and differing views on regulations. Likewise, multiple regulators have conducted investigations and initiated enforcement proceedings against those in the cybersecurity space. The SEC has asserted the opinion that most, if not all, cryptocurrencies are securities; the CFTC has found them to be commodities; the IRS’s official definition is the same as the CFTC, and in particular a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value, and now the Financial Crime Enforcement Network (FinCEN) has asserted that issuers of cryptocurrencies are money transmitters.

    In particular, in a letter written to the US Senate Committee on Finance on February 13, 2018, FinCEN indicates that it expects issuers of initial coin offerings (ICOs) to comply with the Bank Secrecy Act (BSA), including its anti-money laundering (AML) and know your customer (KYC) requirements. FinCEN’s letter responded to a December 14, 2017 directed to it from the US Senate Committee on Finance requesting information on FinCEN’s oversight and enforcement capabilities over virtual currency financial activities. As with other agencies such as the SEC and CFTC, FinCEN desires to promote the financial innovation that can come with blockchain technology and cryptocurrencies, while preventing criminals, hackers, sanctions evaders and hostile foreign actors.

    Virtual currency exchanges and administrators

    FinCEN has been working with the Office of Terrorism and Financial Intelligence (FTI) to ensure that AML and procedures to combat the financing of terrorism apply to virtual currency exchanges and administrators that are in the US or do business in whole or part in the US, but do not have a physical presence here.  Virtual currency exchanges and administrators have been subject to the BSA’s money transmitter requirements since 2011. In 2013 FinCEN issued specific guidance that explicitly states that virtual currency exchangers and administrators are money transmitters that must comply with the BSA. An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency or other value that substitutes for currency, is a money transmitter that is subject to the BSA.

    To assist in identifying risks and the illicit use of virtual currency, including the abuse of virtual currency to facilitate cyber crime, money laundering, terrorist financing, black market sales of illegal or illicit products and services and other high-tech crimes, FinCEN examines BSA filings from virtual currency money services businesses (MSB) and other emerging payments providers, including filings pertaining to digital coins, tokens and ICOs. Trends, red flags and risks and reported to US law enforcement and other governmental agencies.

    Entities that are subject to the BSA must: (i) register with FinCEN as a MSB; (ii) prepare a written AML compliance program that is designed to mitigate risks, including AML risks, and to ensure compliance with all BSA requirements including the filing of suspicious activity reports (SAR) and currency transaction reports; (iii) keep records for certain types of transactions at specific thresholds; and (iv) obtain customer identification information sufficient to comply with the AML program and recordkeeping requirements.

    SAR reports that are filed with FinCEN have identifying information about the owner/customer. In cases where a bitcoin address is identified, FinCEN performs a blockchain analysis which can often enable investigators to tie it to a virtual currency exchanger, hosted wallet, or other source that may have the identity of the account owner. Blockchain network analytic tools can also tie a targeted bitcoin address to other persons that have transacted with a particular bitcoin address.  The investigative process may involve the issuance of subpoenas and FinCEN cooperates with law enforcement to help identify and trace bitcoin used in criminal activity.

    FinCEN also conducts reviews and exams of registered MSBs. Of the approximate 100 registered entities, FinCEN has examined approximately one-third and has initiated several enforcement proceedings as a result of those exams. However, financial crimes and terrorism are international issues and not all countries regulate virtual currency businesses or require them to keep records. Accordingly, FinCEN has been working to encourage foreign countries to regulate these businesses and to cooperate in criminal investigations.

    ICO issuers

    FinCEN is working with the SEC and CFTC to clarify and enforce AML and counterterrorism obligations of businesses that engage in ICO activities. Although the FinCEN letter indicates that the obligation to comply with the BSA and its ensuing AML, registration, SAR and other requirements depends on the nature of the financial activity and a facts-and-circumstances analysis, ICO participants have unilaterally interpreted the FinCEN letter as requiring all ICO issuers to comply in one way or another.

    FinCEN specifically states that an issuer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value, including fiat currency, is a money transmitter that must register as an MSB and comply with the BSA, including AML and KYC procedures. However, to the extent that an ICO involves the sale of securities or derivatives that would be under the jurisdiction of the SEC through its regulation of broker-dealers or CFTC through its regulation of merchants and brokers in commodities, those entities could comply with the SEC and CFTC’s AML and counterterrorism requirements.

    The Securities Exchange Act of 1934 (“Exchange Act”) specifically requires brokerage firms to comply with the BSA and FinCEN rules. Brokerage firms are also required to comply with AML rules established by FINRA, including FINRA Rule 3310. The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. FINRA also provides a template to assist small firms in establishing and complying with AML procedures.

    In May 2016, FinCEN issued new final rules under the BSA requiring financing institutions, including brokerage firms, to adopt additional anti-money laundering (AML) procedures that include specific due diligence and ongoing monitoring requirements related to customer risk profiles and customer information. The rules also require financial institutions to collect and verify information about beneficial owners and control person of legal entity customers.  My blog on those rules can be read HERE.

    FinCEN requires that financial institutions address the following four key elements in all of their AML programs: (i) customer identification and verification; (ii) beneficial ownership identification and verification; (iii) understanding the nature and purpose of customer relationships to develop risk profiles; and (iv) ongoing monitoring for reporting suspicious transactions and maintaining and updating customer information.

    Further Reading on DLT/Blockchain and ICOs

    For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

    For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

    For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

    For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

    For an update on state-distributed ledger technology and blockchain regulations, see HERE.

    For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

    For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

    For a review of the CFTC role and position on cryptocurrencies, see HERE.

    For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

    To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

    To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

    For more information on platforms that trade cryptocurrencies and more on the continued regulatory confusion in the space, see HERE...

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    Regulation A For Publicly Reporting Companies, Economic Growth and Regulatory Relief

    Tuesday, July 3, 2018, 8:22 AM [General]
    0 (0 Ratings)

    Regulation A+ will soon be available for publicly reporting companies. On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law. Although the Act largely focuses on the banking industry and is being called the Dodd-Frank Rollback Act by many, it also contained much-needed provisions amending Regulation A+ and Rule 701 of the Securities Act.

    The Act also amends Section 3(c)(1) of the Investment Company Act of 1940 to create a new category of pooled fund called a “qualifying venture capital fund,” which is a fund with less than $10,000,000 in aggregate capital contributions. A qualifying venture capital fund is exempt from the registration requirements under the 1940 Act as long as it has fewer than 250 investors. Section 3(c)(1) previously only exempted funds with fewer than 100 investors. The amendment is effective immediately and does not require rulemaking by the SEC, although I’m sure it will be followed by conforming amendments.

    Giving strength to the annual Government-Business Forum on Small Business Capital Formation (the “Forum”), the Act amends Section 503 of the Small Business Investment Incentive Act of 1980 to require the SEC to review the findings and recommendations of the Forum and to promptly issue a public statement assessing the finding or recommendation and disclosing the action, if any, the SEC intends to take with respect to the finding or recommendation. For a review of the finding and recommendation of the 2017 Forum, see HERE. This provision is effective immediately without the requirement of further action.

    Regulation A

    Section 508 of the Act directs the SEC to amend Regulation A+ to remove the provision making companies subject to the SEC Securities Exchange Act reporting requirements ineligible to use Regulation A/A+ and to add a provision such that a company’s Exchange Act reporting obligations will satisfy Regulation A+ reporting requirements.

    I have often blogged about this peculiar eligibility standard. Although Regulation A is unavailable to Exchange Act reporting companies, a company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to use Regulation A. Moreover, a company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A. A wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued. It just didn’t make sense to preclude Exchange Act reporting issuers, and the marketplace has been vocal on this.

    In September 2017 the House passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A/A+. See HEREOTC Markets also petitioned the SEC to eliminate this eligibility criterion, and pretty well everyone in the industry supports the change. For more information on the OTC Markets’ petition and discussion of the reasons that a change is needed in this regard, see my blog HERE.

    As noted, the Act directs the SEC to amend Regulation A to enact the changes; however, the timing remains unclear. Whereas many provisions in the Act have specific timing requirements, including a requirement that the changes to Rule 701 be completed within 60 days, Section 508 has no timing provisions at all.

    For a recent comprehensive review of Regulation A/A+, see HERE.

    Rule 701

    Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

    Section 507 of the Act directs the SEC to increase Rule 701’s threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation-adjusted every five years. The amendment must be completed within 60 days.

    For a review of Rule 701, including recent guidance, see HERE...

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    SEC Spring 2018 Regulatory Agenda

    Tuesday, June 26, 2018, 9:10 AM [General]
    0 (0 Ratings)

    On May 9, 2018, the SEC posted its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. According to the preamble, information in the agenda was accurate as of March 13, 2018. On April 26, 2018, SEC Chairman Jay Clayton gave testimony before the Financial Services and General Government Subcommittee of the House Committee on Appropriations regarding the SEC’s requested fiscal year 2019 budget. This blog will summarize the newest regulatory agenda and SEC upcoming budgetary requests.

    Usually the agenda is separated into two categories: (i) Existing Proposed and Final Rule Stages; and (ii) Long-term Actions. The Spring 2018 agenda is broken down by (i) “Prerule Stage”; (ii) Proposed Rule Stage; (iii) Final Rule Stage; and (iv) Long-term Actions. The Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The number of items to be completed in a 12-month time frame have been consistently reduced in each agenda over the last two years. The newest agenda has 21 items, the semiannual list published in December, 2017 had 26, the July 2017 list contained 33 legislative action items to be completed, and the prior Fall 2016 list had 62 items.

    Whereas the agenda concentrates on specific rulemaking, the SEC’s budget request seems more focused on the SEC’s need to modernize its information technology infrastructure and improve cybersecurity risk management. Of course budgetary needs encompass enforcement which would not appear on a rulemaking agenda. Chair Jay Clayton does, however, address the regulatory agenda in his budget request testimony, specifically noting that the reduced number of items on the short term regulatory list does not indicate a shift in the SEC’s needs and focus, but rather is meant to be more realistic regarding what the SEC can accomplish in a 12-month period.

    Whereas the SEC asked for an increase of $100 million in its budget for fiscal year 2018, the current requested increase is $60 million from $1.652 billion to $1.658 billion. Chair Clayton’s particular areas of focus include (i) leveraging technology and enhancing cybersecurity and risk management; (ii) facilitating capital formation; (iii) protecting Main Street investors through multiple channels, including focusing on the most vulnerable investors, markets that are fertile ground for fraud and market integrity efforts such as combating insider trading, market manipulation and accounting fraud; (iv) maintaining effective oversight of changing markets; and (v) supporting SEC leasing efforts. The increased budget would also lift the current hiring freeze and allow the hiring of approximately 100 positions to help fill the approximately 400 position that were lost during the freeze.

    Related to technology and cybersecurity, the SEC has an immediate plan to (i) invest in information security to improve monitoring, protect against advanced persistent threats and strengthen risk management; (ii) retire antiquated IT systems to improve cybersecurity; (iii) expand data analytics tools to facilitate earlier detection of potential fraud or suspicious behavior and better identify high-risk activities deserving examination; and (iv) modernize the EDGAR electronic filing system to make it more secure, more useful for investors and less burdensome for filers. For more information on the SEC’s cybersecurity efforts and the EDGAR hacking, see HERE and HERE

    Regarding the need to facilitate capital formation, Chair Clayton testified about different initiatives the SEC has already undertaken, such as the staff rule allowing confidential submissions of registration statements (see HERE). On a forward-looking basis, Chair Clayton admits that there is a need to encourage small and emerging growth companies to access public markets; however, he does not make any particular suggestions, but rather just states that the SEC is trying to come up with ideas and initiatives.

    In the area of protections for Main Street investors and markets, the SEC is focused on conduct by investment advisors and broker-dealers. Where Clayton sees the need to increase standards of conduct for both investment advisors and broker-dealers, he, like many in the marketplace, is not an advocate of the Department of Labor’s fiduciary rule. The SEC also supports “vigorous enforcement” against fraud and improper market activity by both market insiders such as investment advisors and broker-dealers, and by all market participants.

    The Unified Agenda of Regulatory and Deregulatory Actions

    The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year.

    The first Agendas published after the 2016 presidential election stated that the Agenda “represents the beginning of fundamental regulatory reform and a reorientation toward reducing unnecessary regulatory burden on the American people.” Furthermore, the Office states, “[B]y amending and eliminating regulations that are ineffective, duplicative, and obsolete, the Administration can promote economic growth and innovation and protect individual liberty.”

    Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives. Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action.  The SEC is not the only agency with a reduced Agenda. Agencies withdrew over 1,600 actions that were initially proposed in the Fall 2016 Agenda. Also, adding transparency for those of us who like to stay up on these matters, the agencies will now post and make public their list of “inactive” rules.

    SEC Flex Regulatory Agenda

    Only 11 items are listed in the final rule stage.  On the Agenda in the final rule stages are Regulation S-K disclosure updates and simplification rule changes we have all expected. The proposed rule change was issued in October 2017, a summary of which can be read HERE. Business, Financial and Management Disclosure Required by Regulation S-K remains in the proposed rule stage, continuing the topic of disclosure reform.

    Included in the final rule stage are amendments to the smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems. Amendments to the interactive data (XBRL) program have been moved up from proposed to final rule stage since July 2017.

    Disclosure on hedging by employees, officers and directors was moved from long-term action to final rule stage. The proposed rules were issued in February 2015 (see HERE) and will result in checking another box on the Dodd-Frank rulemaking list. Also moved from proposed to final is implementation of FAST Act report recommendations (see HERE).

    Also included for final rules are amendment to the SEC’s Freedom of Information Act Regulations, modernization of property disclosure for mining companies, investment company reporting modernization and amendments to the Investment Advisers Act, disclosure or order handling information, and amendments to municipal securities rules.

    Items of interest in the proposed rule stage include amendments extending the testing-the-waters provisions to non-emerging growth companies (see current testing-the-waters provisions HERE) which were previously on the long-term list; financial disclosures about entities other than the registrant (see HERE), disclosure of payments by resource extraction issuers, amendments to the financial disclosure for registered debt security offerings, filing fee processing updates, bank holding company disclosures, exchange traded funds, auditor independence with respect to loans or debtor-creditor relationships, amendments related to fair access to investment research, fund of fund arrangements, investment company liquidity disclosure, and amendments to the Whistleblower Program Rules.

    Rule on disclosure for unit investment trusts and offering variable insurance products, use of derivatives by registered investment companies and business development companies, Business, Financial and Management Disclosure Required by Regulation S-K, personalized investment advice standards of conduct, and amendments to marketing rules under the Advisors Act, are also included in the proposed rule stage.

    Still on the long-term actions are rules related to reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), Form 10-K summary, and revisions to audit committee disclosures.

    Items on the long-term agenda include amendments to the accredited investor definition (see HERE), registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

    Other items of interest on the long-term action list include simplification of disclosure requirements for emerging growth companies and forward incorporation by reference on Form S-1 for smaller reporting companies (EGCs may already incorporate by reference – see HERE), Regulation Crowdfunding amendments, several securities-based swaps regulatory actions, conflict minerals amendments, amendments to Guide 5 on real estate offerings and Form S-11, and incentive-based compensation arrangements.

    Added as a Prerule Stage item is fund retail investor experience and disclosure requests for comment.

    Regulation A amendments are on the long-term action list. I am hopeful that these amendments may include an increase in the offering limits and opening up Regulation A to reporting issuers.  See HERE. Moreover, now that the Economic Growth, Regulatory Relief and Consumer Protection Act has been signed into law requiring that Regulation A be amended to allow for use by reporting companies, I suspect this item will be moved up the line.

    Not included in previous lists, and now on the long-term action list, is Regulation Finders. The topic of finders has been ongoing for many years, and I am extremely pleased to see it make the list. See HERE for more information.

    Still not on the short-term agenda are future Dodd-Frank rules, including proposed regulatory actions related to pay for performance (see HERE), executive compensation clawback (see HERE) (which is not on the agenda at all), and clawbacks of incentive compensation at financial institutions (also not on the list at all), although some of these items remain on the “long-term actions” schedule.

    The SEC rulemaking agenda may not include further rulemaking on many Dodd-Frank rules, but it also does not include specific rulemaking to repeal existing regulations, such as the pay ratio disclosure rules which were adopted in August 2015 and initially apply to companies for their first fiscal year beginning on or after January 1, 2017. See HERE for more information on this rule. The pay ratio rules do not apply to emerging-growth companies, smaller reporting companies, foreign private issuers, U.S-Canadian Multijurisdictional Disclosure System filers, and registered investment companies. All other reporting companies are subject to the new rules. In October 2016 the SEC published five new compliance and disclosure interpretations (C&DIs) on certain aspects of the final rules. The C&DIs covered two main topics: (i) the use of a consistently applied compensation measure in identifying a company’s median employee; and (ii) the application of the term “employee” to furloughed employees and independent contractors or “leased” workers...

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    The SEC Has Provided Guidance On Ether and Bitcoin, Sort Of

    Tuesday, June 19, 2018, 8:23 AM [General]
    0 (0 Ratings)

    On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he made two huge revelations for the crypto marketplace. The first is that he believes a cryptocurrency issued in a securities offering could later be purchased and sold in transactions not subject to the securities laws. The second is that Ether and Bitcoin are not currently securities. Also, for the first time, Hinman gives the marketplace guidance on how to structure a token or coin such that it might not be a security.

    While this gives the marketplace much-needed guidance on the topic, a speech by an executive with the SEC has no legal force. As a result, the blogs and press responding to Mr. Hinman’s speech have been mixed. Personally, I think it is a significant advancement in the regulatory uncertainty surrounding the crypto space and a signal that more constructive guidance will soon follow. I will summarize the entire speech later in this blog, but first right to the most salient point.

    Although a speech by an SEC official does not have legal weight, it does give practitioners a firm foot on which to proceed. William Hinman is the Director of the Division of Corporation Finance (“CorpFin”), whose responsibility includes reviewing and commenting on SEC filings, a topic I’ve written about before. As described in my recent blog on the subject (see HERE), when responding to SEC comments, a company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director.

    Related to Bitcoin, Director Hinman stated, “…when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.” Similarly, related to Ether, Mr. Hinman stated, “…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

    As a direct result of these statements, at least 2 of our clients, with our support, have shifted how they will proceed with Regulation A offerings in which tokens are being offered, and Bitcoin and Ether expected to be excepted as a form of payment. Prior to Mr. Hinman’s comments, CorpFin issued comments to our clients, which comment letters gave an indication of the progression of the SEC’s thinking. In particular, in an earlier letter the SEC comment was in relevant part as follows:

    We note that you will accept Bitcoin, Ether, Litecoin or Bitcoin Cash as payment for your common stock. Please disclose the mechanics of the transaction. For example, explain the following:

    • whether the digital assets are securities and, where you have determined they are, how you will structure each individual transaction so that you are in compliance with the federal securities laws;
    • disclose how long the company would typically hold these digital assets, some of which may be securities, before converting to U.S. dollars;
    • include risk factor disclosure discussing the impact of holding such assets and/or accepting this form of payment, including price volatility and liquidity risks as well as risks related to the fragmentation, potential for manipulation, and general lack of regulation underlying these digital asset markets; and
    • disclose how you will hold the digital assets that you may receive in this offering as payment in exchange for shares of your common stock. If you intend to act as custodian of these digital assets, some of which may be securities, please tell us whether you intend to register as a custodian with state or federal regulators and the nature of the registration.

    The comment letter included many other points on cybersecurity, price volatility, risk factors and other issues not related to whether the Bitcoin or Ether were a security. In a recent comment letter for a different client, also offering tokens in a Regulation A offering and accepting Bitcoin and Ether as payment, the SEC did not issue any questions as to whether Bitcoin or Ether were a security, but did include substantially the same questions related to cybersecurity, price volatility, risk factors and other business points.

    The SEC CorpFin is pragmatic in its approach and despite frustrations at times, would not allow its Division Director to make public statements and then allow its staff to issue comments or take positions that were in direct contravention to those statements. Keep in mind that SEC no-action letters technically do not set precedence or have any legal bearing outside of the parties to the letter, but are regularly relied upon by the SEC and practitioners for guidance.

    Although Mr. Hinman’s speech does not have legal authority, I am confident that the SEC will not raise the issue or question whether Bitcoin or Ether are a security in current and future registration statements or Regulation A offerings, at least until there is different legal authority than exists today.… And, there could be different legal authority in the future. I attended a Regulation A conference in New York in the beginning of June, and one of the panels was related to cyrptocurrencies. In addition to attorneys in the space, the panel included Anita Bandy, Assistant Director of the SEC Division of Enforcement.  Referring to token or coin offerings, one of the panel members specifically stated that Ether is a security and Ms. Bandy did not correct him. Furthermore, at the end of the panel, I privately asked Ms. Bandy if it is her opinion that Ether is a security today. She politely refused to answer the question, letting me know that she couldn’t express an opinion on that without conferring with other SEC management.  Two days later, Mr. Hinman gave his speech.

    …. But, Mr. Hinman is Director of CorpFin and Ms. Bandy is part of the Division of Enforcement.  Although I believe that the SEC divisions are communicating with each other on the very relevant and important subject of cryptocurrency, and have even issued joint statements on the subject, they are separate. Moreover, decoding Mr. Hinman’s statements further, he said, “… putting aside the fundraising that accompanied the creation of Ether…” This begs the question: What would happen if the SEC Division of Enforcement took action related to the initial fundraising and creation of Ether, and how would that impact the current status of Ether? My thought is that they are mutually exclusive.  Ether is decentralized today and will continue its own course.

    The SEC Division of Enforcement could take action similar to the Munchee, Inc. case where it settled the proceeding with no civil penalty. The SEC could also issue another report on Ether similar to the Section 21(a) Report on the DAO issued a year ago in July 2017, though I don’t know what new or different information it could add to that analysis. If Ether violated the federal securities laws at its issuance, it did so in the same way as the DAO, using the SEC v. W. J. Howey Co. test. Perhaps a new report could provide more guidance as to the analysis of when a crypto reaches a point where it is decentralized enough such that it no longer meets the parameters laid out in Howey, or that might be wishful thinking on my part.

    Director Hinman’s Speech “Digital Asset Transactions: When Howey Met Gary (Plastic)”

    Director Hinman opens his speech with the gating question of whether a digital asset that is offered and sold as a security can, over time, become something other than a security. He then continues that in cases where the digital asset gives the holder a financial interest in an enterprise, it would remain a security.  However, in cases where the enterprise becomes decentralized or the digital asset can only be used to purchase goods or services available through a network, the purchase and sale of the digital asset would no longer have to comply with the securities laws.

    Reiterating the oft-repeated view of the SEC, Hinman notes that most initial coin or token offerings are substantially similar to debt or equity offerings in that they are just another way to raise money for a business or enterprise. In particular, funds are raised with the expectation that the network or system will be built and investors will get a return on their investment. The investment is often made for the purpose of the return and not by individuals that would ever use the eventual utility of the token. The return is often through the resale of the tokens or coins in a secondary market on cryptocurrency trading platforms.

    In this case, the Howey Test is easy to apply to the initial investment. The Howey Test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. The emphasis is not on the thing being sold but the manner in which it is sold and the expectation of a return.  Certainly, the thing being sold is not a security on its face; it is simply computer code.  But the way it is sold – as part of an investment, to non-users, by promoters to develop the enterprise – can be, and in that context most often is, a security. Furthermore, in the case of ICOs, which are high-risk by nature, the disclosure requirements of the federal securities laws are fulfilling their purpose.

    The securities laws apply to both the issuance or initial sale, and the resale of securities. In the case of coins or tokens, a careful analysis must be completed to determine if the resale of the coin or token also involves the sale of a security and compliance with the securities laws. If the network on which the token or coin is to function is sufficiently decentralized such that purchasers would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the assets may no longer represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful, such as with Ether and Bitcoin as discussed above.

    An analysis as to whether an investment contract and therefore a security is being sold must be made based on facts and circumstances at any given time.  Investment contracts can be made out of virtually any asset if it is packaged and promoted as such. Accordingly, although Bitcoin or Ether may not be a security on their own, if they were packaged as part of a fund or trust, they could be part of an investment contract that would need to comply with the federal securities laws.

    Hinman provides some guidance in determining whether a particular sale involves the sale of an investment contract. The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment. Questions to consider include:

    1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
    2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
    3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
    4. Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
    5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
    6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

    Hinman then, for the first time, gives some guidance to issuers and their counsel in determining whether a particular token or coin is being structured as a security. Hinman is clear that this list of factors is not comprehensive but rather lays the groundwork for a thoughtful analysis.  Items to consider include:

    1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
    2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
    3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
    4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
    5. Is the asset marketed and distributed to potential users or the general public?
    6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
    7. Is the application fully functioning or in early stages of development?

    In another step towards regulatory guidance, Hinman said the SEC is prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use. As recently as 3 months ago, the SEC had indicated it was not processing no-action letters on the subject at that time. In his speech, Hinman recognizes the implication of determining something is a security, including related to broker-dealer licensing, exchange registration, fund registration, investment advisor registration requirements, custody and valuation issues.

    Hinman also expressed excitement about the potential surrounding digital ledger technology, including advancements in supply chain management, intellectual property rights licensing, and stock ownership transfers. He thinks the craze behind ICOs has passed, and I agree. In particular, as he states, realizing that securities laws apply to an ICO that funds development, industry participants have started to revert back to traditional debt or equity offerings and only selling a token once the network has been established, and then only to those that need the functionality of the network and not as an investment.

    There have been earlier signs that the SEC is softening and rethinking its approach to cryptocurrencies as well.   In a speech to the Medici Conference in Los Angeles on May 2, 2018, SEC Commissioner Hester M. Peirce warned against regulators stifling the innovation of blockchain by trying to label token and coins as securities and even when they are securities, being myopic on the need to fit within existing securities laws and regulations.  Like Director Hinman, Commissioner Peirce encourages communication between market participants and the SEC as everyone tries to navigate the marketplace and technology.

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    The 2017 SEC Government-Business Forum On Small Business Capital Formation Final Report

    Tuesday, June 12, 2018, 8:45 AM [General]
    0 (0 Ratings)

    The SEC has published the final report and recommendations of the 2017 annual Government-Business Forum on Small Business Capital Formation (the “Forum”). As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation.  The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation.  I previously summarized the opening remarks of the SEC Commissioners. See HERE.

    The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations.  Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. In 2015 the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also in 2015 the forum recommended changes to Rules 147 and 504, which recommendations were considered in the SEC’s rule changes that followed.  See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

    The 2017 Forum had two breakout groups which discussed exempt securities offerings, including micro offerings and smaller registered and Regulation A offerings.  Many of the recommendations relate to Regulation A. I recently wrote an update on Regulation A, including many suggestions recommended by the Forum.  For a complete review of Regulation A and suggested changes, see HERE.

    Forum Recommendations

    The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

    1. The first recommendation was also the first recommendation last year. As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
    2. The SEC should issue guidance for broker-dealers, transfer agents and clearing firms regarding Regulation A issued securities and OTC securities. Moreover, the SEC should revise Regulation A to: (i) mandate blue sky preemption for secondary trading of Regulation A Tier 2 securities; (ii) allow at-the-market offerings; (iii) allow all reporting companies to use Regulation A; (iv) increase the maximum offering amount in any twelve-month period from $50 million to $75 million for Tier 2 offerings; (v) consider overriding any state advance notice requirements and putting a limit on state filing fees; (vi) require portals conducting Regulation A offerings to be registered similar to funding portals under Regulation Crowdfunding and require the portals to make disclosures, including those related to compensation.
    3. The SEC should lead a joint effort with FINRA to provide clear guidance for Regulation Crowdfunding offerings.
    4. Related to Regulation Crowdfunding, the SEC should: (i) remove the cap for investments by accredited investors; (ii) raise the investment cap for non-accredited investors by making the limit applicable to each investment instead of the aggregate; (iii) rationalize the investment cap by entity type, not income; (iv) allow portals to receive compensation on different terms such as warrants, and allow portals to co-invest in offerings; (v) amend the rules for small debt offerings to limit the ongoing reporting requirements to only the note holders and to scale the regulatory obligations to reduce the legal, accounting and other costs of the offering; (vi) increase the offering limit to $5 million in any twelve-month period; (vii) allow the use of special purpose vehicles (SPVs); and (viii) allow testing the waters before a filing.
    5. Small intermittent finders should be exempt from broker-dealer registration. See HERE.
    6. The SEC should clarify the relationship between exempt offerings that allow general solicitation (506(c)) and those that do not (506(b)) by: (i) applying the facts and circumstances analysis as to whether a particular investor was brought into an offering as a result of general solicitation (thus avoiding the necessity to verify accredited status); and (ii) apply Rule 152 to a Rule 506(c) offering to avoid integration with a follow-on registered offering. I note, however, that I believe Rule 152 already applies or if it does not, that a subsequent registered offering is not otherwise prohibited.
    7. Permit an alternative trading system, such as OTC Markets, to file a Form 211 application with FINRA and review the FINRA process to reduce the Form 211 application process burdens. See HERE.
    8. Amend the definition of smaller reporting company and non-accelerated filer to include a company with a public float of less than $250 million or with annual revenues of less than $100 million.
    9. Related to venture exchanges, Congress and the SEC should look to existing alternative venture exchanges (OTC Markets) and work within the existing framework. See HERE.
    10. The SEC should mandate additional disclosure on short positions and enforce Regulation SHO and Regulation T for all IPOs.
    11. Proxy advisory firms should be brought under SEC registration so that the SEC may oversee how these firms make recommendations and mitigate conflicts of interest.
    12. Withdraw the proposed rule changes to Regulation D, Form D and Rule 156. See HERE.
    13. The SEC should lead a joint effort with NASAA and FINRA to implement the private placement broker-dealer as recommended by the American Bar Association. See HERE.
    14. The SEC should allow a quick response (QR) code to suffice for delivery prospectus requirements after effectiveness of a registration statement or qualification of an offering circular.
    15. Study and propose a revised regulatory regime for true peer-to-peer lending platforms for small businesses and consumers, using current European regulatory and other models as reference.
    16. The SEC should expand disclosure requirements for stock promotion activity, including updating Section 17(b) to require better disclosures when a company is engaging promotional and investor relations firms.
    17. The SEC should amend unlisted trading privileges rules to allow small and medium-size public companies the option to consolidate secondary trading to one or more trading platforms.
    18. The SEC should allow for flexibility in tick sizes and consider making the pilot program permanent. See HERE.
    19. The SEC should provide greater clarity with respect to which courts and authorized governmental entities may act to satisfy the exemption from registration for exchange transactions under Securities Act Section 3(a)(10), and communicate the same to broker-dealers...

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