Laura Anthony

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    • Member Type(s): Expert
    • Title:Founding Partner
    • Organization:Anthony L.G., PLLC
    • Area of Expertise:Securities Law
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    SEC Cautionary Statement on Audits of Public Companies Operating in China

    Tuesday, February 12, 2019, 6:46 AM [General]
    0 (0 Ratings)

    Eight years following the crash of the Chinese reverse merger boom and a slew of SEC enforcement proceedings, the SEC is once again concerned with the financial reporting by U.S. listed companies with operations based in China. In December 2018, the SEC issued a cautionary public statement from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III entitled “Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally – Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China.”

    Just reading the title reminded me of the boom in China-based reverse mergers around 2009-2010 followed by the trading halts or delistings of at least 50 companies in 2011 and 2012. In the summer of 2010, the SEC launched an initiative to determine whether certain companies with foreign operations—including those that were the product of reverse mergers—were accurately reporting their financial results, and to assess the quality of the audits being done by their auditors. By June 2011, the SEC was strongly warning investors of the risks posed by reverse mergers in general, and Chinese deals in particular, singling out six Chinese issuers.

    Numerous SEC enforcement actions and civil lawsuits were filed claiming fraud and misrepresentations in SEC filings including financial reports.  Partially as a result of the crisis, in late 2011 both the NYSE and Nasdaq amended their listing requirements to add a seasoning requirement following a reverse merger. The seasoning rules prohibit a company that has completed a reverse merger with a public shell from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange, for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements.  In addition, the rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report.

    In addition, the seasoning rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes an exception for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.

    In addition to the specific additional listing requirements contained in the new rule, the Exchange may “in its discretion impose more stringent requirements than those set forth above if the Exchange believes it is warranted in the case of a particular reverse merger company based on, among other things, an inactive trading market in the reverse merger company’s securities, the existence of a low number of publicly held shares that are not subject to transfer restrictions, if the reverse merger company has not had a Securities Act registration statement or other filing subjected to a comprehensive review by the SEC, or if the reverse merger company has disclosed that it has material weaknesses in its internal controls which have been identified by management and/or the reverse merger company’s independent auditor and has not yet implemented an appropriate corrective action plan.”

    Slowly since that time, Chinese companies have again started to access U.S. capital markets via both reverse mergers and direct IPO’s.  However, clearly the issues and concerns raised by the SEC in 2011 have not all been resolved.

    SEC Public Statement

    The SEC’s recent cautionary public statement was issued jointly from SEC Chair Jay Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III.  The statement’s opening sentence sets the tone for the rest of the content, and in particular, “[A]s we are nearing the end of the fiscal year for many reporting companies, it is important to remember that complete, accurate financial statements and credible audits are things we—investors, issuers, and regulators worldwide—all care about.”

    The statement continues with a recognition of the global nature of both capital markets and companies, with U.S.- and non-U.S.-based companies seeking access to the U.S. capital markets and the fundraising and liquidity they bring. The statement points out that U.S.-listed companies accounted for approximately 40% of the market capitalization of global public companies in 2017. Capital access and liquidity are made possible by the assurance that companies that list and trade on U.S. markets provide high-quality and reliable financial information and that U.S. rules, regulations, and regulatory oversight apply. When the listed company operates outside the U.S., regulators must operate in multiple jurisdictions to be able to access audit-related information and otherwise effectuate their responsibilities over any company trading in the U.S. markets.

    A multinational company must comply with financial reporting obligations in many of the countries in which it operates and its auditors must be able to operate on a worldwide basis. The multi-jurisdictional aspect is sometimes challenging in that information necessary for regulatory oversight does not always flow back to the U.S. as it should.  Barriers to the information flow include data protection, privacy, confidentiality, bank secrecy, state secrecy, or national security laws. The U.S. has been working with foreign jurisdictions to address these laws and barriers where a company subjects itself to U.S. regulatory oversight by listing on U.S. securities exchanges and accessing U.S. capital markets.  For example, the SEC is one of over 120 signatories to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding, which provides for enforcement consultation and cooperation, and the exchange of information.  Moreover, the SEC has over 75 formal cooperative arraignments with foreign regulators, the PCAOB has conducted inspections of registered accounting firms in over 50 foreign countries, and the PCAOB has cooperative arrangements with 23 foreign regulators.

    Unfortunately, China is not one of these cooperative arrangements, and the PCAOB has been facing issues being able to inspect auditing firms in China, as well as Hong Kong where the audit client has operations in mainland China.  Based on reports to the PCAOB from audit firms up to March 31, 2018, there were 213 listed companies in China and 11 in Belgium for which the PCAOB and SEC have not been able to inspect audit records despite ongoing and significant efforts.  From March 31 to the date of the SEC’s public statement, some of those companies changed their listing or trading status, dropping the number down to 178 companies.

    The SEC is and remains the principal regulator of the world’s largest securities markets and, as such, must often deal with cross-border issues.  The SEC sees its mission as administering and enforcing requirements for reliable financial reporting globally in light of the global nature of the economy and the many companies that operate worldwide.  The SEC furthers this mission by communicating and cooperating with regulators in other countries and by participating in international organizations such as IOSCO (the International Organization of Securities Commissions) and The Monitoring Group, which engages in the monitoring of international accounting, auditing, and ethics standards.

    The SEC also oversees the PCAOB which, in turn, is the principal U.S. regulator that oversees the audits of public companies and SEC-registered brokers and dealers.  The PCAOB is required by U.S. law to conduct regular inspections of all registered public accounting firms, both domestic and foreign, that issue audit reports or that play a substantial role in their preparation.  As noted above, the PCAOB has inspected audit firms in 50 different foreign countries.  The PCAOB also often works in cooperation with foreign regulators and their audit inspection authorities.

    However, despite the cooperative arrangements, there are legal impediments blocking the free flow of information from some countries.  In particular, blocking statutes and data protection, privacy, confidentiality, bank secrecy, state secrecy, and national security laws sometimes complicate or outright restrict the sharing of information with U.S. regulators.  Some of these laws prohibit foreign-domiciled companies from responding directly to SEC requests for information and documents or doing so, in whole or in part, only after protracted delays in obtaining authorization.  Other laws can prevent the SEC from being able to conduct any type of examination, either on-site or by correspondence.  Accordingly, securities regulators around the world seek agreements with one another for access to business books and records or auditor documentation. Likewise, some countries prohibit the PCAOB from inspecting audit firms within their borders, even if the auditor is PCAOB-registered.  In that case, the PCAOB usually enters into cooperative arrangements with local regulators that allows them to jointly inspect a firm.

    However, the SEC is generally not satisfied with their ability to inspect, investigate and enforce the U.S. securities laws in China.  Despite the significant value of China-based companies trading in U.S. markets, Chinese law requires that the business books and records related to transactions and events occurring within China be kept and maintained there.  China also restricts the auditor’s documentation of work performed in the country from being transferred out of China.  Also, Chinese laws governing the protection of state secrets and national security have been invoked to limit foreign access to China-based business books and records and audit work papers.  As a result, for certain China-based companies listed on U.S. stock exchanges, the SEC and PCAOB have not had access to the books and records and audit work papers.  The SEC and PCAOB are engaging in ongoing discussions with Chinese officials and regulators but have not made satisfactory progress.

    The SEC believes that if a company wants to access U.S. securities markets, the SEC needs to be able to directly supervise these entities and the auditors that audit their books and records.  Any audit firm that registers with the PCAOB is legally obligated to cooperate and provide documents and testimony, if requested, in connection with inspections and investigations regardless of their locations.  If the SEC and/or PCAOB cannot access a company or its auditor, they will seek sanctions and other remedial measures.  To help keep investors informed of these issues, the PCAOB publishes a list of companies and auditors for which they have not been able to conduct inspections or obtain sufficient information.

    The SEC continues to try and negotiate with Chinese authorities to improve relations and allow the SEC and PCAOB to have timely access to information necessary to conduct investigations or inspections but has not been successful to date.  Many China-based companies and companies with significant operations in China want to access U.S. securities markets, but the inability of U.S. regulators to properly access records is causing the SEC concern about the risk to investors.  Even if an audit is conducted correctly and financial reports are accurate, there is a greater risk to investors if the SEC cannot do its job and inspect the records.  Of course, there is also the very real risk of fraud, which could emanate from a large company (for example, Enron or WorldCom) and have a broad market impact.  The SEC is considering remedial measures, which could include requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances...

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    An IPO Without The SEC

    Tuesday, January 29, 2019, 7:03 AM [General]
    0 (0 Ratings)

    On January 23, 2019, biotechnology company Gossamer Bio, Inc., filed an amended S-1 pricing its $230 million initial public offering, taking advantage of a rarely used SEC Rule that will allow the S-1 to go effective, and the IPO to be completed, 20 days from filing, without action by the SEC.  Since the government shutdown, several companies have opted to proceed with the effectiveness of a registration statement for a follow-on offering without SEC review or approval, but this marks the first full IPO, and certainly the first of any significant size. The Gossamer IPO is being underwritten by Bank of America Merrill Lynch, SVB Leerink, Barclays and Evercore ISI. On January 24, 2019, Nasdaq issued five FAQ addressing their position on listing companies utilizing Section 8(a).  Although the SEC has recommenced full operations as of today, there has non-the-less been a transformation in the methods used to access capital markets, and the use of 8(a) is just another small step in a new direction.

    Section 8(a) of the Securities Act

    Section 8(a) of the Securities Act of 1933 (“Securities Act”) provides for the effectiveness of registration statements and amendments.  In particular, the statute provides that a registration statement shall automatically go effective on the 20th day after its filing or such earlier date as the SEC may determine.  Section 8(b) gives the SEC the power to issue a stop order to prevent a registration statement from going effective in accordance under Section 8(a) if the registration statement is “on its face incomplete or inaccurate in any material respect.”

    In practice, companies avoid the Section 8(a) effectiveness by adding language to their registration statements known as the “delaying amendment.”  The typical language for a delaying amendment is similar to the following:

    The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.

    … and with that provision, Section 8(a) is avoided.  A company then goes through a comment, review and amendment process with the SEC which ultimately results in the SEC informing the company that it has cleared comments.  A company then files a letter with the SEC, relying on another rule (Rule 461) requesting that the registration statement become effective.  Technically the request is that the SEC accelerate the effectiveness of the registration statement so that a company does not have to file a final amendment removing the “delaying amendment” language and adding Section 8(a) language and then waiting 20 days for the registration statement to go effective.

    The reasons that Section 8(a) is not used in practice are twofold. The first is that a company and its attorneys, auditors and underwriters believe that there is too much risk of litigation associated with forgoing SEC review. If the registration statement disclosures are later shown to have shortcomings, the unusual lack of SEC review adds fuel to the plaintiff’s lawyer’s claims. However, the SEC does not conduct a merit review, but rather just reviews to determine if the disclosures comply with the rules and regulations. Not only does the SEC not pass on whether a deal is good or bad, but making a statement to the contrary is a criminal offense and Item 501 of Regulation S-K specifically requires a disclaimer on the subject with suggested language, to wit:

    Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

    It seems that if a company has competent counsel and the underwriter has competent counsel, they can together review the disclosures to determine if they are accurate and complete. Moreover, the fact is that if the stock price goes way down, the company is likely to face an investor lawsuit anyway, regardless of what the SEC reviews or doesn’t review. Besides, risk factors are designed to warn investors of potential issues, and Gossamer did so with its newest SEC filing adding the following risk factor:

    As a result of the shutdown of the federal government, we have determined to rely on Section 8(a) of the Securities Act to cause the registration statement of which this prospectus forms a part to become effective automatically. Our reliance on Section 8(a) could result in a number of adverse consequences, including the potential for a need for us to file a post-effective amendment and distribute an updated prospectus to investors, or a stop order issued preventing use of the registration statement, and a corresponding substantial stock price decline, litigation, reputational harm or other negative results.

    The registration statement of which this prospectus forms a part is expected to become automatically effective by operation of Section 8(a) of the Securities Act on the 20th calendar day after the most recent amendment of the registration statement filed with the SEC, in lieu of the SEC declaring the registration statement effective following the completion of its review. Although our reliance on Section 8(a) does not relieve us and other parties from the responsibility for the adequacy and accuracy of the disclosure set forth in the registration statement and for ensuring that the registration statement complies with applicable requirements, use of Section 8(a) poses a risk that, after the date of this prospectus, we may be required to file a post-effective amendment to the registration statement and distribute an updated prospectus to investors, or otherwise abandon this offering, if changes to the information in this prospectus are required, or if a stop order under Section 8(d) of the Securities Act prevents continued use of the registration statement. These or similar events could cause the trading price of our common stock to decline substantially, result in securities class action or other litigation, and subject us to significant monetary damages, reputational harm and other negative results.

    The second is that the S-1, which will go effective after 20 days, must be totally complete, including pricing information.  In a traditional IPO or follow-on offering, the company does not file the final amendment with pricing information until the day it goes effective.  This allows a company to judge the market at the moment of sale to choose the best price, which is especially important in a firm commitment underwritten deal where the underwriter buys all the company’s registered stock in the IPO and immediately resells it to customers and syndicated broker-dealers.  A company also may get feedback during its roadshow, which typically occurs in the 10-15 days prior to effectiveness that affects pricing decisions.

    Interestingly, Gossamer has decided to ignore these market factors and let the world know its believed value up front.  I’m actually not surprised at all.  This is just another way that capital markets are shifting.  There has been a recent rise in different methods of going public including direct public listings without an IPO (see HERE).

    Nasdaq FAQ

    On January 24, 2019, Nasdaq issued five FAQ addressing the listing of new companies during the government shutdown and the impact on already listed companies.  Nasdaq will list companies that had cleared comments, but whose registration statement had not yet been declared effective at the time of the shutdown.  Likewise if a company has substantially cleared comments, Nasdaq is willing to proceed with the listing under certain circumstances.  In particular, the company will have had to clearly address the outstanding comments and Nasdaq will require a representation from the company’s counsel and auditor that they believe all disclosure and accounting comments have been fully addressed.  Nasdaq will not list a company that has not yet received SEC comments or that first filed for its IPO during the shutdown.  Gossamer announced that it has applied for the Nasdaq Global Select Market and so it will likely amend its S-1 to allow SEC review.

    Nasdaq will also allow certain up-listings from the OTC Markets to proceed as long as the company satisfies the listing requirement.  In particular, if the company only needs to file a registration statement under the Securities Exchange Act of 1934 (“Exchange Act”), such as a Form 10 or Form 8-A, Nasdaq will allow it to continue. Keep in mind a registration statement under the Exchange Act does not involve the offer or sale of any securities.  However, if the up-listing involves an offering and the filing of a registration statement under the Securities Act, Nasdaq will review the application the same as a new IPO. That is, if the company has already cleared or substantially cleared comments, they may continue, if not, they will need to complete the SEC review process.

    If a company is already listed on Nasdaq, they may proceed with a follow-on offering without SEC review.

    Although the SEC is again operational, they will be backlogged, so presumably Nasdaq is still willing to proceed with certain companies without SEC action.  Companies that have already filed a registration statement without the delaying amendment and with the appropriate Section 8(a) amendment will likely proceed.  For those that had one or two unsubstantial comments left, they will need to assess which route will be the quickest, wait for the SEC to review the final comments or file a new fully completed registration using Section 8(a).  Of course, Nasdaq may issue updated FAQ altering their position on accepting these applications.

    Continued Shifting Capital Markets

    The rise of decentralized platforms and imminent change in how the capital markets function as a whole and the role of intermediaries in the process has opened the market’s view to relying less on the SEC’s input in their disclosures.  tZero is scheduled to launch its security token platform this week, introducing a new way in which securities, or fractional ownership interests in a company, can be bought and sold.  tZero is starting with launching its own securities tokens on the platform but will soon open up to third-party companies and reportedly already has applications from over 60 companies. tZero may be the first to launch, but it will not be the only and soon we will have independent markets competing with Nasdaq and the NYSE.  Moreover, the securities token markets will have sectors for private company markets and public company markets, blurring the current private equity silo with public trading.

    Much more significantly, though, is that this is the first step in a retooling and complete change in how the clearing and settlement of securities functions (for more on the current clearing and settlement, see HERE and HERE).  The new blockchain technology will allow for instantaneous clearing and settlement, a big change from the current t+2 and sometimes t+3 settlement of today (thus the name tZero).  Notably, blockchain eliminates the need for a trusted intermediary, thus opening up the question as to the future role of DTC and its custodial arm, Cede & Co.

    No regulator, the SEC or FINRA included, is ready for a complete disruption of the capital markets system, but they have been thinking about it for a while.  FINRA published a report on the implications of blockchain for the securities industry back in January 2017 (see HERE).  Furthermore, the SEC has reportedly told tZero, and presumably others following in their lead, that they will allow incremental changes in the market system.

    This is a small concession considering that they will have no choice as the proverbial train has left the station.  tZero is launching a joint venture with Boston Options Exchange, which is one of 12 SEC-listed security exchanges which together comprise the National Market System network. The joint venture seeks to launch a marketplace able to deal in both public securities and digital tokens.  Nasdaq Financial Framework, a software company owned by the exchange, just closed a $20 million Series B funding round into Symbiont which is working to “give Nasdaq the ability to originate a financial instrument and the smart contract to custody it on a blockchain, to allow trading to occur with their matching engine, to allow surveillance to occur across the network using Nasdaq technology and then to perform settlement on a blockchain.”

    Meanwhile, the SEC is clearly not against forgoing the comment and review process and relying on Section 8(a).  As it was shutting down, the SEC posted an FAQ on its website reminding companies that they can proceed to rely on Section 8(a) to effectuate their registration statements, and even providing the exact language that needs to be included in order to accomplish this.  In particular: “This registration statement shall hereafter become effective in accordance with the provisions of Section 8(a) of the Securities Act of 1933.”   Even with the re-opening of the SEC, CorpFin will be exponentially backlogged compared to the time it was shutdown.  It will be interesting to see how the SEC handles the workload – perhaps in addition to simply foregoing comments on many filings, the SEC will continue to support the use of 8(a) on others, especially follow-on offerings completed for a company that has had a full review in the last few years...

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    The Treasury Department Report To The President On FinTech And Innovation

    Tuesday, January 22, 2019, 7:20 AM [General]
    0 (0 Ratings)

    This summer, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Nonbank Financials, Fintech and Innovation” (the “Treasury Report”). The Treasury Report was issued in response to an executive order dated February 3, 2017 which has resulted in a series of such reports. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports. For a summary of the Treasury Department Report on Capital Markets, see HERE.

    The Core Principles identified in the executive order are:

    1. Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
    2. Prevent taxpayer-funded bailouts;
    3. Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
    4. Enable American companies to be competitive with foreign firms in domestic and foreign markets;
    5. Advance American interests in international financial regulatory negotiations and meetings;
    6. Make regulation efficient, effective, and appropriately tailored; and
    7. Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

    This blog will summarize key portions of the 222-page report; however, for those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken down by category.

    Interestingly, the Treasury Report opts not to provide any detailed coverage on blockchain, distributed ledger technologies or digital assets, instead finding that topic to be significant enough to warrant stand-alone treatment. The Treasury Department is party of an interagency working group of the Financial Stability Oversight Council focused on this new area of technology and capital resources.

     Non-bank Financials, Fintech, and Innovation

    A non-bank financial firm provides financial services, including extending credit; providing investment advice; executive retail investment transactions; processing payments; facilitating back-end check processing; enabling card issuance, processing, and network activities; and providing customer-facing digital payments software. As such, non-bank financial firms play an important role in the U.S. economy.

    During the financial crisis, the government wrote far-reaching laws that mandated the adoption of hundreds of new regulations, many of which either limited certain services by banks or made them unprofitable. As a result, the financial service sector grew rapidly. Importantly, capital is available for companies in the financial services and fintech sectors. The financing of financial services firms has reached in excess of $22 billion globally, and such firms now make up more than 36% of all U.S. personal loans, up from less than 1% in 2010.

    In addition, at the same time, the rapid development of financial technology enabled financial services firms to improve operational efficiencies and lower regulatory compliance costs. The Treasury Report succinctly notes, “[S]ince the financial crisis, there has been a proliferation in technological capabilities and processes at increasing levels of cost effectiveness and speed. The use of data, the speed of communication, the proliferation of mobile devices and applications, and the expansion of information flow all have broken down barriers to entry for a wide range of startups and other technology-based firms that are now competing or partnering with traditional providers in nearly every aspect of the financial services industry.”

    There are abundant examples of significant changes in the world economy. Digital advice platforms make financial planning and wealth management tools available to all households regardless of income level. Technology provides options for the unbanked and underbanked population through mobile-based applications. Consumer and mortgage lending are all available online in a shorter process than ever before. Payment processors allow for quick and easy transactions between businesses and consumers and person-to-person among friends sharing a bill. Cloud computing, machine learning, artificial intelligence, blockchain and distributed ledger technologies are likewise revolutionizing the financial service sectors.

    Issues and Recommendations

    The Treasury Report groups its recommendations into four categories: (i) adapting regulatory approaches to changes in the aggregation, sharing and use of consumer financial data and support competitive technologies; (ii) aligning the regulatory framework to eliminate regulatory fragmentation and support new business models; (iii) updating activity-specific regulations, especially those that are outdated by technological advances; and (iv) advocating an approach that supports responsible experimentation in the financial sector and helps America be competitive internationally.

    Specific recommendations include:

    Consumer Financial Data

    The Treasury Report recommendations focus on improving consumers’ access to data and its use by third parties to support better delivery of services. In particular, there are numerous regulations and regulatory uncertainties that act as impediments for financial service companies and data aggregators desiring to establish data sharing agreements. The Treasury Report also recommends that Congress enact a federal data security and breach notification law to protect consumer financial data and ensures that consumers are notified of breaches in a timely manner.

    Eliminating Regulatory Fragmentation and Supporting New Business Models

    Treasury makes numerous recommendations for removing regulatory burdens and fragmentation and for new regulations that will support cloud technologies, machine learning, and artificial intelligence into financial services. Treasury also recommends a more unified state law system, including the drafting of model laws and unifying licensing processes across states. Treasury supports Vision 2020, an effort by the Conference of State Bank Supervisors that includes establishing a Fintech Industry Advisory Panel to help improve state regulation, harmonizing multi-state supervisory processes, and redesigning the Nationwide Multistate Licensing System.

    Further at the federal level, Treasury encourages the development of a special-purpose national bank charter for non-bank financial service providers.  Interestingly, on the same day as the release of the Treasury Report, the Office of the Comptroller of the Currency announced that it would begin accepting applications for special-purpose national bank charters from financial technology companies that don’t take deposits.  As of the date of this blog, no such charters have yet been issued. Moreover, the Conference of State Bank Supervisors (CSBS) has filed a federal lawsuit claiming the program is illegal.

    The Treasury Report also encourages banking regulators to clarify guidance regarding bank partnerships with non-bank financial firms, encouraging such partnerships, especially those that promote innovation. Furthermore, Treasury makes recommendations regarding changes to permissible activities, including bank activities related to acquiring or investing in non-bank platforms.

     Updating Activity-specific Regulations

    Specific areas with recommendations for regulatory reform include:

    • Marketplace lending – The Treasury Report recommends eliminating constraints on relationships between non-bank and bank lenders, codifying the “valid when made” doctrine and the role of the bank as the “true lender” of loans it makes.
    • Mortgage Lending and Servicing – Non-bank financial firms now originate approximately half of all new mortgages. Regulatory changes should encourage broad primary market participation and the adoption of technological developments, shorten origination timelines, facilitate efficient loss mitigation and generally help deliver a more reliable, lower-cost mortgage product.
    • Student Lending and Servicing – The federal student loan program represents more than 90% of outstanding student loans and is managed by a network of non-banks for servicing and collection. The Treasury Report recommends that the U.S. Department of Education establish minimum effective servicing standards and the increased use of technology for communication with borrowers, monitoring and management.
    • Short-Term, Small Dollar Lending – Treasury recommends that the Bureau of Consumer Financial Protection rescind its Payday Rule as state regulations are adequate. The goal is to encourage access to short-term, small-dollar installment lending by both non-bank and bank financial institutions.
    • Debt Collection – Treasury recommends that the Bureau establish minimum effective federal standards for third-party debt collectors, including standards for the information that must be transferred with the debt for purposes of third-party collection or sale.
    • New Credit Models and Data – Regulators should provide regulatory clarity for the use of new data and modeling approaches that are generally recognized as providing predictive value.
    • Credit Bureaus – Credit bureaus are not routinely monitored for the privacy provisions and data security requirements under the federal Gramm-Leach-Bliley Act and as such, the Treasury Report recommends that processes be put into place for such monitoring. Treasury also recommends that Congress amend the Credit Repair Organizations Act to exclude national credit bureaus and national credit scorers in order to allow these entities to provide credit education and counseling services to consumers to prospectively improve their credit scores.
    • IRS Income Verification – The Internal Revenue Service (IRS) system that lenders and vendors use to obtain borrower tax transcripts is outdated and should be modernized in order to minimize delays in accessing tax information, which would facilitate the consumer and small business credit origination process.
    • Payments – Treasury recommends that the states work to harmonize money transmitter requirements for licensing and supervisory examinations, and urges the Bureau to provide more flexibility regarding the issuance of remittance disclosures. Treasury encourages the Federal Reserve to move quickly in facilitating a faster retail payments system, such as through the development of a real-time settlement service that would allow for more efficient and widespread access to innovative payment capabilities.
    • Wealth Management and Digital Financial Planning – Under the current regulatory structure, financial planners may be regulated at both the federal and state levels. Although many financial planners are regulated by the SEC or state securities regulators, they may also be subject to regulation by the Department of Labor, the Bureau, federal or state banking regulators, state insurance commissioners, state boards of accountancy, and state bars. This patchwork of regulatory authority increases costs and potentially presents unnecessary barriers to the development of digital financial planning services. Treasury recommends that an appropriate existing regulator of a financial planner be tasked with primary oversight of that financial planner and other regulators defer to that regulator.

    Supporting Experimentation in the Financial Sector

    The theme of the Treasury Report is to support innovation and permit experimentation and changes in the financial services industry. Many other countries have created innovation facilitators and other groups to test new technologies in the financial sector. Unfortunately the fragmentation of the U.S. regulatory system makes it more difficult for the U.S. to maintain global competitiveness. The Treasury Report recommendations focus on defragmenting the regulatory system and supporting innovative changes...

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    SEC Solicits Comment On Earnings Releases And Quarterly Reports

    Tuesday, January 15, 2019, 6:18 AM [General]
    0 (0 Ratings)

    On December 18, 2018, the SEC published a request for comment soliciting input on the nature, content, and timing of earnings releases and quarterly reports made by reporting companies. The comment period remains open for 90 days from publication. The request is not surprising as earnings releases and quarterly reports were included in the pre-rule stage in the Fall 2018 SEC semiannual regulatory agenda and plans for rulemaking.

    The request for comment seek input on how the SEC can reduce burdens on publicly reporting companies associated with quarterly reports while maintaining disclosure effectiveness and investor protections. The SEC also seeks comment on how the existing reporting system, earnings releases and earnings guidance may foster an overly short-term focus by companies and market participants. In addition, the SEC is looking for input on how to make the reporting process less cumbersome to investors, such as by having to compare an earnings release and Form 10-Q for differences.

    This has been a hot topic over the years, with President Trump publicly calling for an elimination of quarterly reporting. The April 2016 concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements also requested comment on the subject. See my two-part blog on the S-K Concept Release HERE and HERE. The newest request for comment takes into consideration comments received in response to the 2016 release and drills down further on the quarterly reporting process.

    The request for comment specifically addresses (i) the nature and timing of disclosures in quarterly reports, including when the disclosures overlap with voluntary earnings releases in Forms 8-K; (ii) how the SEC can make the process more efficient by eliminating duplication and how that can affect capital formation; (iii) whether the SEC should allow some or all reporting companies flexibility on the frequency of periodic reporting; and (iv) how the existing periodic reporting system may affect corporate decision making and may foster an inefficient outlook by focusing on short-term results.

    Background on Form 10-Q

    In addition to annual reports on Form 10-K and current reports on Form 8-K, companies subject to the periodic reporting requirements under the Securities Exchange Act of 1934 (“Exchange Act”), other than foreign private issuers, must file quarterly reports on Form 10-Q, which include independent auditor-reviewed interim financial statements and other disclosure items. For more information on SEC reporting requirements, see HERE and related to foreign private issuers, see HERE. Foreign private issuers must file annual but not quarterly reports.

    These quarterly reports, as well as other periodic reports, may be forward incorporated by reference into Securities Act of 1933 (“Securities Act”) registration statements such as Forms S-1 and S-3, reducing the need for duplication of this information through post effective updates.  As an aside, the FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies (see HERE), which category of company has recently increased with the amended definition of a smaller reporting company (see HERE). Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference.

    A Form 10-Q is subject to the anti-fraud provisions of Sections 10(b) and 18 of the Exchange Act and Rule 10(b)(5) and can be the source of liability to the company, affiliates and underwriters under Sections 11, 12 and 17 of the Securities Act, related to the offer and sales of securities offerings. Each of these provisions imposes liability on companies in certain instances for making any untrue statements of a material fact or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. The difference in the Sections relate to whether the cause of action is private or can only be pursued by a regulator or governmental body, if private, who has a right to pursue the action (for example, Section 11 provides an action for any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket), the elements of proof (such as scienter or intent or loss causation), allowable damages, the standard of proof, etc..

    Liability under certain of these provisions, such as Sections 11 and 12 of the Securities Act and Section 18 of the Exchange Act, attaches only to documents that are filed with the SEC or incorporated by reference into a Securities Act registration statement. A Form 10-Q is always deemed filed with the SEC.

    However, the SEC allows certain information to be furnished as opposed to filed as long as the company specifically discloses that it is avowing itself of the ability to furnish and not file. For example, reports in a Form 8-K under Regulation FD and earnings press releases under Item 2.02 related to results of operations and financial condition are allowed to be furnished and not filed. Although liability under Section 10(b) and Rule 10b-5 of the Exchange Act may attach to documents that are “furnished,” the standard of proof and elements to state a cause of action are different under these rules.

    As mentioned above, foreign private issuers must file annual but not quarterly reports.  However, a foreign private issuer has obligations to furnish certain information under a Form 6-K, including, for example, information it (i) makes or is required to make public pursuant to the law of the jurisdiction of its domicile or in which it is incorporated or organized, or (ii) files or is required to file with a stock exchange on which its securities are traded and which was made public by that exchange, or (iii) distributes or is required to distribute to its security holders. This information is subject to liability under Section 10(b) and Rule 10b-5 of the Exchange Act and if incorporated into a registration statement, becomes filed in that registration statement, and subject to liability under Sections 11, 12 and 17 of the Securities Act.

    As a result of these requirements, reports on Form 6-K often include quarterly reports or financial statements. For example, Canada, Hong Kong and Japan all require quarterly reporting. On the other hand, in 2013 the European Union (“EU”) amended its reporting requirements to eliminate the requirement to file quarterly reports altogether, which even prior to that time did not include financial statements. The EU found that quarterly reports were a burden for small and medium-sized companies, didn’t add to investor protection, encouraged a focus on short-term performance and discouraged long-term investments.  Companies may still voluntarily file quarterly.

    Earnings Releases

    Many companies that file quarterly Form 10-Q’s also voluntarily issue quarterly financial results through earnings press releases, earnings calls and/or forward-looking earnings guidance. Other than through the anti-fraud rules, the presentation of non-GAAP financial measures (see HERE) and the requirement to file a Form 8-K, the SEC does not regulate these disclosures. Although when a company does issue earnings release information, it is generally duplicative to some information in the Form 10-Q, the Form 10-Q is more robust and includes XBRL interactive data.  Disclosures in a Form 10-Q that are not in an earnings release also include full financial statements and notes to financial statements as opposed to summaries and a management discussion and analysis. Moreover, the financial statements in the Form 10-Q are reviewed by an independent auditor and the filing includes Sarbanes-Oxley certifications by the principal executive and financial officers.  Contrarily, a Form 10-Q generally does not include expectations of future performance or forward-looking earnings guidance.

    Request for Comments

    In addition to the general request for comment on the issues and matters described above, the SEC drills down their requests into specific questions on the topic, such as why companies choose to issue earnings releases in addition to a Form 10-Q and what would be the impact on these releases if quarterly reports were not required. The SEC seeks information on the specific benefits of both earnings releases and Form 10-Q and standard market expectations and responses to both. Certainly, as a regulator the SEC understands the legal impact of “furnished vs. filed” and the various liability provisions, but their questions are more focused on the market players and investors uses of and needs for information as well as the burdens of providing same. The SEC also touches on XBRL, which has also been oft debated, especially for smaller reporting companies. The SEC lists 14 multifaceted in this area under the heading “Information Content Resulting from the Quarterly Reporting Process.”

    The SEC requests comment on 3 additional multi-layered points related to the timing of the quarterly reporting process including vis-à-vis earnings releases. In particular, some companies issue an earnings release prior to the Form 10-Q while others wait until the same day or close thereafter.  Earnings calls can be scheduled anywhere around the time of either filing or after. The SEC queries the reasons why and impacts of the timing.

    The next area of questions relates to whether earnings releases should be the core quarterly disclosure, with 12 multi-layered queries. In this area it seems that the SEC is considering making an earnings release an optional alternative to a Form 10-Q by allowing the Form 10-Q to incorporate the earnings release by reference and/or only provide supplemental information in the Form 10-Q to the extent it was not included in the earnings release.

    Finally, the SEC tackles the topic of reporting frequency, including considering semi-annual reporting with 17 in-depth, multifaceted questions for consideration...

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    Regulation A+

    Wednesday, January 2, 2019, 6:27 AM [General]
    0 (0 Ratings)

    On December 19, 2018, the SEC adopted final rules allowing reporting companies to Rely on Regulation A to conduct securities offerings. On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law requiring the SEC to amend Regulation A to allow for its use by Exchange Act reporting companies. Since that time, the marketplace has been waiting, somewhat impatiently, for the final rule change to be implemented.

    Section 508 of the Act directed the SEC to amend Regulation A to remove the provision making companies subject to the SEC Securities Exchange Act reporting requirements ineligible to use the offering exemption 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 HERE). OTC 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.

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

    Recent changes in capital markets have made it more difficult for small public companies to raise capital. I believe that by opening up the simplified offering circular and SEC review procedures available through Regulation A, these companies will have a resource that allows them to access capital markets more efficiently. Furthermore, by being able to offer investors freely tradable securities, small public companies will have less pressure to enter into highly dilutive financing arrangements.

    In addition to the obvious benefit to small and emerging company capital formation of allowing small reporting companies to utilize Regulation A, there is also an added potential benefit to the capital markets as a whole. The flow of freely tradable securities into the marketplace for existing public companies could have a positive uptick on the liquidity and overall growth and vitality of small-cap market trading. Institutional investors generally do not invest in thinly traded securities and accordingly, increased liquidity in the secondary marketplace could attract more institutional investments in small public companies.  Likewise, increased activity could prompt additional analyst coverage for these companies...

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    Regulation A+ Now Available For Publicly Reporting Companies

    Wednesday, January 2, 2019, 6:27 AM [General]
    0 (0 Ratings)

    On December 19, 2018, the SEC adopted final rules allowing reporting companies to Rely on Regulation A to conduct securities offerings. On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law requiring the SEC to amend Regulation A to allow for its use by Exchange Act reporting companies. Since that time, the marketplace has been waiting, somewhat impatiently, for the final rule change to be implemented.

    Section 508 of the Act directed the SEC to amend Regulation A to remove the provision making companies subject to the SEC Securities Exchange Act reporting requirements ineligible to use the offering exemption 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 HERE). OTC 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.

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

    Recent changes in capital markets have made it more difficult for small public companies to raise capital. I believe that by opening up the simplified offering circular and SEC review procedures available through Regulation A, these companies will have a resource that allows them to access capital markets more efficiently. Furthermore, by being able to offer investors freely tradable securities, small public companies will have less pressure to enter into highly dilutive financing arrangements.

    In addition to the obvious benefit to small and emerging company capital formation of allowing small reporting companies to utilize Regulation A, there is also an added potential benefit to the capital markets as a whole. The flow of freely tradable securities into the marketplace for existing public companies could have a positive uptick on the liquidity and overall growth and vitality of small-cap market trading. Institutional investors generally do not invest in thinly traded securities and accordingly, increased liquidity in the secondary marketplace could attract more institutional investments in small public companies.  Likewise, increased activity could prompt additional analyst coverage for these companies...

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    Nasdaq Amends Its 20% Dilution Shareholder Approval Rule

    Tuesday, December 18, 2018, 7:10 AM [General]
    0 (0 Ratings)

    Effective September 26, 2018, Nasdaq amended Rule 5635(d) to provide greater flexibility and certainty for companies to determine when a shareholder vote is necessary to approve a transaction that would result in the issuance of 20% or more of the outstanding common stock or 20% or more of outstanding voting power in a PIPE or similar private placement financing transaction. The amendment did not change the remainder of Rule 5635, which requires shareholder approval for transactions such as issuances involving an acquisition of stock or assets of another company, a change of control, or equity compensation that result in a 20% or greater dilution.

    Generally, Rule 5635(d) requires Nasdaq-listed companies to obtain shareholder approval in private placement transactions involving the issuance of (i) common stock or securities convertible into or exercisable for common stock at a price less than the greater of book or market value which, together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of common stock or 20% or more of the voting power outstanding before the issuance; or (ii) the sale, issuance, or potential issuance by the company of common stock or securities convertible into or exercisable for common stock equal to 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance for less than the greater of book or market value of the stock.  The amendment combines these two sections into one and amends the pricing test for triggering shareholder approval.  The new pricing test amends the definition of “market value” solely for purposes of Rule 5635(d) to create a new “Minimum Price” as described below.

    Prior to the amendment, Rule 5635(d) exempted from the shareholder approval requirement offerings priced at or above the greater of book or market value per share with market value defined as the closing bid price. That is, the Rule generally only required a vote if the dilution resulted from offerings that were priced at a discount to market value or book value. The Rule amendment eliminates the book value test, and revises the definition of market value to incorporate a five-day average and to use the last closing price instead of the consolidating closing bid price. As a result, under the amended Rule, a private offering involving the issuance of 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance will not require shareholder approval if the offer price is greater than or equal to the lesser of: (i) the last closing price immediately preceding the signing of a binding agreement; or (ii) the average closing price of the common stock on Nasdaq for the five trading days immediately preceding the signing of the binding agreement (the “Minimum Price”). Shareholder approval will be required for private placements priced below the Minimum Price.

    Nasdaq’s impetus for amending the rule was to strike a balance between the protection of investors via the shareholder approval rule and a company’s flexibility to efficiently negotiate a deal to raise money quickly with a price that accurately reflects the market value of its security. In the Rule change release, Nasdaq noted that book value is based on historic values and, therefore, is not an appropriate measure of whether a transaction is dilutive or should otherwise require shareholder approval. Moreover, book value is one of several financial data points that is already incorporated into the market value of a security.

    Using the last closing price, rather than the last closing bid price, reflects sale prices at one of the more liquid times of the day and, therefore, is believed to be more transparent to investors. Adding the option of choosing between the closing bid price and the five-day average closing price provides more flexibility and certainty for companies in their transactions. For example, in a declining market, the five-day average closing price will be above the current market price, which could make it difficult for companies to close transactions because investors could buy shares at a lower price in the market. Likewise, in a rising market, the five-day average could result in a below-market transaction triggering shareholder approval requirements.

    The Rule amendment also combines the existing two sections of 5635(d) into one such that a 20% issuance for purposes of the Rule would involve a transaction other than a public offering, involving the sale, issuance, or potential issuance by the company of common stock or securities convertible into or exercisable for common stock, which, alone or together with sales by officers, directors, or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. This change does not make any substantive change but certainly makes the language more clear and concise.

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    The SEC’s Strategic Hub For Innovation And Financial Technology

    Tuesday, December 11, 2018, 7:07 AM [General]
    0 (0 Ratings)

    Responding to the growing necessity, in mid-October the SEC launched a Strategic Hub for Innovation and Financial Technology (FinHub). The FinHub will serve as a resource for public engagement on the SEC’s FinTech-related issues and initiatives, such as distributed ledger technology (including digital assets), automated investment advice, digital marketplace financing, and artificial intelligence/machine learning. The FinHub also replaces and consolidates several SEC internal working groups that have been working on these matters.

    According to the SEC press release on the matter, the FinHub will:

    • Provide a portal for the industry and the public to engage directly with SEC staff on innovative ideas and technological developments;
    • Publicize information regarding the SEC’s activities and initiatives involving FinTech on the FinHub web page;
    • Engage with the public through publications and events, including a FinTech Forum focusing on distributed ledger technology and digital assets planned for 2019;
    • Act as a platform and clearinghouse for SEC staff to acquire and disseminate information and FinTech-related knowledge within the agency; and
    • Serve as a liaison to other domestic and international regulators regarding emerging technologies in financial, regulatory, and supervisory systems.

    Although I’m sure FinHub supports engagement in all FinTech areas, the website itself is broken into four categories: (i) blockchain/distributed ledger; (ii) digital marketplace financing; (iii) automated investment advice; and (iv) artificial intelligence/machine learning. Under each category the SEC has tabs with information such as regulations, speeches and presentations, opportunities for public input and empirical information.

                    Blockchain/Distributed Ledger 

    Blockchain and distributed ledger generally refer to databases that maintain information across a network of computers in a decentralized or distributed manner.  Blockchains are often used to issue and transfer ownership of digital assets that may be securities, depending on the facts and circumstances.

    Clearly illustrating the need for regulatory initiatives, the “regulation, registration and related matters” tab under blockchain/distributed ledger is limited to public speeches, testimony and pronouncements, and enforcement actions, and not regulation (as none exists). Although certainly we in the community give public statements weight, they actually have no binding legal authority. The speeches, testimony and pronouncements that the SEC lists in this tab, and as such the ones that the SEC gives the most weight to, include (i) Chair Clayton’s testimony on virtual currencies to the Senate banking committee (see HERE); (ii) William Hinman’s speech on digital asset transactions (see HERE); (iii) statement on potentially unlawful online platforms for trading digital assets (see HERE); and (iv) remarks before the AICPA National Conference of Banks & Savings institutions (see HERE and HERE).

    Providing more legal guidance are the enforcement proceedings. The SEC has provided a running list of all cyber enforcement actions broken down by category including digital asset/initial coin offerings; account intrusions; hacking/insider trading; market manipulation; safeguarding customer information; public company disclosure and controls; and trading suspensions.

    Digital Marketplace Financing

    Digital marketplace financing refers to fundraising using mass-marketed digital media – i.e., crowdfunding. In this category, the SEC includes traditional Title III Crowdfunding under Regulation CF and platforms for the marketing of Regulation D, Rule 506(c) offerings for the offering of debt or equity financing. Under the Regulation tab the SEC includes Regulation CF and the SEC’s Regulation CF homepage, including investor bulletins.

    The SEC does not include a link to Rule 506(c) or Section 4(c) of the Securities Act, which provide an exemption for advertised offerings where all purchasers are accredited investors, and the platforms or web intermediaries that host such offerings, respectively. However, many securities token offerings are being completed relying on these exemptions from the registration provisions – in fact, more so than Regulation CF which is limited to $1,070,000 in any twelve-month period. In my opinion, this is a miss on the site layout.

    This area of the FinHub website also provides a link to one of the first published SEC investor bulletins on initial coin offerings, including some high-level considerations to avoid a scam. Finally, this area provides a link to a Regulation CF empirical information page published by the SEC. Unfortunately I do not find the data to be user-friendly and could not determine how many, if any, Regulation CF offerings have included digitized assets or FinTech-related issuers.

    Automated Investment Advice

    Automated investment advisers or robo-advisers are investment advisers that typically provide asset management services through online algorithmic-based programs. Since their introduction, the SEC has been involved with regulating these market participants. Under this section, the SEC provides links to guidance related to robo-advisors.

    Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Advisers Act. However, since robo-advisers rely on algorithms, provide advisory services over the internet, and may offer limited, if any, direct human interaction to their clients, their unique business models may raise certain considerations when seeking to comply with the Advisers Act. In particular, the Advisors Act requires that a client receive information that is critical to his or her ability to make informed decisions about engaging, and then managing the relationship with, the investment adviser. As a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients. The information provided must be sufficiently specific so that a client is able to understand the investment adviser’s business practices and conflicts of interests. Such information must be presented in a manner that clients are likely to read (if in writing) and understand.

    Since robo-advisors provide information and disclosure over the internet without human interaction and the benefit of back-and-forth discussions, the disclosures must be extra robust and provide thorough material on the use of an algorithm. The SEC’s guidance on the subject contains a fairly thorough list of matters that should be included in the client information.

    Artificial Intelligence/Machine Learning

    Machine learning and artificial intelligence refer to methods of using computers to mine and analyze large data sets. The SEC includes links to a few speeches and presentations under this tab. The SEC uses machine learning and AI in numerous ways, including market risk assessment and helping identify risks that could result in enforcement proceedings such as the detection of potential investment adviser misconduct.

    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 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 the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

    For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

    For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

    For a review of Wyoming’s blockchain legislation, see HERE.

    For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

    For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE; and HERE.

    For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

    Proposed Rule Changes To Simplify Registered Debt Offerings

    Tuesday, December 4, 2018, 7:03 AM [General]
    0 (0 Ratings)

    This summer the SEC proposed rule changes to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The proposed rules follow the September 2015 SEC request for comment related to the Regulation S-X financial disclosure obligations for certain entities other than the reporting entity. The September 2015 request for comment specifically discussed Rules 3-10 and 3-16, which comment responses were considered in the current proposed rules. For more on the September 2015 comment request, see HERE.

    In addition to the amending the contents of the rules, the SEC plans to create a new Article 13 in Regulation S-X and renumber Rules 3-10 and 3-16 to Rules 13-01 and 13-02. The proposed amendments also include conforming changes to related rules in Regulations S-K and S-X and Securities Act and Exchange Act forms.

    The SEC hopes that the rule changes will encourage registration of debt offerings which include a subsidiary guarantee or pledge of affiliate securities, where a company may previously have only completed such offerings using private placement exemptions due to the high costs and burdens associated with registration. Moreover, if the registration process is less expensive, it might encourage companies to use guarantees or pledges of affiliate securities as collateral when they structure debt offerings which could result in a lower cost of capital and an increased level of investor protection.

    The following review is very high-level. The rules are complex and an application of the specific requirements requires an in-depth analysis of the particular facts and circumstances of an offering and the relationship between the issuer and guarantor/pledger.

    Rule 3-10

    Currently Rule 3-10 requires financial statements to be filed for all issuers and guarantors of securities that are registered or being registered, subject to certain exceptions. These exceptions are typically available for wholly owned individual subsidiaries of a parent company when each guarantee is “full and unconditional.” Moreover, certain conditions must be met, including that the parent company provides delineated disclosures in its consolidated financial statements.  If the conditions are met, separate financial statements of each qualifying subsidiary issuer and guarantor may be omitted.

    The theory behind requiring these financial statements is that guarantor of a registered security is considered an issuer because the guarantee itself is considered a separate security. Accordingly, both issuers of registered securities, and the guarantor of those registered securities, have historically been required to file their own audited annual and reviewed stub period financial statements under Rule 3-10. Where qualified, Rule 3-10 currently allows for a tabular footnote disclosure of this information, as opposed to full-blown audits and reviews of each affected subsidiary. The footnote tables are referred to as Alternative Disclosure.

    The requirements under Alternative Disclosure include tables in the footnotes for each category of parent and subsidiary and guarantor. The table must include all major captions on the balance sheet, income statement and cash flow statement. The columns must show (i) a parent’s investment in all consolidated subsidiaries based on its proportionate share of the net assets; and (ii) a subsidiary issuer/guarantor’s investment in other consolidated subsidiaries using the equity accounting method.

    To avoid a disclosure gap for recently acquired subsidiaries, a Securities Act registration statement of a parent must include one year of audited pre-acquisition financial statements for those subsidiaries in its registration statement if the subsidiary is significant and such financial information is not being otherwise included. A subsidiary is significant if its net book value or purchase price, whichever is greater, is 20% or more of the principal amount of the securities being registered. Currently, the parent company must continue to provide the Alternative Disclosure for as long as the guaranteed securities are outstanding.

    When a subsidiary is not also considered an issuer of securities, a parent company consolidates the financial statements of its subsidiaries and no separate financial statements are provided for those subsidiaries. The SEC recognizes the overarching principle that it is really the parent consolidated financial statements upon which investors rely when making investment decisions. The existing rules impose certain eligibility restrictions and disclosure requirements that may require unnecessary detail, thereby shifting investor focus away from the consolidated enterprise towards individual entities or groups of entities and may pose undue compliance burdens for registrants.

    The amendments would broaden the exception to the requirement to provide separate financial statements for certain subsidiaries as long as the parent company includes specific financial and non-financial disclosures about those subsidiaries. In particular, the amended rule would allow the exception for any subsidiary for which the parent consolidates financial statements as opposed to the current requirement that the subsidiary be wholly owned.

    Furthermore, the amendments would replace the existing consolidated financial information with new summarized information, for fewer periods, and which may be presented on a combined basis. The new non-financial information disclosures would expand the qualitative disclosures about the guarantees and the issuers and guarantors, as well as require certain disclosure of additional information, including information about the issuers and guarantors, the terms and conditions of the guarantees, and how the issuer and guarantor structure and other factors may affect payments to holders of the guaranteed securities (“Proposed Alternative Disclosure”).

    Importantly, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. However, the disclosures must move back to the financial statement footnotes beginning with the annual report for the fiscal year during which the first bona fide sale of the subject securities is completed.

    The geography of a disclosure is significant. Disclosure contained in the footnotes to financial statements subject the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Moreover, forward-looking statement safe-harbor protection is not available for information inside the financial statements.

    The new rules would reduce the time that financial and non-financial disclosures are required to the time that the issuer and guarantor have an Exchange Act reporting obligation with respect to the guaranteed securities rather than for as long as the guaranteed securities are outstanding. The Exchange Act provides that if, at the beginning of any subsequent fiscal year after the effectiveness of a Securities Act registration statement, the securities of any class to which the registration statement relates are held of record by fewer than 300 persons, or in the case of a bank, a savings and loan holding company, or bank holding company, by fewer than 1,200 persons, the registrant’s Section 15(d) reporting obligation is automatically suspended with respect to that class.

    Furthermore, the rule amendments would eliminate the requirement to provide pre-acquisition financial statements of recently acquired subsidiary issuers or guarantors.

    Rule 3-16

    Current Rule 3-16 requires a company to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold, for any class of registered securities as if the affiliate were a separate registrant. The affiliate’s portion of the collateral is determined by comparing (i) the highest amount among the aggregate principal amount, par value, book value or market value of the affiliate’s securities to (ii) the principal amount of the securities registered or to be registered. If the test equals or exceeds 20% for any fiscal year presented by the registrant, Rule 3-16 financial statements are required.

    The proposed amendments would replace the existing requirement to provide separate financial statements for each affiliate whose securities are pledged as collateral with new financial and non-financial disclosures about the affiliate(s) and the collateral arrangement as a supplement to the consolidated financial statements of the company that issues the collateralized security.

    In addition, the proposed amendment would change the geographic location of the disclosures to match the amendments to Rule 3-10. In particular, the new disclosures may be provided in the body of a registration statement covering the offer and sale of the securities as opposed to the footnotes to the financial statements. However, the disclosures must move back to the financial statement footnotes beginning with the annual report for the fiscal year during which the first bona fide sale of the subject securities is completed.

    Furthermore, the proposed amendments would replace the requirement to provide disclosure only when the pledged securities meet or exceed a numerical threshold relative to the securities registered or being registered, with a requirement to provide the proposed financial and non-financial disclosures in all cases, unless they are immaterial to holders of the collateralized security...

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    Financial Statement Disclosure Relief Under Rule 3-13

    Tuesday, November 6, 2018, 5:50 AM [General]
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    Rule 3-13 of Regulation S-X allows a company to request relief from the SEC from the financial statement disclosure requirements if they believe that the financial information is burdensome and would result in disclosure of information that goes beyond what is material to investors. Consistent with the ongoing message of open communication and cooperation, the current SEC regime has been actively encouraging companies to avail themselves of this relief and has updated the CorpFin Financial Reporting Manual to include contact information for staff members that can assist.

    As part of its ongoing disclosure effectiveness initiative, the SEC is also considering amendments to the financial statement disclosure process and the publication of further staff guidance. In addition to advancing disclosure changes, allowing for relief from financial statement requirements could help encourage smaller companies to access public markets, an ongoing goal of the SEC and other financial regulators. For a review of the October 2017 Treasury Department report to President Trump, including discussions related to the need to promote public markets, see HERE. For a review of Nasdaq’s publication “The Promise of Market Reform: Reigniting American’s Economic Engine,” see HERE.

    In fact, the SEC, under Chair Jay Clayton, has used current rules and staff prerogative to implement changes over the past two years for the direct purpose of removing barriers to capital formation and making the U.S public markets more attractive. For example, In June 2017 the SEC announced that the Division of Corporation Finance will permit all companies to submit draft registration statements, on a confidential basis. For more information see HERE.

    Rule 3-13 of Regulation S-X

    Rule 3-13 of Regulation S-X reads in total:

    The Commission may, upon the informal written request of the registrant, and where consistent with the protection of investors, permit the omission of one or more of the financial statements herein required or the filing in substitution therefor of appropriate statements of comparable character. The Commission may also by informal written notice require the filing of other financial statements in addition to, or in substitution for, the statements herein required in any case where such statements are necessary or appropriate for an adequate presentation of the financial condition of any person whose financial statements are required, or whose statements are otherwise necessary for the protection of investors.

    That is, the Rule gives the SEC the authority to modify or waive financial statement requirements under Regulation S-X as long as the modification is consistent with investor protections. The SEC has delegated the authority to the Division of Corporation Finance. Rule 3-13 applies to all financial statement requirements under Regulation S-X including financial information that a company may have to provide from other entities such as acquired businesses, subsidiaries, tenants with triple net lease arrangements that comprise a concentration of assets, certain related parties and others. For more information on financial statement requirements for entities other than the registrant, see HERE.

    Although the requirement that relief be consistent with investor protections is not defined by any rules, the SEC uses the concept of materiality as guidance. Materiality requires a facts-and-circumstances analysis. In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.

    The Financial Accounting Standards Board (FASB) has also published guidance on the utilization of the materiality standard in financial reporting. In September 2015, FASB published two concept papers recommending changes to the rules and analysis related to determining materiality. The changes would have given companies more flexibility in determining materiality. FASB’s proposed changes met with opposition from investor groups.  After two years of a back-and-forth process, in November 2017, FASB abandoned its proposed changes and reverted to an earlier materiality standard.

    FASB now defines materiality in the context of “the magnitude of an omission or misstatement of accounting information that, in light of the surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information, would have been changed or influenced by the omission or misstatement.” The FASB materiality analysis is primarily quantitative although circumstances, such as whether a particular matter is outside the ordinary course of business or could have an impact on larger contractual obligations, must also be considered.

    This definition is consistent with the standard used by the SEC, the PCAOB and the AICPA. The old and now new again materiality standard is set forth in FASB’s Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information.

    A materiality analysis must also take into account the relevance of the information. That is, information may be material based on pure magnitude but it may lack relevance. Relevance is generally information that would make a difference to a decision maker such as in making predictions about outcomes of past, present, and future events or to confirm or correct prior expectations.  By its very nature, relevant information is timely. If information is not available when it is needed or becomes available so long after the reported events that it has no value for future action, it lacks relevance and is of little or no use.

    How to Seek Relief

    As with all communications with the SEC, the company should ensure it is prepared prior to seeking relief. Being prepared includes conducting research to see if the SEC has issued guidance on a particular topic or provided relief, such as no-action relief, to other companies in similar circumstances. The SEC’s Financial Reporting Manual (FRM) should always be reviewed.

    The FRM may even provide for self-executing relief from certain requirements, especially where the SEC has granted similar relief on a regular basis. For example, the FRM now allows a company to file a “super 10-K” to catch up delinquent reports, without seeking relief from the SEC prior to doing so. As another example, companies may provide abbreviated financial statements for certain oil and gas properties without first seeking SEC relief.  Furthermore, the FRM provides guidance on seeking relief in certain circumstances, including the criteria the staff will consider.

    As indicated in the rule, a request for relief should be in writing to the appropriate staff member(s). However, under the new regime, the SEC encourages companies to engage in conversations with the SEC staff prior to submitting the written request. The company can discuss any items they believe are relevant to the determination, why they believe a particular disclosure is not necessary for that company’s investors and how and why preparation of the rule-mandated financial statements would be overly burdensome. To avoid unnecessary logjam, the SEC staff cautions against providing unnecessary background or peripheral information.

    Further 

    Background on SEC Disclosure Effectiveness Initiative

    I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.

    In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K.  The comment letter focused on disclosures related to materiality, known trends or uncertainties, critical accounting estimates, strategy, intellectual property rights, sustainability, litigation and risk factors.  For a review of the comment letter, see HERE.

    In October, 2017 the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.

    On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”).  The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE.

    On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

    On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.

    On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

    On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. This proposal is slated for action in this year’s SEC regulatory agenda.

    That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

    As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Both of these items are slated for action in this year’s SEC regulatory agenda.

    As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

    In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

    In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE. These items are all included in this year’s SEC regulatory agenda.

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